Friday, December 26, 2014

“It's a Wonderful Life” versus "The Interview"

Get serious

Washington and media are all aflutter about Sony's movie "The Interview."  One has to wonder what they are thinking.  No one has ever represented "The Interview" as worthy of serious minds.  Of course, at this point nobody who's talking about it has seen it.  So naturally, they can speak with authority about the political and social implications of the movie’s setbacks.  Such is the thinking of Washington and the media.
One doubts whether anyone, in Washington, the media, or the general public, thinks, even for a minute, that they would be better informed if they were allowed to watch "The Interview."  By contrast, ever since the very first posting on the Hedged Economist, at about this time of the year “It's a Wonderful Life” has provided a source of wisdom relevant to Washington and the general public.  Perhaps, rather than fretting about "The Interview," we should insist that policymakers take a break and go watch “It's a Wonderful Life.”
Just perusing the WALL STREET JOURNAL on December 20th provided two good examples of instances where “It's a Wonderful Life” would have provided policymakers with guidance they clearly need.  As we all know and are constantly reminded by the media, about six years ago we had a liquidity crisis.  Since we haven't had a change of administration since then, we still have a lot of people in Washington running around like chickens with their head cut off trying to fix whatever led to the last liquidity crisis.  Alas, they seem to have learned nothing from the actual experience of that crisis.  So, my hope is that if they view “It's a Wonderful Life,” the experience may help them to understand what happened.
The news is not encouraging.  For example, one of the lead stories on the 20th was “Bank Bailouts Approach a Final Reckoning.”  It summarized the experience of the Treasury as it completed the sale of its last holding from the assets it acquired during the financial crisis bailout program.  One has to love the media that can describe an investment that makes billions of dollars as a “bailout."  It would seem more realistic to refer to it as a low-risk, low-return investment for the Treasury.

To quote the above article: “The U.S. government closed a chapter in financial-crisis history Friday when it sold its remaining shares of Ally Financial Inc. and shuttered its auto-bailout program, ending the last major pieces of a $426 billion rescue package that saved a swath of U.S. companies but never won public support…. netted a small profit, returning $441.7 billion on the $426.4 billion invested in firms.”
“It's a Wonderful Life” contains a classic scene of the impact of a liquidity crisis.  While in the 21st century their form will change, in the 19th and 20th centuries they took the form of bank runs.  Bailey Building and Loan experiences a bank run.  When George Bailey decides to turn back from his honeymoon and go to the Building and Loan to manage the run, he finds the crowd there waiting for their money.

It seems that Washington wants to join the crowd in the lobby at Bailey Building and Loan.  First, remember when TARP was initially raised in Congress, Congress voted it down.  As circumstances would have it, I was on vacation and watching it with a friend as the vote was taken.  My comment at the time was that just the act of voting down TARP would extend the recession by a couple of years.  The vote would have to be reversed, but it was the sheer folly of Congress’s failure to address the “crowd in the lobby” that would extend the recession.  
As has been pointed out by Mr. Obama and Mr. Bush, TARP helped avert an even more severe recession following the financial crisis.  But, by demonstrating their collective ignorance, Congress raised serious doubts about whether that objective would be achieved.  That kind of uncertainty assured that the financial crisis would be deep and have lasting effects.

That's history.  Perhaps Congress has learned from its experience and realizes there is a role for a lender of last resort.  However, I wouldn't recommend getting one’s hopes up.  It seems Congress missed the little back room conference between Uncle Billy and George Bailey.

When George enters Bailey Building and Loan during the panic, he finds Uncle Billy a bit distraught.  Uncle Billy takes a strong drink and pulls George into the back room where he explains, between stammering that “we’re in a pickle,” that the bank called their loan and has drained their entire cash position.  Congress and a number of our national figures seem to have missed the point.  They believe that the Federal Reserve Bank's efforts to provide liquidity during the financial crisis put Wall Street’s interests ahead of Main Street’s.  Perhaps, Congress thinks it would be good to have such loans called. So, Congress outlawed future taxpayer bailouts as part of the 2010 Dodd-Frank law.  One can't find a stupider law or one that will do more to impede the response to the next liquidity crisis.

Since Congress reversed itself on the TARP vote and will come to recognize the stupidity of placing obstacles in the way of future responses to liquidity crises, what's the harm?  Well, as “It's a Wonderful Life” illustrates, liquidity crises are temporary, ephemeral phenomena.  Once George meets the liquidity demands of the first depositor, he then asks the next depositor what he really needs.  The response is $20.  Clearly, with the simple act of demonstrating the folly of the demand for liquidity, George has shifted the mental state of the depositors from one of panic to a more rational focus on what they actually need. 

