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Posted on: June 27th, 2011 Thought For The Day

“You are either in the process of living your dreams or denying them.  Living them is easier.”

Have fun, Robyn Allan

Posted on: December 28th, 2008 Loans to Chrysler and GM Part III-Side Bets Are The Real Addiction

Not a lot of what is happening with the Chrysler and GM bailout and rush to turn GMAC into a bank holding company makes business, financial or economic sense.  It does not make business sense because President Bush and Prime Minister Harper are asking for restructuring plans from auto executives who have proven over decades that they can’t come up with them.

It does not make financial sense because Chrysler and GM are exposed to significant obligations from the on and off-balance sheet risk of their financing arms–Chrysler Financial and General Motors Acceptance Corporation (GMAC).   Their extensive involvement with asset and mortgage backed securities (ABS and MBS) and related derivatives is going to absorb any taxpayer backed funding as quickly as it can be advanced.

It does not make economic sense because the extensive non-manufacturing needs of automakers is going to bleed resources away from jobs, production, and pensions.  The support the public thinks is going to workers and their communities through government loans–support that would make economic sense–will not materialize.  Valuable time and money will have been wasted.

It does not make sense, that is, until we acknowledge “the monster in the room”.

Concomitant with the rise in asset and mortgage-backed securities, and other clever financing vehicles, such as collateralized debt obligations (CDOs) of the kind that got Citigroup into trouble, there have been trillions of dollars of credit default swaps written (CDSs) against the success of The Big Three during the past five years.

CDS’s are insurance type contracts where the buyer, for a premium, can bet against the success of a company by taking out coverage against the default of its debt.   If the company goes into bankruptcy, or experiences any other form of credit event as defined in the contract, such as a downgrade, the buyer can collect on the policy.  To purchase protection, the buyer doesn’t have to own any stock in the company, or its debt; the buyer doesn’t have to have anything at risk to place a wager that the company will fail. If they are right, they get paid—assuming that is that the seller (companies like AIG, Citigroup, JP Morgan Chase) has enough capital to pay them.

It’s impossible to know exactly how many contracts there are against the success of Chrysler, GM or Ford. They are traded over the counter and hence are unregulated. However, since the notional value of the credit default swap market is about $45 trillion, and the bond market has been concerned for years about the credit worthiness of automakers, these contracts must be substantial.  In 2006, according to Fitch Ratings and the Federal Reserve Bank of Atlanta, the top referenced entities for volume of protection written were General Motors/GMAC at number one, Daimler/Chrysler at number three and Ford Motor Corp./Ford Credit at number six. The word on the street is that GM alone has $1 trillion in bets against its solvency.

Just take a minute to think about that.  If GM goes into bankruptcy, buyers of protection are going to call for payment on their insurance policies requiring banks and other CDS underwriters to cover $1 trillion in obligations.  Only a portion of these obligations relate directly to debt holdings of GM; say for example when a bank lends money to GM and then hedges its risk by taking out an insurance policy to cover any losses it may incur if GM fails to pay back the loan.  The rest, they are just side bets.

In 2006 the total debt recorded on GM’s balance sheet was $44 billion–a long way from $1 trillion.  Even if you add in the debt on GMAC’s balance sheet of $237 billion, there’s still a lot of insurance to be collected from speculative activity.  The remaining credit default swaps–the speculative side bets–are essentially wagers against the success of the economy.  They are what’s soaking up all the credit.  Speculators have short sold GM, Chrysler and Ford, and wittingly or not, the capitalist system.

The financial firms who wrote the protection on automakers do not have enough reserves to cover them.  This is similar to what happened with the sub-prime crisis and all the credit default swap protection written on mortgage-backed securities.  As insurance claims are made, underwriters (banks, investment dealers, insurance companies and hedge funds) scramble for whatever capital they have available.  When its not there they call for resources from taxpayers.  Real, productive, economic activity suffers–credit for authentic business and consumer demand dries up while the credit default swap monster is fed.

Unfortunately it appears that our current political leaders, ready to write checks that we honor, are not primarily concerned about people’s job or their pensions, or the horrific effect layoffs, plant closures and dealership terminations will have on communities across North America.  If they were they would take a different course of action than ensuring the credit default market is made whole.

They would be ensuring the safety of employment and the funding of pensions, not loaning vast quantities of money to companies who flow it through complex interlocking relationships to pay off derivative side bets while protecting their compensation plans.  The impact the failure of the credit default swap market is having on a few financial firms and wealthy investors is really what concerns the republicans and conservatives.  They want to make sure their colleagues are bailed out of the consequences from short selling North America while the rest of us suffer.

If they wanted to help workers and support real economic activity they would be focusing their efforts on manufacturing and job security. But, just like the auto executives who for years ignored manufacturing and production basics in favor of high finance, Bush and Harper are ignoring jobs and communities in favor of even higher finance.

