12 July 2008

The failings of the bailings

The following was originally presented at The Jacksonian Party.

With the headlines of two home mortgage insurance companies operating under federal guidelines and by those operating from appointment by the President, one does get to wonder just when the federal government will realize that it has very little part to play in housing. Or in bailing out companies. This is getting to be a habit of companies that face extinction due to poor business practices: claim you are 'too big to fail' and the federal government is supposed to come out with billions in support. This talk is not new, as we have all come to see, and the first of the big companies to seek a bailout was Chrysler. Making bad business decisions and having poor accounting procedures in the 1970's led the company on a path to insolvency. While the federal government had helped other companies, this would be the first that would seek substantial backing to survive. This was unusual for the US and many worried that the precedent set, then, would be repeated after that and more frequently and with larger price tags. Looking at Saving Chrysler article of 01 NOV 2005 by Mark W. Dirsmith (Source: All Business):

Legislators were perhaps more concerned with Chrysler as a precedent for the future than they were with consistency with the past. The spectre of a governmental inability to refuse any company in distress in the wake of a Chrysler bailout was proffered, albeit in an intentionally overstated manner (Panetta, 1979). The absence of decisional criteria made conversations of subsequent bailout candidates and susceptible industries range wildly. The epitome of this perspective characterised the Chrysler proposal as a push toward the replication of British subsidisation of industry of this era. Many worried that the problems of private industry would become an inexorable drain upon the public coffers. Again, accounting was not seen as a source of reliable criteria by which governmental assistance could be responsibly provided.


The core of the principled arguments against a bailout rested within the notion that failure was a confirming experience for the exposure of private ventures to the test of the marketplace. Since the well being of all was enhanced by the failure of the inefficient and ineffective (Paul, 1979). A governmental bailout was tantamount to a direct rejection of private enterprise (Friedman, 1979). Moreover, special assistance demonstrates a preference for a few private interests over the more diffuse public interests (Stevens, 1979).


Proponents of the bailout refuted the ideological conclusions of the free market thinkers and offered their own. The business version of the survival of the fittest was characterised as an outmoded depiction of the US economy now that the interconnections between elements of the system have increased (Nelson, 1979). Nothing sacred or novel was said to be involved when competition was already less than pure. Every large company already had an on-going array of relations with the government that were not at arm's length. A more assertive stance proposed that temporary intervention was consistent with the finest spirit of capitalism (Wylie, 1979). Along these lines, government's role in preventing market failure was called essential for the smooth functioning of the modern high-risk market (Eagleton, 1979).

Unlike bailout opponents, advocates indicated the desirability of an ad hoc analysis. Philosophic approaches about the proper function of government without sensitivity to the costs and benefits of particular circumstances were seen as self defeating. To the extent that ideological debate could be displaced, new types of information would take on increased importance. For example, accounting information could fill the breach once an inquiry into particular costs and benefits had been legitimated. However, there did not seem to be an appetite for the exploration of more technically rational questions about the efficiency of the allocation process. Arguments about philosophic predispositions could not set the tone for the introduction of accounting information.

Capitalism is, at heart, a philosophy of markets and trade supplying the best solutions to the greatest number of people at the lowest cost for highest profit margin. While the marketplace is, assuredly, not 'pure' due to such things as Anti-Trust regulation, Securities and Exchange Commission and various federal banking and business regulations, the idea that an 'impure' system improves with more interference is also a philosophical one. If the basics of the marketplace are to work, the foundering of a company, no matter how large, is not going to permanently harm the Nation. For such things as DoD equipment that is vital to the defense of the Nation, there already existed contracts and necessary law to allow for such parts of companies to be taken over if the companies failed: there was no national security part that can be worth mentioning as the government holds the ultimate card for national defense. That is part of the 'impurity' of the marketplace, and yet is highly limited to those things necessary to defend the entire Nation.

