Betting Uncle Sam goes bankrupt

Bloomberg is reporting that credit default swaps (CDS) on U.S. Treasury debt are trading at record high prices of 56 basis points. A market participant buying the credit default swap insurance is essentially betting the U.S. Treasury is going bankrupt. That makes no sense.

First of all, U.S. Treasury debt is conveniently denominated in U.S. dollars. It turns out that if the U.S. government needs more dollars, it can simply fire up the printing press and print some more. That would normally be a bad idea (ask Germany), but there is a strong case that printing money would be better than defaulting on debt. Of course, U.S. Treasury CDS could be different than standard CDS. They could be structured to pay out if the U.S. merely monetizes its debt, instead of defaulting. In that case, can anyone recommend a good broker for buying Treasury CDS?

The second reason Treasury CDS contracts are nonsensical: who exactly do you buy them from? If the U.S. Treasury is defaulting on debt, how bad have things gotten? Who is still in business that is willing to pay out on the insurance policy? U.S. banks that are already dependent on the government? U.K. banks that have even higher leverage than U.S. banks? How about me? I would be a great counter-party: I pay my rent on time every month, and the student loans on my personal balance sheet are backed by highly valued (ahem) intangible assets: accumulated knowledge and transformational experiences.

Outside of the People's Bank of China (who holds one trillion dollars or so of U.S. debt), there does not seem to be any credible counterparty. So who exactly is buying these things? And how do they rationalize these two objections?

Sometimes the refs really do suck

In 2004, professional basketball fans were treated to the “Malice at the Palace,” the name given to the famous Detroit Pistons-Indiana Pacers brawl that took place at Auburn Hills. Years of distrust and enmity between two rival teams finally boiled over at the end of an extremely physical game. Fists flew, benches cleared and players went into the stands to battle the fans. The police were called in and the remainder of the game was cancelled. In the aftermath, players were suspended, people went to jail and the NBA dramatically increased its oversight of players’ on and off court behavior.

The somewhat ironic location of the brawl highlights a metaphorical connection to today’s credit crisis. The NBA’s (read: government) failure to provide adequate oversight of both the players (companies) and the game (financial markets) led to a brawl (credit crunch) that ended up injuring fans (economic recession). In the post-melee analysis it became clear that players, fans and the NBA all shared some portion of the blame. One group that went notably absent from criticism was the referees who let that game get out of hand.

One could argue that the credit ratings agencies (Moody’s, S&P, Fitch) act as referees in the financial marketplace. They don’t set the rules of the game and they don’t decide who gets to play in the game, but using their credit ratings as a whistle, they interpret what constitutes a foul, and which shots should be rewarded with points. They can dramatically impact the outcome of game and players, coaches and fans do everything they can to manipulate their calls.

One could also argue that the rapid escalation of the crisis resulted from bad refereeing by the credit agencies. For years they failed to adequately scrutinize the underlying risk of mortgage backed securities, only taking notice after the risk had burrowed its way into the foundations of our economy. Once that risk became apparent, how did they respond? By threatening or issuing waves of ratings downgrades that ground the credit market to a halt and sent companies into a frantic scramble for capital.

Their actions are not unlike those of ineffective referees who, having kept their whistles in their pockets for the first three quarters of play have allowed the game to get way out of hand. Suddenly they realize something is wrong, and in a vain attempt to restore order they blow their whistles and start handing out fouls to everyone. Things that were acceptable in the first quarter now suddenly merit a technical foul. The fans erupt, players behave irrationally and eventually the game grinds to a halt.

In retrospect, we really should have seen this coming. The agency problems extant in the industry are well-known. Ratings agencies are paid for their services by the very companies whose creditworthiness they are supposed to analyze. This is hardly a recipe for objectivity. While criticism has already begun to emerge from some corners, we haven’t seen any real outrage at the role of credit-rating agencies. Before lobbing “sleeping at the wheel” accusations at the SEC, the Fed, banks and irresponsible homeowners, we should consider taking a hard look at the credit ratings agencies that stood by and blithely let the game go on.

Show me the money!

The Wall Street Journal is reporting [gated] that Treasury's Troubled Asset Relief Program is being hampered by a lack of staff. Given what Treasury's civil service (i.e., non-political appointee) jobs have to offer potential job seekers, this should surprise no one.

First, consider what type of skills are necessary to help run the TARP. It is not dissimilar from a $700B hedge fund, and it requires similar skills: reading financial statements, creating models, and business judgment. In short, TARP requires the sort of skills obtained on Wall Street and at MBA programs. Treasury competes directly with these alternatives for the best talent, and a Treasury civil service career does not compare well, particularly on salary.

Business Week's top ten MBA programs all claim average starting salary above $100,000, with three programs exceeding the $120K mark, and this is just salary: most jobs include bonuses. A search of Treasury job postings yields five positions that could pay eventually pay $100K, and none where the starting pay exceeds $100K. The pay also tops out lower ($149K, lower than the total compensation of a starting management consultant at Bain, BCG, or McKinsey). This problem is not limited to Treasury; closing the salary differential between judges and private sector alternatives is frequently advocated.