Something meaningful could be done with very little cash on the line. Why not a joint venture between U.S. and Canadian taxpayers to buy Chrysler and GM outright with a plan to sell them to employees in the years ahead?  According to Cerberus, Chrysler’s 80% owner, Chrysler isn’t worth anything, so we could just take it off their hands.  And Daimler has written its 20% stake in the company down to zero. GM’s market cap is about $2.2 billion—Canada’s share would only be $440 million. At least the public could be assured industry renewal, jobs, pensions and getting financing to consumers would be the priorities in future decisions; not executive compensation, management fees, interest payments, and making whole investors in risky asset-backed securities and credit default swaps.

As far as the financing arms of automakers; cut them off before their contagion spreads further into the viability of industrial activity. Steps in that direction have already been initiated by turning GMAC into a bank holding company. Let’s be strategic about it and maintain some control and discipline on who gets paid and why they get paid.

As far as CDS side bets—it would be easy enough to pull the senior executives of the banks, securities firms and hedge funds into a room and impart to them the need to declare null and void all contracts that represent a side bet against the success of the economy.  That is, any CDS, where the holder has no direct interest at stake other than the desire to short sell capitalism, should be torn up.  Call it a stand against economic treason.  After all, contracts are made to be broken, just ask the auto workers.

Netting out CDS contracts that have no material benefit for the future of the economy is what is needed.  Instead of bringing down our economic system with the looming obligations,  we would constrain the damage and authentically get the economy running again.  The credit crunch–it’s the sound of the monster eating.  It’s time to stop feeding the monster.

Posted on: December 26th, 2008 Loans to Chrysler and GM Part II–Risky Credit Enabled Automakers’ Neglect

As part of the terms for $20 billion in public loans from Washington and Ottawa, Chrysler and GM must come up with a strategy for industrial renewal by March 2009.  It’s hard to see how they can given the automakers’ historical performance in developing manufacturing strategies.

Every time oil prices spiked in the last 40 years, US automakers struggled, but didn’t do much about it.  In 1980 Chrysler, on the brink of bankruptcy, went cap in hand and got $1.2 billion in government loan guarantees.  After 1980, from an industrial strategy perspective, nothing much changed.  Poor performance was without consequence.

By the late 1980s, with the development of securitization, auto executives found a way to forget about the demands of industry and began to behave a lot like bankers.  They developed excessive access to cash through their financing arms–GM had General Motors Acceptance Corporation (GMAC), Chrysler had Chrysler Financial and Ford had Ford Credit.  With securitization they were able to mask the fundamental weaknesses in their manufacturing strategy–fooling most of the people a lot of the time.

Today things have changed because financial markets are in chaos.  The Big Three are headed for failure.  They ignored market demand signals for decades; now their financing activities–once assets–have become huge liabilities.

Automakers stood by and watched their market share fall by almost 30% from 1995 - 2008; 20% of that decline in the past eight years. They focused on SUVs far longer than was prudent because of the wider profit margin they were able to realize on them.  A new strategy for smaller, more fuel efficient models would force them to live with narrower margins–not an easy adjustment.

The market for automobiles may be reaching a saturation point adding another degree of difficulty for manufacturers. Even without a recession–which is going to have a severe impact on fleet and other business related sales not to mention on consumer demand–the rate of increase in the demand for automobiles would be slowing down. This reality is not being discussed in all the lofty talks about returning the North American auto industry to profitability.

We have enough cars on the road. In 1960 there were 41 vehicles for every 100 people in the U.S. By 2006 it was double: there were 82 vehicles for every 100 people.  Growth in the demand for automobiles is certainly constrained. Rather than coming from an expanding market, future sales will come from vehicle obsolescence and population growth. What’s more, there are other long term trends at work reducing demand further. Peoples’ preferences for driving are changing because of environmental concerns and aging baby boomers have a tendency to lengthen the amount of time they take between purchases.

GM has ongoing obligations regarding the bankruptcy of its major supplier and former subsidiary Delphi.  Since spinning off Delphi a decade ago, GM has paid $7.5 billion to support the company. Delphi still requires $10.6 billion to emerge from bankruptcy. In September GM agreed to that support.  How do these obligations tie into the recent need for public sector loans?

What we do know for sure is that auto executives are adept at benign neglect.  Although that might qualify them for a job in the Treasury, Securities and Exchange Commission, or even on the Board of the Federal Reserve, it has disqualified them as industrialists.  They have proven they are unable to develop and implement effective manufacturing strategies.  Why do Bush and Harper think that over the next three months they can come up with ones that will work?

Not only have automakers failed as industrialists, they have failed as bankers.  These days, however, poor performance seems to be a precondition for reward–if an entity fails as a quasi-financial captive, after failing as a captive, like GMAC–it gets to become a bank holding company.  What makes the Treasury Department think that the same executives who created GMAC’s huge exposure will be able to shepherd them through these challenging times?

In 2007 Cerberus Capital Management, a private equity fund, bought 51% of GMAC from GM under the expectation that majority ownership would see GMAC’s credit rating improve and allow access to cheaper funding sources.   That didn’t happen.  The market already understood how compromised the company’s performance was.