What the argument of those for the bailout was is very simple: political expediency. Any 'ad hoc' process that has no set definitions to it can come up with whatever end result those involved want. By not setting up a system of objectives, goals, and measurements for them, there is no ability to say if *any* action is warranted... or that any action *can* be warranted by this lack of structure. What you get is highly expected:

The multifaceted aspects of the process of attaining governmental support for Chrysler create a context that crowds out the use of real accounting information. In political processes, information is not neutral but instead exists within a system of resource mobilisation and interest alignment that itself is bounded by temporal constraints. In this instance, the accounting information could only be a small part of a much larger package that was manipulated and moderated in a short time frame by a host of parties with much to win or lose.

Raw numbers, market share, profit margin, efficiency of production, capability of sustaining a workforce... all of those have emotional impact to them inside the political process. In point of fact the entire political process *is* emotional and depends more on perception than the actual, real basis for decision making. By moving the question of a bailout from one of pure accounting and into the political arena, the emotional context can be brought into play and decisions slowly move from good economic sense to a biased weighting of emotional values. Thus producing 'gas guzzlers' became a point against Chrysler, no matter how well or poorly such cars sold in the market place - the emotional value of the words trumped actual economic activity.

President Carter, the man who came to Washington as an 'outsider' and with a populist and anti-corporate agenda would be the one to actually push this thing into the political arena. Such things as what compensation packages, or 'golden parachutes', executives would get were balanced against the United Auto Workers demands for representation and continuation of contracts. Even worse was the impact of regulations that caused the problems at Chrysler in the first place: by neglecting the market and being unable to flex their production capability effectively, regulations from CAFE standards and the EPA would negatively impact the cost of the vehicles sold. Not only were Chrysler's vehicles expensive, they were not selling despite their extremely high marketing overhead. In the era before 'Just In Time' production, this caused back-ups of cars in inventory and the loss due to depreciation as multiple model years were in storage meant that the company would be losing value each and every day a car was not sold. What came into play, however, was the fact that Chrysler was 'too big to fail':

Total GNP loss attributable to a Chrysler bankruptcy was estimated at $32 billion as a worse case scenario and $18-20 billion under the assumption that a healthy redeployment of resources would occur (Riegal, 1979). A large portion of this would be lost tax revenue, estimated at $10 billion (Brill, 1980) or less pessimistically, $6 billion (Riegal, 1979). The loss of tax revenue, plus the extra cost of unemployment benefits were estimated at $16 billion (Bohr, 1979). Less precisely denominated estimates of overall economic loss of between $10 billion and $2.7 billion (USNWR, 1979b) were offered. Any loss would add to a federal deficit, which at this time was just beginning to garner concern. Estimates of this incremental worsening included $2.75 billion for 1980 and 1981 (Whitten, 1979) and $11 billion over a longer time frame (Riegal, 1979). Revenue losses for state and local governments were estimated at $266 million (Whitten, 1979). The various estimates cannot be harmonised or compared due to the reckless, unsupported and casual manner they were presented, invariably providing no clue as to what assumptions were utilised. Nonetheless, the rhetorical power of these numbers was not dependent upon their ability to clarify and inform the decision.


The primitive economic analysis of isolated facts was another context for the Chrysler decision. The political process was unable to deal with a general equilibrium analysis which required a much more sophisticated set of tools than most that had voice in this debate could appreciate. For these purposes, the science of economics built a general structure that was not accountable. Therefore, more precise accounting data could not be brought to bear on the question of economic impact and the fairness of distributional consequences.

Yes, no one knew how much of a shock a loss of this large company would be to the US! Somehow the non-factoring in of foreign auto sales to replace domestic sales didn't seem to come into play, and the changes in trade balances that would cause. By being unable to evaluate economic activity, examine how the market could flex to the changes and safeguard against the very worst ones, the emotional analysis of Chrysler trumped anything that would be used in the monetary realm. The major worries of reduced federal income and increased unemployment coming just after the era of 'stagflation' would almost certainly guarantee more years of the same. Thus the company, as a system of employment and tax revenue generation had to continue, and the idea that a foreign purchaser could help out had already taken hold, in the company itself:

The most visible acts undertaken by Chrysler before the bailout was the sale of foreign operations. Under its previous leadership, Chrysler had become a multinational automobile producer. Although much money and managerial effort were invested, non-US operations never lived up to expectations. Sale of productive capacity abroad produced some liquidity. However, these transactions' largest contribution was to eliminate debt from the balance sheet (Business Week, 1979c). Other sales were made domestically that reduced Chrysler to an undiversified automotive maker and therefore presented the image of a "pure play" for Congress that would otherwise have been tainted by a diversified conglomerate structure.