There are other issues as well. Civil service career progression ends when the org chart switches from civil service to political appointee positions. The positions are not breeding grounds for lucrative private sector careers in the future. And, unlike Federal judges, the positions are not regarded as highly prestigious. Finally, the government bureaucracy has a reputation as slow to move, less focused on merit, and discouraging for the entrepreneurial types found in business schools. While the civil service has its benefits - work-life balance, job stability, and, importantly, pride in serving one's country - these benefits do not have top MBAs or Wall Street alumni rushing to Washington.

How to to fix this dilemma? There are examples of government bureaucracies that work. Japan's METI (f/k/a MITI) regularly recruits the nation's top graduates due METI's important role, exclusive hiring practices, and the resulting private sector opportunities. If Treasury's TARP promised similar long-term opportunities, it would have more success in recruiting the needed staff. But more important than that? Show them the money.

Is this a good sign or a bad sign?

Citigroup, after stubbornly insisting on paying out dividends, has realized how paradoxical that practice was. As noted elsewhere on this blog, dividends are a way to return excess capital to shareholders. Yet, Citigroup keeps raising capital - implying they have too little capital. Perhaps the Citi board thought that the dividend was necessary to hold up the share price, which is critical to issuing new equity.

So what explains cutting the dividend now? Has management just now realized that issuing dividends while raising capital both destroys value (round-tripping capital just generates fees and administrative costs) and confuses the market? Or is this a sign that Citi no longer believes it can rise capital from private sources, so why bother worrying whether cutting the dividend causes share prices to fall?

McCaskill-Grassley Bill – Wanted: Managing Director for TARP I, LP

On November 19, 2008 U.S. Senators Claire McCaskill (D-MO) and Chuck Grassley (R-IA) introduced the McCaskill-Grassley Bill to provide additional oversight of the Troubled Asset Relief Program (“TARP”). The bill is designed to increase the power and better define the role of the Special Inspector General (“IG”). The TARP was originally established to purchase troubled assets (bad mortgages) from the flailing financial institutions. The TARP has shifted the programs focus to the Capital Purchase Program (“CPP”), effectively functioning as a private equity fund focused on PIPE (private investments in public equities) investments in out-of-favor industries, which in fact would be every industry in the United States.

With two main focuses, US tax payers may have to take the good with the bad. The bill will “expand the authority of the IG to cover any and all action conducted as part of the Troubled Asset Relief Program.” Currently TARP I, LP is doweling out its LP’s (tax payers) money with only a few investment considerations in mind: (1) limited executive compensation, (2) clawback provisions in place, and (3) no golden parachutes. Missing from the investment committee’s analysis are (1) Tier 1 Capital ratio, (2) asset growth rate, (3) deposit market share, and (4) return on tangible equity, too name a few. As previously mentioned, on November 1 of this year the CBO listed the first $135B in TARP related investments as having a net present value of -$17B; thankfully these investments are not carried at fair market value. Using the KBW Regional Bank Index as a proxy (which lost 25% form October 21 to November) the reported $-17B of TARP expenditures (negative investments) would stand at -$42B.

Additional oversight is necessary for the $700B TARP plan which equates to early 5% of US GDP. Here in lies the bad; the bill will also “give the IG temporary hiring power.” With a government’s P&L that looks strikingly similar to that of General Motors, the US Government is taking on G&A – a hiring binge that will inflate a bloated government. Oversight is important, but at what cost? Keynesians may find the additional government expenditures a demand side stimulus; a few Wall Street types can take their talent to the TARP. The demand side and supply side debate wages on, but both demand siders and supply siders would agree a better alternative would be to fund projects with long-term future benefit, namely infrastructure.

Post-Close work with a portfolio can help drive returns to LPs, but making good investments should be step one. Coupling some prudent oversight with more appropriate investment criterion (capital infusions in otherwise solvent banks) could provide tax payers with return on investment not simply a hope for return of investment.

Presidential Economics

The announcement of Barack Obama’s cabinet positions has generated begrudging acceptance from conservative quarters. The pending appointments of Timothy Geithner as Treasury Secretary, Larry Summers as Chairman of the Council of Economic Advisers and Peter Orszag as OMB head, serve as a sharp rebuke to voters who hoped/feared that the “Change We Need” would include a sophomoric dismantling of free-market capitalism. In an election that seemed especially polarizing, it is a testament to (although some may argue an indictment of) the stability of the American political system that the individuals eventually chosen to manage our governmental institutions fall within the same relatively narrow band of ideology that McCain’s picks would likely have occupied.