All three automakers became extremely active in securitization during the early 1990s. They packaged up consumer automobile loans into asset-backed securities (ABS), thereby removing the receivables from their balance sheet, and sold them to investors.  By 1996 Chrysler was one of the largest issuers managing $28 billion in finance receivables. Their balance sheet assets were half that amount. It continued aggressively pursuing ABS throughout the decade. Chrysler’s exposure to off-balance sheet activity is probably greater in relative terms at present, although information regarding the recent past is being withheld by Cerberus (the same private equity fund that bought GMAC) who bought 80% of Chrysler from Daimler in 2007.

A rough estimate based on Chrysler’s historical activity and the size of the ABS market for auto loan receivables suggests its off-balance sheet exposure could be $100 - $150 billion.  With rising auto loan delinquencies and default rates, and the obligations Chrysler may have to fund shortfalls between the cash flow it receives and the cash flows investors expect, Chrysler Financial is potentially exposed to huge losses.

This unknown degree of exposure from off-balance sheet activity may be why we, as taxpayers, are really being asked for support; why we are being asked to do what Chrysler’s owner, Cerberus, wouldn’t.

In early December Bob Nardelli, Chrysler’s CEO told Congress that he had asked Cerberus for more funding but that the company had turned him down. Cerberus has approximately $27 billion in assets, and $100 billion in annual revenues.  Nardelli said that Cerberus is made up of investors who are unable “to commit…to put more” money into Chrysler. However, in October Cerberus loaned $1 billion to the Canadian Imperial Bank of Commerce to help it out with its sub-prime mortgage exposure. The return for that deal is expected to be 20% over three years.  Inability to provide support seems to be a relative issue—relative to whether or not there is money to be made.

What assurance do we have that public loans to automakers are not finding their way to Cerberus private equity investors through management and other fees? How do we know that taxpayers are not underwriting the returns to one of the largest private equity firms in the U.S.? At the very least, as part of the terms of the loan, a full accounting of the inter-company relationships should be forthcoming.

During the past decade, GMAC went a step further than Chrysler Financial and Ford Credit by expanding its securitization activities to include mortgages.  Its mortgage-backed securities (MBS) became a much larger part of its operation than its ABS activities backed by car loans.  In 2006 GMAC had $150 billion in off-balance sheet securities; $121 billion related to mortgages.  This is one of the reasons why GMAC’s financial problems started to present themselves early in 2007–GMAC was being hit hard by delinquencies and defaults in its sub-prime mortgage exposure. GM has been called upon to fund its 49% share of losses.  In the third quarter of 2008, GM’s year to date obligation was $2.7 billion.  Losses continue to mount because loan delinquencies and defaults in mortgages and car loans are rising.  By year end GM’s obligations could be substantially higher.

During much of the 1990s and into the first half of this decade, relatively cheap and ready cash from securitization meant that automakers were able to force-feed consumer demand. Not only has front-end loading of automobile purchases added to the current decline in demand, much like the sub-prime mortgage situation, lax underwriting standards have set up a wave of loan defaults in the months ahead.

Securitization accelerates and inflates the availability of credit.  An auto finance company, say Chrysler Financial, pools a number of auto loans into an ABS and sells this security to investors.  They promise to pay investors principle and interest, less a servicing fee.  Normally Chrysler Financial would have to wait for the cash flow from the loans to come in to make new loans.  By promising the stream of future payments to an investor, Chrysler Financial gets the value of the ABS up front.  If the ABS sells for $100 million, Chrysler Financial can turn around and make another $100 million in auto loans and then package them up into another ABS.

Each sale of a pool of loans to investors quickly enables another wave of lending.  How much more quickly does the access to ABS facilitate car sales?  The term for the average auto loan is a little over three years while the average ABS placement could happen in a matter of weeks.  Its easy to see how auto loan asset-backed securities grew from $71.4 billion in 1996 to $202.4 billion by 2006–a rate of almost 20% per year.

The automaker not only gets the profit from increased sales it also makes money on the servicing and financing of those sales.  Depending upon the accounting rules followed it may even be able to book the servicing profits from future years immediately, rather than waiting until the ABS has reached its term to maturity.  When market conditions are good, the results for car makers are really good since financing subs pass the profits through to the consolidated statements.  But when they turn bad…

Reported gains from financing activities are developed using assumptions about future market conditions. Prior to 2008 the future looked pretty bright and underlying estimates in financial statements reflected that outlook.  Things have changed dramatically; estimates will need to be adjusted. Cash and non-cash flows in consolidated statements will go the other way.  This will bleed necessary resources away from manufacturing. Losses from financial arrangements will prove to be far in excess of earnings from prior years—earnings that may prove to have been an illusion.

It has been known since the mid-1990’s that industrial firms who resort to ABS do so when they are financially weak; when debt markets have said “enough”.  The development of ABS market essentially enabled The Big Three to access funding when traditional debt markets were trying to signal that these companies posed too much risk; that they needed to do something about their business model. The market tried to speak–no one was listening.  Are we listening now?

Posted on: December 25th, 2008 Loans to Chrysler and GM Part I–There’s a Hole in Daddy’s Arm Where All the Money Goes

Protecting auto industry jobs, wages and pensions is extremely important, not just for workers, but for the economy. This is not going to happen with the direction Washington and Ottawa are taking. Providing billions in loans with oversight on major expenditures and asking for a recovery plan by March 2009 is tantamount to kissing the dollars goodbye.