If George had to wait for Congress to recognize the liquidity crisis before he would meet withdrawal requests, Ms. Davis would never have asked for only $17.50 and Bailey Building and Loan would have failed.  Alas, because Congress will have to scrap the Dodd Frank restrictions on bailouts before liquidity can be injected into the financial system; Congress may have ensured that there will never be a Ms. Davis.
Many of national leaders didn't realize from the start that the so-called bailouts would make a profit.  They didn't hear Bagehot’s advice echoing across the centuries.  Bagehot’s advice, “to lend freely against good collateral during times of financial crisis and you always make a profit,” has been demonstrated to be successful over centuries of experience.  But perhaps, if our leaders can't learn from history and can't learn from the recent financial crisis, they will learn from watching “It's a Wonderful Life.”
Mary and George recognize a liquidity crisis, identify the opportunity to invest, and as a consequence they save Bailey Building and Loan.  More important than saving Bailey Building and Loan is the fact that their action saves their borrowers from foreclosure and results in a wonderful life.

However, as the article notes: “Criticism has persisted that TARP put Wall Street ahead of troubled borrowers whose housing woes were at the root of the crisis….Less than $15 billion of $75 billion promised for homeowner assistance has been spent.”  It is worth noting the subtle change in terminology associated with that quote.  Note that the author presents the $75 billion as “promised.” That's quite different from the terminology used when discussing other parts of the bailout.  The difference between a guarantee to pay and a promise to pay is important.  A promise is much more likely to be viewed as an obligation that must be met while a guarantee is simply a promise that the obligation will be met if needed.
When discussing TARP loans to banks, one should remember that the Congressional authorization was over $700 billion.  The article reports the actual use of the lower expenditure, $426.4 billion.  One can get lost in the details of the accounting, but clearly the cost of TARP would have been far greater if the Fed hadn't essentially guaranteed liquidity.  Witness how European markets responded to the simple statement of their central bank that they would do “whatever is necessary." 

“It's a Wonderful Life” is more subtle as an explanation of why bailing out the banks worked but mortgage relief wouldn't.  One has to remember that many of the people clamoring for mortgage relief didn't lose the equity in their home.  They never had any equity in their home.  One can't lose something one never had.  By contrast, George Bailey can pay the first of his depositors and insist that it is just a loan, because he knows that the depositor has good collateral, the equity in his home.  Similarly, the TARP loans to the banks made sense if they were backed by good collateral.  The fact that the vast majority of the loans were repaid with a slight profit indicates that the collateral was good.  What collateral could underwater homeowners provide?  Using that simple criteria the Treasury lent to banks against good collateral, and as consequence, they were repaid.
That the Treasury demanded good collateral is apparent from the fact that some of the same people who criticize the Treasury for "giving" banks bailouts also complained that it didn't demand enough from the companies.  The contradiction doesn't seem to bother them.  For example, the article quotes Christy Romero, the TARP special inspector general,  as complaining, dare I say whining, that the Treasury did not get concessions from banks taking funds. “There were no strings on the money,” she said.  Perhaps, she forgot what happened when too many concessions were demanded from Lehman Brothers.  One has to wonder at the audacity of those who can feel that the intervening six years have not influenced their perception of the value of the collateral.

There is considerable potential for fault when it comes to the terms banks were forced to accept under TARP.  Bagehot makes the point that during the crisis the lending should be done at usury rates.  It's a legitimate argument that interest and a claim on future earnings in the form of a warrant wasn't adequate usury.  However, one has to wonder whether those complaining about banks receiving the loans would have been willing to accept similar terms.  It's also well worth noting that many banks wanted to opt out of the program.
Nevertheless, one has to admit that attaching a value to collateral during a financial crisis is a difficult task.  It's well worth noting that George Bailey when bailing out Bailey Building and Loan doesn't bother to try.  He does recognize that Potter’s offer of $.50 on the dollar is a disservice to his shareholders.  Potter has just taken over the bank at this point in the movie making him the perfect evil banker for the rest of the movie.  Perhaps, those who criticize TARP as not having inflicted enough pain on the banks view themselves as modern-day Potters.  The point is George Bailey is proved right in that $.50 on the dollar might clear the market but it hardly is justified once the liquidity crisis passes.

A second article in the Wall Street Journal on December 20th illustrates why this will always be a contentious point.  The article entitled “MetLife Vote Wasn’t Unanimous” discusses the decision of the Financial Stability Oversight Council to give the insurer the “systemically important” label.
Insurance does have a role in “It's a Wonderful Life.”  It is the asset (i.e., collateral) that George Bailey can offer to Potter when George is desperate for liquidity because of a lost deposit.

