The Financial Accident Chain

With a tip of the hat to Mark the Pilot, the financial collapse was a confluence of unforeseen events in various sectors of the economy, all of which are largely regulated!

1. The mortgage backed securities business begins in the 80’; led by Salomon Brothers and largely due to the savings and loan industry collapse. S&L’s found themselves lending long at modest rates when they made mortgages and paying higher rates for short-term depositors and got squeezed out. The creation of mortgage backed securities allowed lenders to off-load the mortgage paper, a good thing, but also took some creditability out of the underwriting process and institutions were no longer directly impacted if the loans failed.
2. In the early 90’s there were concerns raised that banks and others were not lending enough in distressed areas (a process called redlining). Studies proved there were similar foreclosure rates across all neighborhoods suggesting the same underwriting criteria were being applied equally – basically the borrower needed a down payment and good credit. The problem wasn’t banks were overly protective in lending in distressed areas; there simply weren’t enough viable borrowers. Not good enough said the Clinton administration – we need more loans. Thus the relaxation of normal underwriting guidelines and the birth of sub-prime loans.
3. Meanwhile our friends on Wall Street determine sub-prime loans which carry a slightly higher interest rate can be bundled up, packages and also sold as mortgage backed securities and we are off to the races, so to speak.
4. Foreign emerging nations, China in particular, are now piling up hoards of US cash as they provide goods to the US. Typically investing in US Government securities, they are discouraged by low investment yields – Wall Street says have we got a deal for you – mortgage backed securities, particularly those backed by Fannie Mae and Freddie Mac – which – wink,wink – may have some form of Federal guarantee. Further, securities are broken into “traunches” which carry varying levels of risk and return. For example, the first 80% of the principal value carries a lower rate, as there was less likelihood of default.
5. The credit rating agencies (S&P, Moodys and Fitch), relying on historical data driven by tradiotonal lending – a down payment and good credit – improperly rate the newly minted securities giving a false sense of security to bond purchasers.
6. The Bush Administration makes home ownership a priority and does nothing to rein in the making of sub-prime mortgages prompting the beginning of Fannie Mae and Freddie Mac excesses. Congress also does nothing not wishing to squelch the American Dream for those who can’t afford it anyway.
7. The banks and Wall Street firms recognizing the profitability of the mortgage-backed securities leverage their own capital to unprecedented levels.
8. Alan Greenspan keeps the Fed rate low – banks borrow at 1-2% and invest in 5-6% mortgages. The new paradigm of the 3-6-3 rule: borrow at 3%, lend at 6% and on the golf course at 3:00.

Finally, as the economy slows, homeowners walk away from homes, the collateral value for mortgage-backed securities diminishes rapidly and the upward spiral in housing prices reverses to the detriment of all.

Who’s to blame: no one and everyone. As of July 2009, there have been no major scandals or indictments related to the collapse of the economy.

With all the political activity being devoted to health care reform based largely on the presumption that health care costs too much in this in country, have you noticed no one is asking why? We spend $2.5 million on healthcare in the=is country, more than twice what the Japanese spend per capita and the Japanese have longer life expectancies.

I asked my physician and her response (with owl edits), noting that like many aspects of modern society and economics, there are many facets is as follows:

1. Defensive medicine - the extra tests, cost of medical liability insurance, etc.

2. Patient expectations - since someone else is picking up the tab, patients request numerous tests, medicines, etc.

3. Medicare rules and procedures do not invite cost control. If a Medicaid patient wants an extra day in the hospital following a procedure, they get it and the hospital has to absorb the cost.

4. Refusal to pull the pug on the elderly when they are past any chance of meaningful life.

5. Obesity and the resultant cost for illnesses such as diabetes.

6. Poor lifestyle choices with respect to lack of exercise, overeating, smoking and drinking.

None of the matters are being addressed by Congress and health care reform will be non-existent until they are.

Socialism Lite

As we seem to be progressing toward European Democracy or “socialism lite” I have to wonder if US citizens have considered the overall standard of living in Europe. The European model is based on status vs. mobility.