Problems in the auto industry run much deeper than the sums being asked for. Although improved design and technology in manufacturing are needed, their absence are neither the biggest nor most expensive blunders made by automakers in recent years. Before structural reforms can take place we need to untangle complex and expensive arrangements embedded in automakers’ financing arms. If you look closely you can see track marks—this is an industry high on risky debt, over-exposed assets, and off-balance sheet arrangements that dwarf the problems apparent in their financial statements.

By the time March rolls around the extent of the damage may be so enormous that standing in line in front of debt holders won’t be anywhere near the front of the line of other creditors. Regardless, even before March automakers will be back asking for substantially more credit.

On December 19, 2008, President George Bush announced $17.4 billion in funding for Chrysler and General Motors (GM).  The next day, Prime Minister Stephen Harper announced $4 billion in Canadian dollar loans.  He said “we have a social responsibility that goes beyond the marketplace.” Nice words if he actually meant them. But he doesn’t. This is a man who just a month ago wanted to restrict public sector strike rights, suspend pay equity for women and stack the deck in favor of his party’s political funding.

Harper also said “we will not allow a catastrophic failure” of the Canadian auto industry. That also sounds good, except the Canadian auto industry takes its orders from its U.S. parent. If head office asks for the cash, head office will get it. Even if it means circuitously through inter-company relationships.

General Motors Acceptance Corporation of Canada (GMACCL) has CDN $7.7 billion in loans due over the next nine months.  General Motors Acceptance Corporation (GMAC) guarantees these obligations, and GM—who we’ve loaned money to—owns 49% of GMAC. A failure on GMACCL’s part to pay its debt could unduly harm GMAC—but wait, the credit facility granted by Canadian taxpayers may be a way to avoid the hit. It’s not clear whether the terms of the deal Harper made explicitly restricts such an event. The terms of the deal have not been made public even though taxpayers may ultimately be responsible for it.

On December 24, 2008, the Fed approved GMAC’s bank holding company application underscoring GMAC’s desperate situation.  The mortgage and auto financing activities must be deteriorating extremely rapidly to precipitate such dramatic action. Even with the requirement that GM’s ownership in GMAC be reduced to 10% sometime in the future, it’s hard to see how GM’s current obligation to fund 49% of GMAC’s losses will be avoided this year.

Then there’s the relationship between Chrysler and Chrysler Financial.  How do we know where the money is going and who’s receiving it?  Cerberus Capital Management, the private equity fund that bought 80% of Chrysler from Daimler in 2007, isn’t talking.   But in early December, Bob Nardelli, Chrysler’s CEO told Congress that Chrysler requires $4-$5 billion to make auto loans which gives us a little insight into the challenges the financing side of the business is facing.

Meanwhile, Daimler has written its remaining 20% ownership in Chrysler down to zero giving us an indication of what it thinks of the automaker’s future.  More significantly, in November Cerberus issued a press release accusing Daimler of “intentionally and materially” misrepresenting it underwriting practices of vehicle acquisition financing and leasing.  Cerberus alleges it suffered losses well in excess of what it should have and is demanding $7.2 billion from Daimler.

None of this information addresses the bigger issue regarding Chrysler Financial’s losses in its on and off-balance sheet financing activities.  If we are not being told how large that hole is, we can only assume it is very large.  As lenders, we should be privy to this information.  After all, look what happened with Citigroup and AIG after their initial granting of support.

Posted on: December 17th, 2008 Whose System Is It Anyway?

Three questions:  what went wrong, how will we fix it and how long will it take?  Not surprisingly the answers to question two and three depend on adequately answering “what went wrong”?

Unless we understand how the financial market floated out of control to create the biggest economic crisis in human history, the solutions prescribed to fix it will be mediocre at best.  They will prolong the downturn or create a false recovery setting in motion another crisis in the near term.  Our cultural tapestry is not strong enough to weather either result.

For this reason I am going to explain in clear economic terms what went wrong.  Before I begin I need to provide disclosure regarding my assumptions about the economic system and who it belongs to.

1. The Economy Is An Invention

We invented the capitalist market system as a method of allocating society’s resources efficiently and effectively.  We equipped it with a sophisticated credit structure and enforced it with property rights to fulfill wants and needs because it can work so effectively.  Critical to the invention of the market system is the acceptance of a series of beliefs about how people will behave.

As a culture we agree business people operate in their own self-interest; we believe it makes them work harder.  We agree that profit maximization is a worthy goal for entrepreneurs to determine the least cost method of production for the highest quality output.  We have decided that price is the most important signal in the market place for identifying consumer demand.  We support the availability of dependable information in a timely and reliable manner.  We believe that it’s unacceptable to misrepresent, mislead or lie.  We rely on competition to reward success and discipline failure and thereby expect that the best and brightest ways and means of doing things will surface.  Much of how we operate in the market is based on trust and the notion of good faith.

When the market fails, we feel shocked, but we also feel betrayed.  We forget that the nature of the economic game is such that is can easily become bigger than the players–and that the players are us.  We need to remember that the system is our invention.  We need to reclaim control over it by adjusting the terms of how it operates so we achieve economic success for the benefit of society.