This not to say that the incoming administration won’t do everything it can to position itself as a dramatic shift from its predecessor. Barack Obama has spent the last 12 months (and will probably spend the next 12) casting America’s economic health in the direst terms possible. This time-honored strategy has worked well for previous presidents. Recessions are very effective tools for ousting the incumbent party and if marketed properly, can insure that the previous administration carries the blame for any economic woes that may occur during its successor’s watch. Case in point: during these waning days of the Bush administration, economists have lavished Barack Obama with consolation for the supposed mess that he has inherited. The storyline goes something like this: the irresponsible Bush administration has dug Obama into a cavernous hole that will require at least one term to crawl out of. Obama’s ambitious agenda of change will have to be shelved while he picks up the pieces of a destroyed economy.

While we will have to wait for history to reveal the true economic impact of this crisis- and by extension, the economic policies of the Bush administration- there is ample historical evidence to suggest that economists’ pity for Mr. Obama is misplaced. Since the end of WWII, there have been eight presidents who were elected and able to finish out a term (Kennedy, Nixon and Ford being the exceptions). Only three have left with approval ratings greater than 50% and all three of those were elected into deteriorating economic environments. Bill Clinton (1992-2000) and Ronald Reagan (1980-1988) were elected in the midst of full-fledged recessions, and Dwight Eisenhower (1952-1960) was elected during a slump that followed the period of inflationary spending associated with the Korean War. All three left office with positive approval ratings and a perceived legacy of prosperity firmly in hand.

Sources: http://www.measuringworth.com/ , http://www.presidency.ucsb.edu/

Conversely, those presidents who entered the White House in good economic times were either voted out of the White House or else forced to hand the keys over to the other party. Harry Truman (1945-1952), LBJ (1963-1969), Jimmy Carter (1976-1980) and George W. Bush (2000-2008) were all elected during periods of positive GDP growth, yet were ushered from the political scene in relative disgrace.

One can draw two different conclusions from this data. The first conclusion is that good leaders succeed irrespective of the challenge, while bad leaders are capable of screwing up anything. The other, more compelling argument is that the economy is cyclical. While presidents can use policy to either extend the length of an economic boom or shorten the period of a recovery, they are in a sense prisoners of timing and expectations. In abstract, most rational people recognize economic cyclicality as a natural, somewhat uncontrollable phenomenon. In practice, they prefer to blame one leader for the downturn and praise another for the recovery.*

Objective analysis may eventually prove George W. Bush culpable (to some degree) for the economic mess, and Barack Obama could emerge as the next great economic turnaround artist. Whatever the outcome, if the past serves as any guide for the future then the odds are stacked in Barack Obama’s favor.

*Note: It should be of little surprise that presidential approval ratings are strongly correlated to the growth of the economy. In the last forty years there have been three deviations from this historical relationship, all related to issues of national security. In 2001, George W. Bush enjoyed record approval ratings in the wake of 9/11 and the subsequent wars in Afghanistan and Iraq, despite a tumbling stock market and economic retraction at home. In 1991 George H.W. Bush presided over a similar scenario, as popularity for the first Gulf War initially overshadowed a receding economy. In 1952, Truman’s slide in popularity came in the wake of Gen. Douglas MacArthur’s firing and reflected growing unpopularity with the stalemated conflict in Korea. The economy actually grew during this initial downturn in Truman’s popularity. By the time the economic began trending downward in late 1952, Truman’s popularity was already low enough that his party was unwilling to support him for a third term.

GM's board takes Broadway

GM's board members' current woes would make Avenue Q's concerns in "Sucks to be me" seem manageable. With deteriorating profitability, a bailout looking less likely, and mangled PR, life as a GM board member is not fun these days. Might these board members need to worry about legal liability as well?

Board members are fiduciaries; that is, they must act in the best interests of the corporation and its shareholders. But when facing a possible bankruptcy, the board must give increasing consideration to the corporations creditors, who often end up as shareholders in bankrtupcy.

GM has stated repeatedly it is not considering bankruptcy as an option. But with the company's cash dwindling fast and a bailout - if it materializes - delayed for weeks, is this strategy of brinkmanship prudent? Could the lack of preparation for a bankruptcy lead to great harm to GM's stakeholders - workers, customers, creditors, etc. - in the event that a bankruptcy does materialize?

It is not difficult to make the argument that GM's board is abdicating its responsibility to take prudent measures in the best interest of the corporation. GM's board would be remiss in not pushing for a bailout, but it is equally irresponsible in assuming it will materialize.

UPDATE: The Wall Street Journal is reporting that GM's board is now considering a bankruptcy filing. According to the Journal, the Board is breaking with GM CEO Rick Wagoner in considering the filing, and "is committed to considering all options in light of circumstances as they may develop." Good, consider their fiduciary exposure covered. Now the nation can turn to hoping they make the tough decisions on restructuring required if GM is to pull through this crisis.

The fiduciary rubber meets the pension road

Business groups are asking Congress to delay required payments to pension funds, and a bi-partisan group of Senators seem willing to oblige by proposing the Pension Protection Technical Correction Act of 2008. The problem arises from the Pension Protection Act of 2006, which requires companies to fully fund pensions, paired with the recent securities markets declines that have greatly reduced the assets of existing pension plans. The result is that many companies will be forced to inject significant capital to pension funds to make up for the pension funds' losses.