Chrysler shed parts that had been a drag on it and sold off its foreign groups as they were a source of the debt that had been piling up. The question is: why did this require Congress to step in? What was provided was a series of loan guarantees to Chrysler which bolstered its backing even while it re-organized. This meant that a bailout was available only if confidence in the restructuring foundered, and if there was renewed confidence that the smaller and streamlined Chrysler would increase, then the guarantees would not be used. This forced a 'middle of the road' between bankruptcy and bailout, as neither were palatable economically. And yet the question still would arise: why is a company too big to fail?

An economic loss of one entity means that the market is now opened up in the areas that it once occupied. Other companies may take advantage of that or the entire market restructure along a new path that is not foreseen at the start of the problem. Saving a company is a form of emotional insurance and an attempt to continue on economic activity as it is as an enforced status quo.

Chrysler did set a precedent, however, and the next 'crisis' would be in the Savings & Loan companies that had moved into areas of competition they were not familiar with and would suffer from that inexperience. As various S&L organizations went insolvent, the threat of a run on them was starting to appear along with long lines of depositors wanting their money. Again, the actual balance sheet and budgetary numbers would be utilized in the political arena with emotion weighing more heavily than actual cost. A special report from Time Magazine on 20 FEB 1989 by Barbara Rudolph would look at this bailout:

One widespread early complaint was that Administration officials, notably Budget Director Richard Darman, were using sleight of hand to downplay the bailout's true cost. Darman originally seemed to say that the cost to taxpayers would total about $40 billion in the first decade, but that number in fact described only how much the plan would aggravate budget deficits. The actual spending from general revenues would be closer to $60 billion. But purely from an accounting standpoint, its impact will be offset by $20 billion in increased insurance-premium fees to be collected from the banking industry -- even though the funds will be earmarked for future banking bailouts rather than for cleaning up the thrifts.

Moreover, financial consultants pointed out that the Administration was projecting the cost of the rescue based on the rosy scenario of a robust economy, declining interest rates and fast-growing thrift deposits. Over the next decade, taxpayers may have to shoulder rescue costs that are tens of billions more dollars than now expected. Yet even those who recognized the Bush plan's shortcomings praised it as the best and boldest solution so far.

A primary objective of such a sweeping rescue was to restore the confidence of thrift depositors, some of whom have withdrawn their savings in fear of the system's insolvency. In fact, the Administration secretly feared a long-shot possibility that the drama of its bailout might spark a run on S & L deposits. To prepare for that dire prospect, senior White House officials and Federal Reserve Board Chairman Alan Greenspan met in the Roosevelt Room of the White House the night before Bush's plan was made public. Greenspan agreed that the Fed would stand ready to pump billions of dollars in emergency loans into threatened thrifts.

In the end, depositors stayed calm, even though some chafed at the idea of the cost of the bailout. "Honestly, it's the stupidest thing I've heard," said Leroy Scrues, a Detroit retiree. "Why should the public be paying for these rich peoples' mistakes?" Yet legislators and savers were relieved that Bush repudiated a proposal that his Administration had floated two weeks earlier: to levy a fee -- 25 cents for each $100 of deposits -- on all insured accounts. That ploy was widely seen as a tax in everything but name. The short-lived proposal was so distasteful that it made Bush's new plan seem all the more palatable. Said Fred Dorey, a Los Angeles medical statistician: "We were going to pay for it one way or another. At least the banks have to pay some too. It's a fair deal."