A sustainable economic system must support our dreams and desires and, over time, improve the quality of life for all people.  The economic system should not be structured to benefit the privileged or the few at the expense of the many.  Participation in the economic system is a basic human right.  The game works on the notion that if you practice hard and play fair there is every reason to believe you can improve your standard of living and quality of life.

Why would sane people invent a system to work any other way?

2. Expect Market Failure

The market system requires sound regulatory control because there is nothing inherent within it to avoid market failure.  Market failure occurs when the pursuit of self-interest by one or a few players results in an unfair advantage in market power.  This unfair advantage results in actions that lead to unsatisfactory results for society, and in the extreme can cause the demise of the system.

Our system is a cat and mouse game.  Unfortunately, during the past three decades the role of government intervention in the economy has been demonized.  Not only have the mice been winning, they have evolved into rats.

Since markets are not self-adjusting intervention is necessary.  Effective regulation is a sign of a healthy system because it keeps the game honest and clean.  It is not the role or responsibility of business people to regulate their behavior in the public interest.  Their job is to play the game and endeavor to win–to try to seek an advantage.  It is the job of regulators to make sure that any advantages gained enhances the overall effective functioning of the system in the public interest.  If not, then the opportunity for advantage must be removed.  It is imperative that we hold both business and government accountable.

3. Capitalism and Democracy Are Not Inherently Compatible

Capitalism is good and democracy is good but they are not inherently compatible.  They both must be nurtured and protected to ensure they continue a healthy co-existence.

Capitalism is efficient and effective in deciding how goods and services are allocated and wants and needs met.  But our reliance on the market economy moves us away from democracy–away from one person; one vote.  It moves us toward a reliance on wealth to determine voice.  The price system determines that whoever has more money, has more decision making power, has more control and hence, has more freedom.

Our reliance on democracy to govern society attempts to redress this imbalance.  If efficiency was the main criteria then monarchy, dictatorship, fascism, or any other form of authoritarian control would be preferable.  But we have chosen to uphold the values of fairness, equality, and justice and we believe that each person has the right to participate.  Market capitalism attempts to exclude, democracy attempts to include.

To ensure democracy remains strong people must participate and hold the system accountable.  We must be engaged in the democratic process to ensure that the free market is not taken over by the interests of the few and powerful.  We must guard against the power of vested interests who attempt to weaken consumers and overburden taxpayers with the costs of their irresponsible and irreverent pursuit of money.  We must acknowledge their greed.  We must understand they will continue to behave in the same manner that got us into this mess as we are called upon to get them out of it.

As this crisis unfolds we must use the opportunity to demand full disclosure.  If public investment and/or loans are required then it is necessary the public obtain commensurate ownership and/or right to collateral that reflects the risk of the support.  We must reintroduce access to the credit markets for consumers–not just the business elite.  As business complains about how hard it is to cover checks it never should have written in the first place–we must remain strong.  These are alligator tears.

As government rushes to the rescue using our future to underwrite their plan without adequately protecting our interests, it must be stopped.  Government has spent the past thirty years perfecting the art of benign neglect, how can it be expected to understand how deep the problems run or how difficult it’s going to be to come out from under them.

This is going to be a long and drawn out problem, make no mistake.  You can’t create a tangled web of contracts, complete with inadequate security, unbridled risk, and destabilizing side-bets that amount to more than $55 trillion of toxic hot air and not have it pollute the workings of the entire system when it explodes.  It’s time to shift the balance of power.  We are being called upon to be accountable.  The least we deserve in return is commensurate control.  If nothing  more, it makes good business sense.

Posted on: December 8th, 2008 Are Canadian Taxpayers Being Asked To Bail Out US Sub-Prime Mortgages?

The major bailout of automakers seems to be focused on giving them financial room for survival while they restructure to make better, more fuel efficient and modern cars.  However, if we check under the hood, the bailout might actually be all about bad money management linked to the US sub-prime mortgage mess.

The looming bankruptcy is said to be caused by high fuel prices, changing consumer demand, wages and benefits, and an unexpected downturn in sales as a result of the global financial crisis.  There’s little argument those factors play their part in Detroit’s problems.  But, in fact, the problems today relate in large part to what auto manufacturers have been doing in the non-manufacturing side of their business.  Financing activities through General Motors Acceptance Corporation (GMAC), Chrysler Financial and to a lesser degree so far, Ford Motor Credit, have put at risk the jobs and retirement security of more than 400,000 Canadian workers.

By way of background, General Motors owns 49% of GMAC having sold 51% to Cerberus Capital Management in 2006. Chrysler owns Chrysler Financial but as of August 2007, Cerberus bought 80% of Chrysler from Daimler AG who still holds 20%. Ford owns Ford Motor Credit Co.

The interlocking relationship between manufacturing and financing must be understood. Steps need to be taken to ensure that any bailout package borne by Canadian taxpayers does not find its way to feeding the losses in the financial arms of the auto makers. If not, taxpayers could find themselves footing the bill for not only sub-standard auto loans to US consumers, but also bailing out a good chunk of the US sub-prime mortgage crisis. Without carefully negotiated rescue terms, layoffs and job losses are likely to continue with automakers failing anyway.

