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.