This is indeed a hardship on companies. With capital constrained and profit margins declining, companies will have a difficult time procuring that capital. Even those companies with sufficient cash flow may find themselves deferring jobs-creating projects, as the capital for those projects is instead diverted to top-up pension assets. But many companies continue to reward shareholders while asking the government and labor for subsidies. Since shareholders are residual claimants, the government should seek to limit such actions.

The list of petitioning companies includes many - IBM, Rockwell Collins, ITT Corp, Northrop Grumman, to name a few - that are currently paying a dividend. In case their boards forgot, dividends are a way to return excess capital to shareholders. Eliminating these dividends would be an excellent source of cash to divert to pension funds.

While searching for more sources of capital, it would not be unreasonable to examine executive compensation. Executives who generate substantial profits are often paid substantial compensation, and it is unlikely you will find this space arguing for a restraint of the executive compensation market. However, pension accounting can distort earnings. In the current case, if the company needs to inject additional capital to pension funds now, it could mean previous earnings were overstated (see note on pension accounting below). If executives were paid in accordance with the profits generated in the past, and it turns out profits were actually overstated, it follows that executives were over-compensated. Clawing back compensation would free up cash to fund pensions.

But even for responsible companies, deferring payments to pension plans creates a subsidy, born by the Pension Benefit Guaranty Corporation and labor. The PBGC is an insurance scheme that insures pensions. If a company defers payments to underfunded pensions, and then goes bankrupt - and with Ford and Chrysler amongst the companies petitioning for this change, this is a real risk - someone must bear that loss. Retirees could see pensions reduced to the PBGC ceiling, and the PBGC would be obligated to fund any shortfalls to payout the guaranteed PBGC rate. If too many companies default, the PBGC could require taxpayer money to remain in operation, shifting the cost of these deffered payments directly to taxpayers.

So how should policymakers balance companies' legitimate need to defer contributions while minimizing the risk to labor and the PBGC?

First, ensure companies truly are in need of deferral by only allowing companies that ban dividends and share buybacks to participate. This eliminates a company's ability to divert capital to shareholders at the expense of labor or the government.

Second, charge participants a penalty rate to be insured by the PBGC. Currently, companies pay $9 per year for each $1,000 of unfunded, vested benefit. Given that participating companies will be cashflow constrained, they are at much higher risk of bankruptcy and should be made to pay a significantly higher rate - the exact rate to be determined by government actuaries, but in excess of expected losses. The premiums collected from this program could help offset any eventual costs to the PBGC, limiting the exposure to taxpayers, while still significantly relieving the cashflow burden. Instead of being required to fund the full amount of under-funding, companies would simply pay the higher insurance rate of, say, 4% of the under-funded amount.

With these two mechanisms in place, it will be up to the company's board to decide how to best proceed. Since the program is costly, companies should only participate if they have no better option. This will force boards to consider other ways to generate cash - and as noted above, a good place to look may be executive compensation. For those boards that determine funding the plan would be impossible or too costly, they can choose to participate at the costly rate. The board would have to exercise their fiduciary responsibility to choose the course of action that is best for the corporation. Hopefully, the much maligned hedge fund industry can help keep boards honest in making these decisions.

Note on pension accounting
Pension accounting is extraordinarily complex, and far too involved to explain in detail here. But, considering a stylized example should provide a similar benefit. Pensions are a substitute for wages. In short, a pension is part of the cost of paying workers, and therefore is similar to labor cost. The cost of this benefit is simple: the amount of cash the company must deposit today to pay pension benefits to the worker in the future. This cash will be invested, and the proceeds of that investment will be used to pay workers in the future. This amount - the amount of cash contributed today - is an expense, which runs through the income statement and lowers net income.

Now, if a company has to inject more cash today to make up for pension benefits incurred in previous years, that implies the company did not pay enough cash into the fund in the past. If the company did not pay enough earlier, that means its total EXPENSES were UNDERSTATED, and therefore its NET INCOME was OVERSTATED. In short, the company did not really make as much money as everyone thought. This is a particularly challenging issue, mostly due to the fact that the inverse is also true: if a pension is overfunded today, that implies that the company could have injected less cash and shown higher net income in the past. Measuring these changes every year creates significant volatility, and complicates this issue. It is not clear whether the pension fund will show gains or losses in subsequent years or not, creating confusion as to what exactly the appropriate assumptions are for determining "fully funded" pension plans, the expense associated with those plans, and the resulting financial statements.

I'll see your executive order, and raise you one

As the Obama administration prepares to takes office, there has been much ballyhoo regarding the speculated decision on the part of the President-Elect to overturn roughly 200 of President Bush's executive orders.

Rulings on these executive orders tend to large be the spoils of war. There has been a long tradition of incoming President of a different party reversing policies of the prior administration. President Reagan enacted a ban on incidental funding of abortion programs overseas through foreign aid restrictions. President Clinton overturned this when he came into office, and President G.W. Bush responded in kind.