The healthy portion of the thrift industry will pay its share through an increase in its insurance premiums. The rate would rise from the current $2.08 per $1,000 of deposits to $2.30 from 1991 until 1994, after which it would decline to $1.80. The rate for banks would increase too, from 83 cents per $1,000 to $1.20 in 1990 and $1.50 thereafter. Even though both industries' insurance funds would be administered by the FDIC, their proceeds will be kept separate.


How did the S & Ls arrive at such a sorry state? Traditionally, running a thrift was a relatively tranquil business. S & L managers used to follow what was known as the 3-6-3 rule: pay depositors 3%, lend money at 6% and tee up at the golf course by 3 p.m. When interest rates remained stable, the strategy worked well. But by the late 1970s, thrifts began steadily losing depositors to the new money-market funds, which were not covered by deposit insurance and paid higher interest rates.

Thrift executives pressured Congress to let them fight back. In 1980 Congress lifted restrictions on interest rates that S & Ls could pay. But regulators waited a year before freeing the other side of the balance sheet by allowing S & Ls to grant adjustable-rate mortgages. The delay left the thrifts in a bind, because interest rates had rocketed from 13% at the end of 1979 to more than 20% a year later. Thrifts were collecting interest rates of around 8% or less on their 30-year mortgages, while paying double-digit interest to new depositors. During 1981 some 85% of all S & Ls were losing money.

Again the politically expedient route was taken, instead of letting the insolvent S&L institutions fail and having the solvent ones bought out by regular banks. Stability in the domestic economy was the goal and that was achieved by walking a line between full government intervention and take-over or letting the market do what it normally does. By 01 OCT 1990 Time Magazine would present an article by John Greenwald on what was going on:

At the height of his power in the Roaring Eighties, Charles Keating commanded an estimated $100 million personal fortune, controlled $1 billion in financial assets and counted a handful of U.S. Senators among his powerful buddies. Last week he stood as a wretched symbol of the past decade's financial follies. After the former owner of California's bankrupt Lincoln Savings and Loan was indicted on 42 counts of criminal fraud and was unable to raise the $5 million bail, police handcuffed and jailed him. California alleges that Keating bilked investors who bought $250 million of now virtually worthless junk bonds. The state's charges were the latest in a flood of legal actions against the disgraced businessman. Overall, taxpayers will have to pay more than $2 billion to clean up the mess left by Lincoln's collapse, one of the costliest in the nation.

Keating was the most visible villain last week in an S&L debacle that could cost Americans as much as $1 trillion, or some $30 a month for every household over the next four decades. In inflation-adjusted dollars, that is nearly twice the cost of the Vietnam War and almost four times the cost of the Korean conflict. So far, the government has seized more than 490 insolvent thrifts, or nearly one-fifth the entire industry. An additional 600 are troubled and may fail.

Even as jail doors slammed behind Keating, who remained in prison pending his arraignment next month, shock waves from the thrift crisis rippled across the U.S. The impact contributed to the budget deadlock in Washington and aggravated the slump in real estate prices in cities glutted with condominiums and office towers. In Denver federal regulators filed a $200 million lawsuit against the President's son Neil Bush and 10 other officials of the failed Silverado S&L, charging them with "gross negligence." Meanwhile, Neil Bush prepared to respond this week to previous federal charges that he abused his role as a Silverado director. In Congress, L. William Seidman, chairman of the Resolution Trust Corporation, asked for at least $100 billion for fiscal 1991 to keep the S&L bailout moving. Only a year ago, regulators had expected that $50 billion would do the job.

While Charles Keating would go behind bars, the actual solution would not provide much more than a temporary stability that would allow the various institutions to actually start to merge and shift into the rest of the normal banking structure. At the International Monetary Fund's Kenneth S. Rogoff would look at what the actual cost of the S&L bailout and looking at a similar one for the IMF in the 2002 SEP edition of Finance & Development:

So what could be the scale of the costs of moral hazard associated with the IMF's operations? First, consider an analogy. In the mid-1930s, the United States became the first country to establish a broad-based system of official insurance for bank deposits. This invention appears to have been a significant factor in the subsequent stability of the U.S. banking system and an important factor in banks' role as an engine of growth. Deposit insurance, like IMF lending, induces some moral hazard. But it was not until the savings and loan crisis of the 1980s that moral hazard engendered any significant fiscal cost. The ultimate cost of the savings and loan bailout amounted to some 3 percent of GDP. Was this such a stiff price for 50 years of stability? Of course, some other countries have fared worse, with bailouts amounting to 10 percent of GDP and more.