Financing arms of automakers were established to facilitate dealer inventories and auto purchases. This relationship was direct and risk underwritten accordingly. The financial side lent money to people to buy and lease cars and was responsible for collecting loan obligations. Funding future loans came from repayment proceeds and from direct debt; the cost of which was a function of corporate bond rating. When market conditions weakened, raising funds from traditional sources became more difficult so manufacturing adjusted and operating strategies more effectively matched economic realities.

Beginning in the early 1990s securitization became a new form of financing for automakers removing their need to rely on debt markets. Securitization takes place when asset-backed securities (ABS) are created from a pool of financial assets, such as auto loans. They are packaged together with the claims on loan repayment being sold in the market.

In 1997 ABS outstanding in the US were about $500 billion increasing rapidly to $2.5 trillion by 2007. Of these, $200 billion were backed by auto loans. What this meant was auto manufacturers had direct access to a new and powerful source of funding auto sales. They effectively front-end loaded consumer purchases. One of the major reasons for the downturn in demand is that the market has been saturated with inexpensive and easy credit terms made possible because of securitization. Many of these loans are now at risk.

Coincident with an increase in auto loan securitization was securitization of mortgages through mortgage-backed securities (MBS). Several major lenders used this market as a way to enter the sub-prime mortgage market. GM was a major player in the sub-prime market. By 2005 GMAC earned over 50% of its net revenue from its mortgage lending activity with total financing profits of $2.4 billion flowing through to GM’s bottom line.

In recent years however, GMAC’s mortgage lending activity has been the source of significant losses. In the third quarter of 2008 it recorded year to date losses of $3.7 billion. This year auto securitization activities also began to deteriorate with rising delinquencies and defaults. For the first three quarters of 2008, total losses in GMAC reached $5.6 billion putting GM on the hook for $2.7 billion.

Securitization isn’t the end of the story. Also important is the relationship between securitization, credit derivatives, and accounting methods used to record exposure. These can be the source of significant future losses.

In an effort to make ABS and MBS more marketable, particularly since the tech bubble burst in 2001, underwriters aggressively tried to minimize default risk through subordination where loan pools are segmented into different tranches. They also introduced a form of insurance called credit default swaps. These enhancements have actually increased risk, volatility and are partially responsible for massive, largely unanticipated losses.

Subordination of securities can result in the issuing agent holding an equity position and facing first claim on any losses. However, in order to place the securities in the first place, the agent may have given up its right to the underlying assets (that is, the cars or the houses the loans were made on). Its quite possible automaker financing arms have significantly reduced access to collateral when loans go sour.

The use of credit default swaps to reduce risk is a complex and sophisticated area of the derivatives market. The degree to which auto financing companies have been involved, either as a buyer or seller of default insurance, would need to be clearly understood. Otherwise, there is a potential for a very long tail of obligations to potentially numerous related financial institutions that has nothing to do with the making and selling of automobiles.

Creative structuring of ABS and MBS in specialized vehicles can allow them to be recorded off-balance sheet thereby reducing capital requirements and providing an appearance of greater return on equity. That is unless market conditions deteriorate and they are brought back onto the balance sheet. More capital can be needed in a hurry.

An effective barrier between manufacturing and financial obligations needs to be established with assurances that Canadian taxpayer money will not used to pay for credit market mismanagement. Last week, automakers asked Ottawa and Ontario for $6.8 billion in assistance. Any funding needs to go to maintaining jobs and supporting communities in Canada, not to paying off the bad decisions of US financial executives in the sub-prime mortgage and auto receivables markets.

Posted on: November 26th, 2008 Time to Stop Feeding the Monster

In a democratic society the economy should work to support people rather than people working to support it.  Let’s not forget we invented the economy—every bit of it, from the creation of money and credit, to the way we keep score with double entry bookkeeping, to the notion of GNP and theories of monetary and fiscal policy.  When things go terribly wrong, as they have in recent months, we should be able to reinvent a functioning system not have it turn on us like some Frankenstein monster.

Our market system is exceptional.  It needs to be rescued.  But to function it requires good information and a clear connection between cause and effect.  We have lost that connection.  Nowhere is this more evident than the myth the sub-prime market was responsible for the current financial crisis.  The facts show that the market was neither large enough nor struggling enough to cause this chaos.

At the end of 2006, when large US mortgage lenders started to fall like dominoes, the entire mortgage market in the US was worth $10 trillion.  The sub-prime portion, and its close cousin the slightly better-heeled Alt A, represented 15% and 5%, respectively.  At its peak, when financial executives started to call in their insurance policies, the pool of high risks mortgages was about $2 trillion.

Let’s think about that.  The tab for the financial crisis in the US is $7.8 trillion.  For a quarter of the cost all homes underlying sub-prime mortgages could have been purchased outright.  The US could have had a housing program for its low and middle income families envied around the world, rather than what its ending up with; a corporate welfare scheme shoring up the bad decisions of a few hundred financial executives.