On the energy front, the big prize is the 18-year executive order banning offshore drilling in certain areas of the coast of the United States. Both Congress and the President have the authority to enact this ban, and environmental groups are pushing hard for Obama to renege on an election promise to allow these coastal regions to be explored.

Two orders that conservationists are hoping to kill without too much controversy:
1. Order directing agencies to remove some restrictions and regulation regarding distribution of exploration permits to oil and gas companies
2. Order requiring agencies to issue "impact statements" if they adversely affect energy development

The huge irony here is that any action the Obama administration does or does not take is largely symbolic in nature. Any areas of the country that are opened up to exploration as a result of refusing to reinstitute the drilling ban are years away from being able to yield oil and gas. Since the price of oil has dropped dramatically in recent weeks, the impetus to explore and find proven reserves with a high extraction cost has also waned. Therefore, resolving this issue will not help the price at the pump, nor will it make a dent in the US’s dependence on foreign sources of oil.

Any debate on this issue is a total waste of time. Spending time on this debate will only detract from the real problem, which is to put a solution in place that will curb the long-term domestic demand for petroleum.

Hank channels Yossarian

Yossarian, the protagonist in Joseph Heller's Catch-22, tries to avoid additional missions as a bomber pilot by asserting he is crazy. However, military rules stipulate that an insane person must not suspect they are insane. Yossarian finds great frustration in trying to defeat this dilemma.

Treasury Secretary Hank Paulson must surely understand Yossarian's frustrations. After initial criticisms of the TARP, Secretary Paulson modified the plan to directly inject equity. Treasury was afraid injections would be stigmatized like Fed discount window lending, or worse - that banks not receiving capital would be assumed insolvent. To avoid this issue, Paulson required the biggest banks to take what had been advertised as "voluntary" government capital. Now the Treasury is taking heat for allowing these same banks to pay dividends, acquire foreign banks, and hoard capital instead of loaning it out. Here, Hank really starts to channel Yossarian. If he had restricted banks ability to pay dividends or make certain acquisitions, bank CEOs - and economic conservatives generally - would have been even more livid at being forced to accept government money. Without these restrictions, he watches $7B of taxpayer money flow to China.

The way out of Hank's catch-22 is to force this capital to be deployed to loans and restrict dividends and certain (e.g., foreign) acquisitions. Half of the $700B TARP funds already out the door, and the rest is waiting for the incoming Treasury Secretary. This Secretary will find it better to loan conditional capital to willing banks than to force ineffective loans on unwilling banks.

Review of the CBO’s Annual Report to Congress

In September the Congressional Budget Office (CBO) published The Budget and Economic Outlook: An Update (“The Update” references the September 2008 report).  The piece is developed to provide US Congress with a basis for comparison of current legislation to the proposed changes in tax law and spending allocations.  The report is developed in accordance to section 202(e) of the Congressional Budget Act of 1974; the CBO is instructed not to make recommendations, to simply report impartial analysis.  In addition to the annual report, the CBO publishes monthly results.  While the CBO may not be able to explicitly make recommendations, implicitly the CBO recommends that congress reign in spending, increase receipts, or both with the following statement regarding the long-term outlook, “Over the long term, the budget remains on an unsustainable path.” 

The Update paints a grim picture for the United States in terms of both the budget and economic outlook; two items that cannot be viewed in isolation.  The Update predicted a FY2008 deficit of $407B, which was actually $455B per the November 2008 Monthly Budget Review, verse $161B in 2007.  The deficit widened in 2008 as expenditures rose 8.3% year-over-year with flat revenue.  The revenue was flat primarily due to the February 2008 stimulus package.  Absent the rebates and depreciation tax credits, revenue would have increased 2.5%, lagging the growth in outlays.  The deficit is expected to remain greater than $400B (~3% of GDP) through 2009.

Absent a few years in the last 1990’s and early 2000’s, the United States has been effectively running deficits since the 1970.  The CBO’s An Analysis of the President’s Budgetary Proposals for Fiscal Year 2009 saw an end to this deficit spending, forecasting a net surplus of $0.3T over the ten year period ending 2018; unfortunately, The Update in September was in sharp contrast with an estimated aggregate deficit of $2.3T for the same period.  $1.0T of which is related to revised forecasts of outlays for defense spending in Iraq and Afghanistan; an additional $850B is a result of a downward revision in economic projections.  Outlays during the upcoming decade are forecasted in excess of the historical 40 year average of 20.6% of GDP.  While outlays are anticipated to rise during the period, receipts are anticipated rise as well from 17.3% of GDP in 2008 to 20% in 2012, resulting in a reduction in the annual deficit.