The cost of the scandals went beyond the institutions and by the federal government stepping in, that cost was passed on to the US taxpayer. While many would point to this as a 'soft landing' or 'middle of the road' or 'least of all bad results', the question is: why is the US taxpayer funding the poor economic behavior of investors that put money into them without due diligence? If Chrysler was a government backing to get the company to do something it should have already been doing, namely changing its management, outlook and corporate structure, then the S&L bailout was rewarding the negative behavior of investors who only cared about a bottom line return and not about the safety of their investments.

Now, for those with relatively short attention spans, there have been other large companies that faced very hard times and yet were not supported by the federal government. One of those was IBM, who had been a world leader in computing via some very nasty tactics and a powerful global presence, that allowed them to marginalize competitors. What they also did was to start up a small group looking to examine the realm of personal computing, seen mainly as a way to input data more efficiently into mainframes. What that would do, however, is put a start-up group in Boca Raton, FL that would scrabble for a way to get this done. They settled on commodity parts, an open architecture so that other could make pieces to fit into their computer, and an operating system. In each of these realms this group found the ability to execute these ideas and created something that would be the foundation of the IBM PC era. That era would also see a substantial shift in markets away from the monolith that was IBM and serious erode profitability, market-share and put the company at risk.

If IBM executed based on their old views of how to control markets, which was to put out proprietary architectures, such as the PS/2 Microchannel, then the smaller companies executed an extended ISA bus, then VESA, then PCI. By the last IBM was no longer a factor in the industry for components, software or hardware. IBM was forced to finally reconcile their business structure around the profitable areas, which were large scale integration and services, and jettison most of its hardware work to other companies. While it retained the laptop line for some time, the rest of the PC market was essentially ceded to upstarts, and the company actually invented new ways of organizing its sub-structures that were and are revolutionary by creating a continuous adjustment management system that relies on low level knowledge from all parts of the system to adapt the system itself.

What most people fail to realize is that the actual architecture of the PC is based around a microprocessor that, itself, was invented because of the failure of another giant: Fairchild Electronics. With the creation of the integrated circuit behind it, Fairchild could have become a dominant player in control circuit design, if it were not for its management. That management saw a great benefit in not disrupting its market and continuing in its profitable cycle as a market force for ICs. A group of engineers who wanted to do more left Fairchild and founded Intel which itself started to move towards a commodity memory market. What happened, however, is that the engineering basis of the company sought control circuitry for embedded devices as a way of marginally increasing profit. In one design they were asked to price out a central logic circuit for a hand calculator, and they put forward a price for it that was acceptable. What they did, however, was to design a non-dedicated logic chip which could be reprogrammed. That would become the central processing unit of the PC era after a couple of more design cycles and it was that chip that the Project Chess group chose over the more expensive chip from Motorola that Apple was using. Fairchild became footnote in the IC world, while Intel would found a new industry.

Intel, itself, once established, would farm out its older CPU manufacturing overseas to a Taiwanese company called AMD. What AMD would do was utilize more modern fabrication techniques to boost speed and throughput, and compete at the low-end margin of the component business. That remained true until the first rev of 64-bit chips, where AMD used their gained knowledge from designing competition for Intel in the 32-bit market, where its Athlons had taken a small market share, to put out a new 64-bit architecture that was not only different than the Intel design but better. It would be Microsoft, the company that was able to get the original contracts from IBM for the PC, that would be the market dominant force and it would choose which chip to design for. It chose AMD, which was a shock of sorts in the processing world. Although Intel would not suffer significantly from this, its role as market leader and innovator was challenged for the first time in decades. AMD would start to suffer management problems and, while still a market factor, has actually declined somewhat in how the market views it.