In particular, based on news articles I have read:

1. I saw a comment that the overall standard of living was 30% lower than in the US ( see 3. and 4. Below).

2. Unemployment seems to average 2-3% above the US.

3. The cost of housing in Europe is relatively higher, percentage of home ownership lower and average dwelling unit size smaller.

4. I would guess, due to the cost of fuel and 1. Above, the typical European family has a small car and scooter (Fiat and a Vespa) as compared to the US desire for a family sedan and an SUV (Toyota Camry and Chevy Tahoe). GM thinks they have problems now!

5. Higher educational programs are more limited and expensive. Even in these difficult times the community college/state college and state university system in many of our states provides tremendous opportunity at very reasonable costs.

6. The role of ethnic minorities in business and government I suspect is far more limited.

As we embark on dramatic changes to our economy and social fabric, I thought it would be interesting to track the large numbers we toss about these days.

BIG NUMBERS

M = Millions

B = Billions

T = Trillions (million X million)

FEDERAL GOVERNMENT

2009 stimulus package $ 787B

Federal spending in FY2009: 4+T, 28.5% of GDP, highest level since WWII

Federal deficit: 2008 - $459B; 2009 - $1.845T

Federal revenues $2.5T in 2007, 18.8% of GDP

FY2010 Federal budget sent by White House $ 3.6T

Federal debt outstanding $11T (Mar 2009)

Interest on federal debt $412B per year

TAXES

Gross tax gap: taxes owed vs. paid $ 345B; estimate collectible $100B

Total income taxes $2.1T

Individual incomes taxes $1.1T (2006)

Paid by top 5% - $616B (Earn over $153k)

AUTOMOBILES

Loans to date to GM & Chrysler: $17.4B

Cars produced in US: 10M for 2009 vs. peak of 16M

US ECONOMY

Gross Domestic Product: 2009 - $14T

Value of US commercial real estate $ 6.5T; related mortgage debt $3.1T

Consumer home equity loans $1.1T; default rate 3% prox

ENERGY

Cost of President’s cap and trade program – $646B over 10 years

Cost per family of four - $4,500 per year

RECESSION

Loss of value from stock prices and home values - $12T

Effect on consumer spending - $600B

Unemployment rate 8.1%

Number unemployed – 5.7M

Last major recession: 1982 – unemployment 12.5%

The Bush Team Auto Analysis

Not much coming from the White House re: The Auto Bailout.  

My guess - a savvy team has been camped out in the Executive Office Building and figured out the business model being followed by the Detroit Three is totally dysfunctional and any tax payer dollars given them might just as well be set on fire and dumped in the Potomac River. 

Their conclusion so far is no doubt that only a per-arranged bankruptcy proceeding will work including (i) eliminating unprofitable brands and the associated dealer network (ii) re-writing the UAW contract to modestly reduce wages and benefits to existing workers but eliminating costly work rules which hamper productivity and efficiency (iii) reduce health care benefits to retirees - ie a silver standard instead of a gold standard and (iv) eliminate the CAFE rules requiring the Detroit Three to produce high mpg vehicles no one  in the US wants to buy.

How do you sell this plan to the Reid-Pelosi crowd???

Lastly, they no doubt looked around the room and asked "When was the last time you bought a Detroit Three made car?

It's the Cars, Stupid

Letter to WSJ:

I find it fascinating with all the attention and possibly cash being paid to the Detroit Three that there is little mention of the simple nuance, their product is not well received in the marketplace.  The infusion of government funds will not cause the buying public to become more enamored with automobiles perceived as poorly built, with dated styling and sold with inattentive customer service.

How do fix the Detroit Three: (i) move the headquarters to be near the car-buying public: mid-Atlantic, Florida, Texas, Southern California, (ii) give executives/managers a car allowance instead of the company's best made autos - let them replicate the car buying public experience and (iii) negotiate with the unions the elimination of costly and quality reducing work rules.

Since only the Detroit Three have UAW contracts and other foreign-owned domestic manufacturers have fared well, it is only common sense union leadership is culpable.

Regards, Mr. Owl

Who owns GM

GM  acknowledged in its most recent annual report that from 1993 to 2007 it spent $103 billion “to fund legacy pensions and retiree health care — an average of about $7 billion a year — a dramatic competitive and cash-flow disadvantage.” During those 15 years, G.M. paid only $13 billion or so in shareholder dividends. The company has been sending far more money to its retirees than to its owners.