The unsustainable path is exacerbated by the aging US population.  Outlays for the foreseeable future will be categorized in three forms, Mandatory, Discretionary, and Net Interest; in Camelot not only would it only rain at night, but Net Interest would be a receipt.  Mandatory Outlays are established based on eligibility rules and benefit levels which are set in law (Medicare, Medicaid, Social Security, etc).  Mandatory outlays are the largest source of increases in outlays; healthcare costs are expected to increase from 4.6% of GDP in 2008 to 6.0% in 2018, a 30% increase over the decade.  Healthcare costs are expected to continue to explode to 12% by 2050.  Less substantially, Social Security is expected to increase from 4.3% of GDP to 5.0% by the end of the forecast period.  Over the near term, the CBO anticipates spikes in outlays for deposit insurance, unemployment, food stamps, and other payments related to the current economic recession.

Discretionary outlays are set a new each year in accordance to appropriations acts.  Discretionary expenditures are divided into defense (59% of discretionary) and non-defense (41%).  As noted earlier, defense spending was revised upward by $1.0T over the forecast period as a result of a nearly $0.1T increase in the 2009 budget, which was anticipated to continue annually during the forecasted period.  Discretionary outlays are subject to sharp swings and are difficult to forecast with substantial uncertainty in the composition of Congress and Presidential Suite.  The Update projects Net interest to jump 17% over the next year, which was developed prior to the passage of the Emergency Economic Stabilization Act of 2008.  The Update projected the national debt balance at $9,568B at the end of 2008, growing to $10,247B by the end of FY2009.  After recent treasury auctions totaling roughly $1.0T in prior three months, the US debt burden has swelled to $10,618B as of November 14, 2008.  The increased debt burden with further add to the previously forecasted 6.4% annual growth in net interest outlays reported in The Update. 

With forecasted increases in outlays, receipts will need to increase to narrow the projected deficit.  The projected deficits begin to fall in 2012 with the expiration of many tax provisions set in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and Jobs And Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) as of December 31, 2010.  Absent Congressional action to extend the provisions regarding capital gains, dividends, and ordinary income, statutory rates will increase for the 2011 tax year.  The elimination of such provisions will increase receipts to roughly 20% of GDP in 2012 and individual tax receipts will increase from 8.2% to 10.9% by 2018.  Over the prior decade capital gains has increased as a percent of receipts substantially, absent the dramatic decline in financial markets, this increase would be expected to continue until the expiration of the temporary decrease in capital gains rate to 15%.  Depressed asset prices and an increased statutory rate will decrease the level of receipts from capital gains. 

The November 7, 2008 Monthly Budget Review provided preliminary insight on the US post-TARP.  October 2008 saw receipts decline $13B with a $63B increase in outlays, resulting in a $77B increase in the monthly deficit year-over-year.  Included in the $63B increase in outlays was $17B related to TARP.  The CBO is reporting TARP payments based on the net present value of the Government’s investment in the troubled institutions.  The Government disbursed $115B in October, which according the CBO has a net present value of $98B, thus a $17B outlay. 

With the overall macroeconomic environment worsening, unemployment at 7.5% verse a predicted 6%, rising national debt burden, and evaporating consumer confidence, the likelihood of budget surpluses in the near-term are increasingly unlikely.  The unsustainable path of budget deficits and ballooning debt burden will continue to weigh on US citizens and global citizens.  Parents are no lot saving for their children’s education; instead they are borrowing against their children’s future income.

Is what’s good for GM good for the country?

Abstract: A modified Chapter 11 bankruptcy funded with DIP financing from the U.S. government would balance avoiding an economically painful GM liquidation with the need to restructure the firm to minimize distortions to the economy.

General Motors is about to drive off of a cliff with the U.S. economy riding shotgun – unless Washington intervenes with a well-crafted policy intervention. The GM debate has focused on the two extremes of a spectrum of options. One extreme allows private markets to work without government interference. The other demands government-provided financial assistance. Neither extreme is attractive.

Pure market solutions: an invitation to pro-cyclical downward spirals

Without intervention, GM will declare bankruptcy. When pundits urge no intervention, they probably assume a Chapter 11 bankruptcy. Chapter 11 restructures debts, changes contracts, and modifies strategy. Supervised by a Federal judge, it is politically insulated and a known, existing process. Unfortunately, it is not available to GM because of the lack of debtor-in-possession (DIP) loans at manageable interest rates. DIP loans provide cash necessary for the restructuring. Without DIP loans, Chapter 11 will not work for GM. DIP lenders are unlikely to lend to GM for three important reasons: (1) lack of available funds at banks due to the economic crisis, (2) GM’s inability, even with restructuring, to generate profits or cash flow anytime soon, and (3) assets worth little in a liquidation.

With the Chapter 11 door closed and without government intervention, GM would be forced to file a Chapter 7 (liquidation) bankruptcy. This liquidation process, where GM would shut down all operations and sell its assets, would be an economic nightmare. With constrained available capital and unattractive alternative uses, assets would command low prices. Layoffs of automotive and related workers could approach three million, pushing the unemployment rate towards 10%. Suppliers would lead a wave of bankruptcies ensnaring businesses nationwide. Financial institutions would be weakened by bad loans and credit default swap payments. The Pension Benefit Guaranty Corporation would assume GM’s pensions (which appear funded prior to the financial meltdown, save for Delphi's obligations). Amidst the turmoil, consumer confidence would plunge. It is not difficult to envision an economic meltdown that must be avoided.