Microsoft was the 'Giant Killer' in this arrangement, with a start-up vision stated by Bill Gates in the late 1970's that he wanted a computer on everyone's desk running a Microsoft operating system. The fact that 90% of the world's PCs actually *run* a version of a Microsoft operating system *today* points out where an upstart vision can muscle aside a Giant of the industry and, itself, utilize very similar tactics bordering on the illegal to accomplish those goals. Microsoft would marginalize competitors, actually steal technology (like the Stac disk compression technology), and generally become the New Giant in PCs. One of the things lifted was from Apple computer, which was the graphical user interface. The GUI, however, had its roots starting in a demonstration of graphical computing in the late 1960's and then first instantiated at a market leader in another area.

When Steve Jobs toured the Xerox Palo Alto Research Center (PARC), he saw a vision of computing that actually worked: desktop computers with GUIs, all networked together with Ethernet, and attached to laser printers. Xerox PARC made possible the technology of Local Area Networks, GUI based computing for office work and the devices that would make it all possible.

And then couldn't market them or create them at a reasonable price.

In creating a vision of the future, Xerox had no intention of actually selling that vision, just a few parts of it. Bob Metcalf would take Ethernet with him and revolutionize the PC business, and the GUI would span hundreds of different implementations of which the Apple Macintosh is the best known. Microsoft would lift from that, from other GUIs and from the original ideas at Xerox PARC to create Windows. While starting out as a 'kludge' and still one in many respects, it represents a design legacy that traces its routes to academia and then a large company unable to realize that its vision of a networked office could make it money. Xerox PARC remained a place where visions of the possible future are tried out and some actually investigated a bit more...

The federal government would not step in to save IBM. Nor should it have done so as it served as a nucleus for a new industry that would change its role in the economy and actually increase overall economic production. Even Microsoft has no assured place for all the fact they have helped to make computing easier, and spread the headaches of its platforms to a global scale. Companies do fail, even when still existing, their management may so limit the view of what the company can do that it no longer remains competitive. When Fannie Mae and Freddie Mac were set up, the government intruded into the mortgage market to offer underwriting of loans to families. It is questionable as to if that was *ever* needed as it was a response to the Great Depression and changed the basis for what is and is not an acceptable risk to private mortgage lenders. The fact that the American people have realized this and have actively exploited the problems of poor management and political appointees to its own advantage is not putting just these two institutions at risk, but the credibility of the ideas that founded them: that government is the best place to actually *insure* mortgage risks and underwrite them.

If these two organizations are 'too large to fail' then just why have they been let alone to grow so large in their market share for mortgage underwriting? Do we not have Anti-Trust regulations to prevent this and disperse the risk across a broader market both public and private? Or is it the control of that portion of the market for private individuals that government seeks to control, so that those utilizing such mortgages come to rely upon the views of the federal government as to their credit worthiness and not private financial institutions? Just why *is* the federal government better to look at these things which were never given to it in the US Constitution to do?

That 'slippery slope' started by underwriting Chrysler, then bailing out the S&Ls now comes back very hard with the politically corrupting influence of appointees elected by NO ONE and accountable to NO SHAREHOLDER distorting how the public at large views the mortgage market. It is your money that the federal government wants to use to reward bad economic behavior on the part of its appointees and those encouraged to make unwise decisions by those appointees. Perhaps, as the federal government started this mess, it is time for it to get out of the direct market underwriting and manipulation area all together. Because, in the doing of those things, it is now the source of the problem.


Emmanual said...


A Jacksonian said...

Emmanual - It does to a great extent, but these latter day 'leaders' are micromanagers, not executives.

A leader sets policy and crafts events to it... and does not depend on Congress to do his or her work for them. Sad to say we don't have capable leadership any more as there aren't any people who look to policy, not plans. Plans means you think you know, in detail, what to do. Policy is the general direction you want to go and then you change the events to help further the policy.

Democracies require policy.

Authoritarian states require plans as the government 'knows better' what to do than you do particularly about your own life.

I've pretty much had it with the latter.