The Financial Stability Oversight Council’s reasoning is designed to explain their interpretation of “systemically important.”  It reveals much more.  It makes clear why regulators are totally unable to assess collateral during a liquidity crisis. 
So, one is left to wonder: what is the concern?  How could MetLife become systemically important?  The Financial Stability Oversight Council cites as reasons for the designation “the scale of MetLife’s investments and also the extent to which the value of that portfolio can fall.”  In other words, they're using mark-to-market accounting during a financial crisis.  Nothing could be less appropriate, unless, of course, they are going to force mark-to-market accounting on MetLife at a time when it's totally inappropriate.  If that's the case, it is the Financial Stability Oversight Council that presents the systemic risk.  Unfortunately, that seems to be the desire of many of the people who complain that TARP didn't impose sufficient costs on its recipients.

In summary, perhaps the next time Ron Paul or Elizabeth Warren are tempted to go into one of their rants about the evils of the bank bailouts they should instead take a deep breath, go to a quiet place, and watch “It's a Wonderful Life.”  The only thing that would be better would be if instead they would restrict their comments to the evils of Sony's decision concerning "The Interview." Wouldn’t that be a wonderful Christmas present?


Wednesday, December 17, 2014

Oil Prices

So, a simple question is what do we now do with cheap oil?  What to sell?  What to buy? 

I would suggest buying gasoline but only if the needle on your dashboard gets close to E. 

The widows and orphans portfolio that was posted on this blog a couple of years ago included Exxon and/or Chevron.  The logic behind holding them is that the dividends would be superior to what one could get in a savings account and would grow faster than inflation or rising interest rates.  The logic still holds.  So, someone who owned the widows and orphans portfolio would not do a thing.  On the other hand, if someone were constructing a portfolio, the current price of Exxon and/or Chevron would present a good entry point. 

As commentators have pointed out, the Saudi's might continue supplying enough oil to keep prices down, what they refer to as “a big sweat.” They have done it before in order to drive out higher cost producers.  If they do, Exxon and Chevron's stock could go down more, but their current prices looks good.  Exxon and Chevron will not be the producers that the Saudi's drive out of business.  It is very unlikely that the Saudi's will even be able to force them to cut dividends.  For a very good analysis of the issue of the dividend safety of various oil companies I'd recommend “Which Big Oil Dividends Are Safe?” published today on

There is one wrinkle.  US is now the second-largest oil producer.  A fair share of the high cost production the Saudi's are targeting is in the US.  Today General Electric outlined the effect of lower energy prices on its energy divisions.  We should anticipate more of those secondary effects on firm supplying the energy industry. 
ECONOMIST magazine had an interesting cover two weeks ago.  The title was "Sheikh vs shale."  It showed a picture of a sheikh and a roughneck standing back-to-back with their gas pumps drawn.  It is an interesting concept.  Shale producers are in many respects the swing supply.  However, unlike the high-cost producers of the past, shale production does not require a huge upfront fixed cost to develop the field.  In addition, although shale may be the swing production, it is not necessarily the highest cost production.  Consequently, shale production can gear up and down fairly easily.  Highly leverage producers may go under and have to sell their fields to that less leverage producers during periods when the industry is gearing back.  But, if prices go back up, those less leverage producers will quickly restore production.

If prices stay down long enough to reduce the drilling activity in shale fields, it may also cause extreme duress for other higher cost producers.  The Canadian tar sands are clearly vulnerable especially given the one-two of the Saudi's unwillingness to support prices and environmentalists success at delaying increases in efficiency of the transportation sector that would allow their production to reach global markets.  However, the greatest risk to the global economy may result from governments that own or have strong links to producers.  That affect is already shifting foreign exchange rates.  The Russian ruble has been an early casualty, but the risk to Venezuela, Nigeria, and to a lesser extent Brazil and Mexico are very real. 

The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.  Today PIMCO’s emerging-market fund is showing the stress caused by significant holdings of Russian bonds.  We should expect more of that.  In fact, a default by one of the government's that has nationalized its oil resources, and thus the risks associated with energy production, is not out of the question.  It is worth keeping in mind that the vast majority of oil reserves are owned by governments.

There will also be many winners and losers among European companies that export to Russia.  For US investors in US corporations, exports to Brazil and Mexico may be more important than Russia or Venezuela.  However, the major risk is not from slower exports.  One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.  That is a far greater risk for European banks than US banks.  However, some US banks, such as Citi, are so global, and the banking system of the developed economies are so linked, that financial dislocation is not out of the question.