Bailouts: distorting economic incentives

While less dramatic, injecting taxpayer capital – no strings attached – has its own faults. Bailouts add to already huge U.S. deficits, reduce the need to make painful restructuring decisions, halt the process of creative destruction, and undermine U.S. calls for other countries to liberalize. Wealth would be transferred from taxpayers to equity or debt holders, retirees, employees and/or customers, depending on structure. With precedent set, every U.S. business would go hat in hand to Washington for their own subsidy. Without meaningful restructuring, a GM bailout would avert economic disaster but come at significant cost to the long-term health of the U.S. economy.

Efficiently restructuring GM requires relying on market forces that will result in necessary economic losses for different stakeholders. Equity holders recover nothing, bondholders face significant losses, suppliers lose business, and employees – whether unionized or not – face layoffs and lower compensation. Unions must rethink work rules, VEBA arrangements, and the Job Bank, while the management that isn’t fired faces reduced compensation and perks. Taxpayers lose wealth to bailout the industry. It is important that these groups face some costs to minimize the moral hazard in subsequent years. While losses are important to the overall functioning of creative destruction through bankruptcy, each group will engage in political maneuvering to avoid these costs by leveraging political power and the threat of liquidation or strikes.

The balancing act

Policy-makers must realize that neither extreme is without substantial cost. A policy solution must balance limiting “collateral damage” to the U.S.’s citizens and economy with the market forces that could shape GM into a competitive company. Limiting collateral damage requires avoiding liquidation at all cost. But how to balance avoiding economic catastrophe on one hand and forcing restructuring on the other? Pure market mechanisms are indifferent to political forces but force restructuring. Policy makers avert economic disaster but cannot overcome political pressure to sufficiently restructure. Conditional DIP financing provided by the government for a Chapter 11 bankruptcy could balance these two aspects.

Attractiveness of Chapter 11 restructurings

Chapter 11 is attractive because it is an established procedure and relies largely on the market mechanism of creditors acting in self interest to achieve efficient outcomes. With Chapter 11, politicians would have difficulty interfering and creditors would act in their own self interests to maximize returns. Managers would not be fired due to political pressure, but rather only if the creditors thought someone else would do a better job. Union contracts would not be renegotiated on the basis of delivering votes in the next election, but on the basis of economic negotiations. This market mechanism would pervade nearly all decisions, with two importation exceptions.

First, DIP loan specifics – size and interest rate – are typically determined by competitive market forces that do not exist in this scenario. Therefore, a substitute must be found to determine loan size and rate. A third party restructuring firm could develop the restructuring plan in coordination with auto company management. By paying that firm based on the return on capital, the incentives would be to minimize both the amount and duration of capital deployed.

Second, a systematic risk regulator would be required to avoid decisions that maximize GM’s returns but threaten the wider industry. An ideal regulator would be from the Federal Reserve, a non-partisan, politically insulated institution that is already tapped to be the systematic risk regulator in a new Treasury proposal. This regulator would ensure that no actions taken by the bankruptcy court would undermine the broader economy. For instance, the regulator would be able to halt liquidations, require additional capital injections, or veto decisions that would cause waves of bankruptcies. This is the critical addition of a limit to the normal market forces that drive a bankruptcy proceeding.

In addition to the benefits described for the high probability that GM ended up in such a system, this mechanism also has the benefit of incentivizing parties to avoid bankruptcy. Currently, GM has a strong bargaining position to argue for a bailout: the alternative is economic disaster. However, if the government announces not that it will prevent a GM bankruptcy, but rather GM liquidation, management teams of GM and similar firms will be strongly incentivized to avoid filing for bankruptcy and the probability they are forced from their jobs.

Conclusion

Modified in these ways, a Chapter 11 bankruptcy system would provide the safeguards required to keep the economy from starting down a negative spiral while imposing the fewest distortions to the effective bankruptcy system already in place. It limits short-term dislocations by ensuring, via regulation, that a firm that is “too big to fail” does not create a procyclical economic decline while requiring painful restructuring that limits firms’ willingness to rely on government intervention.

The future of campaign finance

One of the biggest changes that will likely emerge from the 2008 presidential election is an overhaul of campaign finance rules. This election calls into question the continued relevance of both federal matching funds as well as federal limits on individual contributions.

Federal funding for presidential campaigns was instituted in the wake of Watergate as a means to limit the influence of special interest groups. Following the abuses perpetrated in the 1996 and 2000 campaigns, John McCain and Russ Feingold led the charge to add teeth to campaign finance laws. Commentators have already noted with irony that McCain’s demise in the last few weeks of the campaign was hastened by the very legislation that helped build his reputation as a reform-minded maverick.