When the sub-prime mortgage market allegedly triggered this crisis, delinquency and default rates were lower than they had been in 2001-2002.  The problems could have, and should have, been contained and redressed well within traditional mortgage lending practices if the old rules of the game had been in play.  But they weren’t.

What’s changed?  Enter the monster.  In less than five years the rules of the game fundamentally changed due to the rise in power of derivatives markets and the underlying agreements embedded in the clauses of credit default swaps.¹

A credit default swap is a contract between two parties where the buyer makes regular payments to a seller in return for protection.  Although credit default swaps are often referred to as insurance, unlike insurance which requires the insured party own the protected assets, the holder of the swap does not need to.  In fact, the buyer of protection does not have to suffer a loss to collect—all that has to happen is for a predetermined default event to occur and the buyer collects a payment.  The existence of these contracts on a wide scale, often providing multiple contracts for the same class of assets, has transformed the historical market incentive to accurately assess and underwrite risk into an incentive to disregard it.

Consider the impact credit default swap protection had on mortgage loans.  Historically the prudent course of action, even within the sub-prime sector, was to keep known risks within a certain range:  some would-be home owners were refused.  Not so when you have unlimited protection.  No income,  no job, no assets, no problem.  Prudent business practices got in the way of gobbling up market share.  The appetite of the derivatives market for new mortgages was insatiable, as it was for credit card receivables, car loans, or any other activity that could be leveraged into an ante-up for the default swap market.  The market was fattened up and then?  Well, the monster sunk its teeth in.

The majority of credit default swaps last 1-5 years with a sizable increase in volume starting in 2004.  It’s like these bets against the success of the economy were sitting on the shelf chanting “don’t forget our best-before date”.  Remember, these are like insurance contracts without the insurance checks and balances of responsibility.  Knowing your pool is insured if defaults begin to climb reduces significantly the desire to mitigate them, particularly if the negotiation process takes you past an expiry date.

This built-in disincentive to take prudent action in the face of adverse circumstances is known in insurance circles as “moral hazard”.  The greater the degree of coverage, the easier the claims process, the more likely the insured party will act in a hazardous fashion—will act irresponsibly.

An absence of consequence ruins prudent lending practice and destroys the incentive to workout a solution when borrowers face difficulty.  Renegotiating loans, behind closed doors and in good faith, has become old school.  In the past we could rely on renegotiation to contain a downturn.  Not any more.  It’s not so much that credit is unavailable, its that its going to feed the monster leaving the rest of the market to starve.

The unwillingness of lenders to renegotiate loans is now seeping into the consumer retailing sector causing large companies to head straight for bankruptcy rather than seek the useful protection of Chapter 11.  The closed door to renegotiation in the private sector is what causes companies to ask for government bailouts.

The recent $326 billion rescue package for Citigroup was in response to the company’s exposure to collateral debt obligations (CDOs).  Guess what, behind every synthetic CDO lurks a credit default swap, but its impossible to ascertain how Citigroup’s problems are in direct consequence of these obligations.  These contracts are generally held in entities not reflected on the balance sheet and the definition of credit events differ from contract to contract.  How, if and when they net out is important to know.  Based on their losses to date they’ve found themselves on the wrong side of protection way too often.  What we do know–a $25 billion problem grew thirteen times in a matter of weeks.

The powerful role credit default swaps play can not be overlooked in the recent requests for public aid from the top three auto makers.  Both US and Canadian governments are being pressured to come up with bailout packages.  What assurance is there that the money will not just go to the holders of swaps to pay off their positions?  These contracts have a tail and depending on their terms, financial institutions may be able to benefit many times over on the same pool of assets.  The nature of these agreements is that they thrive on instability and volatility.  When the tangled web of agreements are unwound its quite possible auto manufacturers will fail anyway because the rescue aid was not directed to its intended purpose.

Protection of industrial activity and jobs is critical, but if we continue to rescue entities who are lined up for slaughter to feed the economically unreasonable demands of derivatives contracts, we will not find the solutions we seek.  Until we reign in the derivatives mess we’re looking at taxpayers bailing out just about everything—except ourselves.  It’s time to stop feeding the monster.

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1.  In December 2004 the notional value of credit default swaps in the over-the-counter (OTC) derivatives market was $6.4 trillion (2.5% of the total notional value of all OTC derivatives contracts).  By December 2007 it was $57.9 trillion (9.7% of the notional value of all OTC derivatives) while credit default swaps to OTC derivatives contracts in terms of gross market values, went from 1.4% of the total in December 2004 to 14% in December 2007.  See Table 19, statistical appendix September 2008 and September 2007 Bank for International Settlements Quarterly Reviews.

Posted on: November 15th, 2008 International Financial Crisis — Swimming in Quicksand

Watching pension savings deteriorate and home equity evaporate while hearing we can expect layoffs, decreased output and lower incomes in the months ahead, is leaving many feeling bewildered and confused. Being told this bleak future is a result of defaults in the U.S. sub-prime mortgage market—a market very few of us even knew about, much less participated in—only adds to the confusion. How bad and how long it lasts depends upon whether governments accurately identify the magnitude of the problem and how quickly they adopt appropriate policy measures to solve it.