NY Times Op Ed July 2008

Who shot General Motors? The company’s stock is at its lowest level in 50 years, and its market valuation has plunged to $5.9 billion, less than that of the Hershey candy-bar company. The automaker is weighing yet another round of layoffs — and maybe even a fire sale of venerable brands like Buick and Pontiac.

General Motors once manufactured half the cars on the American road, but now it sells barely 2 in 10. Bankruptcy is not unthinkable for Detroit’s former king. The immediate cause of G.M.’s distress, of course, is the surging price of oil, which has put a chill on the sale of gas-guzzling sport utility vehicles and trucks. The company’s failure to invest early enough in hybrids is another culprit. Years of poor car design is another.

But none of G.M.’s management miscues was so damaging to its long-term fate as the rich pensions and health care that robbed General Motors of its financial flexibility and, ultimately, of its cash.

General Motors established its pension in the “treaty of Detroit,” the five-year contract that it signed with the United Automobile Workers in 1950 that also provided health insurance and other benefits for the company’s workers. Walter Reuther, the union’s captain, would have preferred that the government provide pensions and health care to all citizens. He urged the automakers to “go down to Washington and fight with us” for federal benefits.

But the automakers wanted no part of socialized care. They seemed not to notice, as a union expert wrote, that if Washington didn’t provide social insurance it would be “sought from employers across the collective bargaining table.”

Detroit was too flush to envision that it would ever face a financial strain. Ford and Chrysler signed identical pacts with labor, so all three automakers were able to pass on their costs to customers. Besides, the industry’s work force was so young that few workers would be collecting a pension any time soon.

But pension commitments last forever. They far outlived Detroit’s prosperity.

General Motors got into the dubious habit of steadily increasing worker benefits. In 1961, G.M. was able to get away with a skimpy 2.5 percent increase in wages by also guaranteeing a 12 percent rise in pensions. Such promises significantly burdened the company’s future. As workers lived longer, the cost of fulfilling pension commitments rose. And health care costs exploded.

By the 1980s, it was clear that the Big Three automakers faced a serious threat from Japan. But General Motors and the U.A.W. were locked in a mutually destructive embrace. G.M., fearing the short-term consequences of a strike, continued to grant large increases in benefits — creating an intolerable gap between its costs and those of its foreign competitors. Union officials feared to face the rank and file without a big contract.

In the ’90s, the consequences of maintaining a corporate welfare state became too obvious to ignore. In that decade, General Motors poured tens of billions of dollars into its pension fund — an irretrievable loss of opportunity. What else might G.M. have accomplished with that money? It could have designed new cars or researched alternative fuels. Or it could have acquired half of Toyota — a company that the stock market now values at close to $150 billion.

G.M. acknowledged in its most recent annual report that from 1993 to 2007 it spent $103 billion “to fund legacy pensions and retiree health care — an average of about $7 billion a year — a dramatic competitive and cash-flow disadvantage.” During those 15 years, G.M. paid only $13 billion or so in shareholder dividends. The company has been sending far more money to its retirees than to its owners.

After falling $20 billion behind on its pension earlier this decade, G.M. doggedly put money into its plan to catch up. It has also agreed to invest more than $30 billion in a fund to cover future health-care expenses. But these efforts have starved its business.

The sorry decline of General Motors has proved Reuther right: the government is the better provider of social insurance. Let industry worry about selling products.

Unhappily, however, the fate of many public-sector pension plans is even worse than G.M.’s. Responding to the same temptation to offload expenses into the future, public employers have committed to trillions of dollars in future liabilities. In New Jersey, a huge pension liability has created a budgetary nightmare for the state. The city of Vallejo, Calif., burdened by police pensions, recently filed for bankruptcy.

Just as G.M.’s shareholders bore the burdens of its pensions, states and cities will have to force taxpayers to sacrifice in the form of service cuts, tax increases or both.

It is too late to restore G.M. to its former grandeur. But if public officials do not show courage by quickly funding the pensions they have promised to their workers, taxpayers will soon find themselves in an even worse crisis than the one G.M.’s shareholders are facing now.