Spending restrictions associated with federal funding left him unable to match the media blitz orchestrated by the Obama campaign. Buoyed by the sheer volume of money that poured into his campaign coffers, Obama chose the rational path and declined federal funding:

Individual Contributions vs. Federal Funding- 2008/2004 elections

Source: Federal Election Commission

Democrats had been the strongest supporters of campaign finance reform in recent years, having been out-organized and out-spent by Republicans for the better part of 25 years. Now that they have achieved a degree of parity, it remains to be seen who will emerge as the patron saint of federal election funding. If the program is to remain relevant, the government must either dramatically increase the amount of money available or else remove the spending restrictions altogether.

The fundraising success of the Obama campaign may also provide Democrats with a new perspective on federal limits to individual contributions. Obama raised nearly $600M in individual contributions, which comes out to about $9 for each of the 65 million votes he received. Individual contributions are limited by FEC to $2,300 per candidate. Had those limits not been in place, Obama could have conceivably raised close to a billion dollars in individual contributions. These numbers reflect a fundamental shift in how people involve themselves in the democratic process. In today’s world, many voters’ preferred mode of political engagement to sign onto an e-mail list, join a Facebook group and then use PayPal to send their candidate $50. In that context, why should they be limited to $2,300? Why should they be limited at all?

In 1995, Harvard University Professor Robert Putnam wrote a now famous essay entitled Bowling Alone: America’s Declining Social Capital, in which he decried Americans’ increasing disengagement from civic organizations, local bowling leagues being one such example. He argues that national organizations have displaced local ones, dramatically changing the way in which Americans use their social capital:

Perhaps the traditional forms of civic organization whose decay we have been tracing have been replaced by vibrant new organizations. For example, national environmental organizations (like the Sierra Club) and feminist groups (like the National Organization for Women) grew rapidly during the 1970s and 1980s and now count hundreds of thousands of dues-paying members. An even more dramatic example is the American Association of Retired Persons (AARP), which grew exponentially from 400,000 card-carrying members in 1960 to 33 million in 1993, becoming (after the Catholic Church) the largest private organization in the world. The national administrators of these organizations are among the most feared lobbyists in Washington, in large part because of their massive mailing lists of presumably loyal members.

These new mass-membership organizations are plainly of great political importance…For the vast majority of their members, the only act of membership consists in writing a check for dues or perhaps occasionally reading a newsletter. Few ever attend any meetings of such organizations, and most are unlikely ever (knowingly) to encounter any other member. The bond between any two members of the Sierra Club is less like the bond between any two members of a gardening club and more like the bond between any two Red Sox fans (or perhaps any two devoted Honda owners): they root for the same team and they share some of the same interests, but they are unaware of each other's existence. Their ties, in short,are to common symbols, common leaders, and perhaps common ideals, but not to one another.

The 2008 election precisely confirms Putnam's hypothesis. As the last three elections have shown, presidential campaigns have evolved into powerful civic organizations. Campaign visionaries like Karl Rove and David Axelrod recognized the power of creating sustainable organizations in which contributors saw themselves more as members than as donors.

Detroit Automakers and Fuel Efficiency

About a month ago, this blog discussed Detroit's request for $25B in federal aid but it seems to have gone unnoticed during the creation of the $700B TARP.

As reported here, the original idea for the $25B in aid was that it was supposed to help ease burden on automakers who were mandated to improve their fuel efficiency 40% by 2020 as described in the Energy Independence. Thus, it was meant to be a long-term subsidy designed to help fuel R&D. Unfortunately, due to the economy and Detroit's pattern of behavior, it seems highly unlikely that the federal aid will ever be used for this purpose.

It turns out that October has been a terrible month for the domestic automakers. They have been burning through cash at a faster rate than any had forecasted, and GM and Chrysler are now seeking to merge in order to stave off filing for bankruptcy.

In addition to the $25B in aid, which has yet to be disbursed, GMAC (a GM subsidiary which holds auto mortgages) is looking to convert to a bank holding company in order to access the $700B in TARP funds. Furthermore, GM and Chrysler have asked for an additional $10B in federal funds in order to effect their merger.

What happened to reduced dependence on oil? Politics aside, it seems to me that the $25B will now never find its way into R&D in order to improve fuel efficiencies. Perhaps the money was better spent funding providing equity or debt capital to alternative energy or clean tech start ups and established companies. Indeed, if a private sector solution is not to one's liking, then there are plenty of government funded research programs at academic institutions and government labs which are perfectly equipped to start an organized research effort (see Manhattan Project or Apollo Program) with an end goal in mind.

Perhaps it's not to late. There has been talk of the government taking warrants in a combined GM / Chrysler entity which should allow it to push its energy policy through a private organization. Given that curbing gasoline usage in the transportation sector is the most important way to solve the country's energy needs this will make the government a long term partner in this sector. Thus, the government will create for itself a lever in the marketplace in addition to current regulatory mechanisms (fuel efficiency and emissions standards).