On Wednesday, October 29, the Federal Reserve Board in the United States released a statement¹ explaining its rationale for cutting the Fed funds rate to 1%. “Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures and official steps to strengthen financial systems should help over time to improve credit conditions and promote a return to moderate economic growth.”

Reassuring words, but unfortunately they belie the fact that the world’s most powerful central bank does not have a grasp on the problem we face. All policy measures focus on getting the free flow of credit moving. The Board believes that if they make money cheap enough, bankers will see the wisdom in lending to consumers and businesses, returning us to economic growth and price stability. After all, it worked to get us out of the tech bubble in 2001 didn’t it?

There is no possibility that monetary policy will work. The circumstances surrounding the current crisis are fundamentally different than ever before. It is not a flow of funds problem but a stock of funds problem. Until this is acknowledged the polite debate regarding the merits of monetary policy versus fiscal policy will drag on as the timeliness for implementing effective policy solutions becomes stale-dated.

Paul Krugman’s column² on Friday, October 31 in the New York Times, identified the crux of the issue. Monetary policy could work “unless for some reason the Fed can’t offset the fall in consumer spending.” The reason the Fed can’t offset the fall in consumer spending is because the economy is drowning in a liquidity trap. “Fed policy has lost most of its traction…the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year. The ongoing efforts to bail out the financial system, even if they work, won’t do more than slightly mitigate the problem.”

What is desperately required is an expansionist fiscal policy by government which would protect people from foreclosures. Large scale foreclosures don’t just hurt individuals, they hurt entire neighborhoods. Current estimates suggest that as high as one in five U. S. homeowners hold mortgages that are greater than the resale value of their home. Policy makers should also significantly increase spending on health care, education, public housing, roads, bridges, rapid transit, and other forms of productive physical assets. This will create meaningful employment and generate income that is sorely needed.

There’s no doubt consumer spending has decreased and access to credit has fallen off. What doesn’t make sense is how quickly the trend changed and by how much. When sub-prime mortgage market failures hit the news it seemed shocking that so many defaults could occur so quickly. Usually the effects of a downturn take much longer to feed into the economy and there are warning signs. When people have difficulty paying their mortgages, banks try to avoid triggering the lengthy and expensive process of repossession. Not this time.

The circumstances of this credit crisis are fundamentally different because of underlying agreements embedded in the clauses of derivative contracts called credit default swaps. ³ These contracts transform the incentive to renegotiate loans for a troubled debtor into incentives to trigger their write-off and collect on insurance. Why bother renegotiating at a lower interest rate and longer term to maturity when you can get a higher return by collecting insurance on the entire amount outstanding? Renegotiating loans, behind closed doors and in good faith, becomes outdated.

The incentive to renegotiate loans has always provided a type of holding-tank protection for market adjustments. It keeps things in a flow of funds environment. Renegotiated loans may be akin to swimming in dirty water: not very comfortable but you can still do it. Write-offs are akin to swimming in quicksand.

In and of itself the disincentive to restructure, although significant, would not cause a full scale collapse of the financial services sector. Coupled with the unique features of the derivatives market which allowed too many swaps to be written on the same pool of assets without corresponding reserves to back them up has multiplied the problem. When one entity triggers a default it sets in motion a string of calls, each with the incentive to trigger other calls. Multiple parties held rights to what historically would have been a single string of payments. Reserves are eaten up very quickly and institutions fail. These multiple claims help explain why the U.S. Treasury bailout to financial companies is already close to $3 trillion while the amount needed to forestall foreclosures directly would have been much less. ⁴

Until the nature and magnitude of the problem is acknowledged, U.S. federal policy makers are going to think and act like monetarists while banks and other financial institutions continue to think and act like liquidators. Accordingly, calls for meaningful solutions for homeowners are going to go unheeded with their problems translating into problems for us all.

The need to acknowledge this disconnect between financial institutions and consumers becomes even more critical in light of the impending problems in credit card and auto loan receivables. The market for credit receivables, packaged as asset-backed securities, is structured much the same way as the sub-prime mortgage market. It’s very likely this will be the next shock to hit the market. It’s hard to imagine how an already weakened system will absorb the hit if the policy response copies that of the sub-prime mortgage crisis.

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1. Board of Governors of the Federal Reserve, The Federal Open Market Committee decided to lower its target for the federal funds rate 50 basis points to 1 percent, Press Release, October 29, 2008.

2. Krugman, Paul, When Consumers Capitulate, New York Times, October 31, 2008.

3. For a broader discussion of the implications of the derivatives market see Scott-Quinn, Brian and Walmsley, Julian K., The Impact of Credit Derivatives on Securities Markets, International Securities Market Association, Zurich, Switzerland, 1998. and Arthur D. Little, Demystifying the Credit Crunch, July 2008.

4. As of November 10, 2008 the bailout package is estimated at $3 trillion including a $700 billion fund to buy equity and assets of troubled financial companies and $1.5 trillion in a term auction facility. A fund of $300 billion has been set aside for direct assistance to homeowners at risk on future mortgages, but lenders have been reluctant to access these funds. See Where AIG’s New Bailout Ranks, CNNMoney.com, November 10, 2008.