February 6, 2009
CBO Stays Stimulus Bill Worse that Doing Nothing
The Congressional Budget Office, hardly a Republican bastion, has reported that the stimulus bill will lead to a lower GDP 5 to 10 years out than if Congress did nothing. The bill will crowd out private investment that has a higher chance of increasing GDP than the spending in the stimulus bill. Correction: Here is the cite to the letter. http://www.cbo.gov/ftpdocs/99xx/doc9987/Gregg_Year-by-Year_Stimulus.pdf
More Mortgages in Trouble: Neg-Am and Option-Am
The housing crisis is not over if we address subprime or even alt-A mortgages. While the subprime crisis may be peaking, there's another tsunami of defaults coming, this time from "prime" borrowers. Option Arms, Neg-Am's, and Alt-A mortgages, totaling in size of 2-3 times larger than the subprime market, are expected to default in percentages reaching 85% default rate. There are $500B of option arms alone. These products are exotic variations of "interest only" mortgages, but allow the borrower opportunities to pay only part of the interest, while having the rest of the interest charge added to the outstanding principal. Thus, the principal loan on these mortgages actually grows over time. These products usually reset (full interest and principal payments due) 5 years out. There will be a wave of resets beginning in late 2009, peaking in 2010, and ending in 2012. Thus far, only a few have reset, but almost 40% of them are already 2 months delinquent. Against their original plan, borrowers cannot refinance these mortgages because they are upside down on their loans (owe more than their house is worth) due to home price declines. This will be a wave of defaults that will further cripple the financial sector, as holders of these mortgages are the same holders of the toxic subprime debts. Most of these negative amortization mortgages were given to folks with good credit, "prime" borrowers, not the subprime market. Often, they also allowed borrowers to "state" their income rather than "verify" it, and the loans were traditionally "jumbo" in size (but with serious and unique problems that traditional jumbo's did not encompass). Obviously the reason you'd take a negative amortization loan is because you can't afford the purchase price now (or are flipping), but are betting prices will increase so you can refinance later. But that didn't happen, and as principal increased and home value decreased, any equity in the home was/is devastated.
These products were not disbursed across the country evenly like subprime loans, and are located almost entirely in a few states such as California and Florida. The current Senate's plan to stimulate housing with 4% interest rates and a $15,000 credit for homes bought in 2009 will not help this looming wave of defaults.
Arguments Over the History of Government Stimulus Packages
We all know the familiar quote: "Those who do not know history are doomed to repeat it." But there is another: "Those who know history are doomed to spin it." The history of the government works packages in Japan in the 90s and in the United States in the 30s is the subject of competition theories. All who study both periods agree that neither worked well. There was tremendous waste and the programs did not solve either economic crisis, other conditions did (the War in the United States and growth of demand for exports from Japan). There is stops. Big spenders argue 1) waste can be avoided and 2) the programs were not big enough. The United States, for example, hesitated in 1936 -- the debt was unnerving--and lost momentum. If we want to "go big", bigger than their Japan or the United States in the 30s, we will need to at least double the current spending bill -- we need to spend at least $2 Trillion. I am on the other side. The history shows the reverse: government spending bills do not work and they are inherently wasteful. Japan's history shows in detail that a spending bill written by a democratically elected legislature will necessarily include pork for everyone and will necessarily be wasteful (and backward looking). Our current bill is more evidence of the same. We are shocked, shocked, that the government has mispriced $78 b in TARP securities, has failed to follow the effects of $350 billion in TARP payments, and is currently fighting over obscure cash grants for golf courses. I am not; I expect it. The President's arrogant attempt at mocking critics "Of course, it's a spending bill...that's the point." is hilarious. We fools thought it was a "jobs bill" or a "GDP increase bill."
Keep in mind that on top of this $800 to $900 b "spending bill," we will spend another $350 b in TARP and another $600 b in the Fed rediscount purchases and may have another round of $1 T bank bailout packages in the works. We should ask our representatives in Congress first how we will pay it back, before we spend it. The payback debate should accompany the debate over whether we could use the babbles. Have you heard any serious discussion by Pelosi or Reid on how we pay it back??? The debates should not be over whether we need new schools and road, of course we do (Obama's arguments on the merits of the spending programs was disingenuous--of course, given no cost, we'd rather have the stuff), the debates should be over whether we can afford new schools
February 5, 2009
The Bank of America/ Merrill Lynch Deal: Questions, Questions
The Wall Street Journal's excellent front page story on the details behind the Bank of America purchase of Merrill Lynch raises many, many questions, both political and legal. The story reveals a Secretary of Treasury that forces an unwilling CEO of one of the country's largest banks to close a deal for one of the country's largest brokerage firm. The Secretary of the Treasury 1) impliedly threaten to fire the CEO through the country's bank regulatory system (even though it holds no-voting stock), 2) offered the CEO more government cash (which only came out several week later) to close and 3) appealed to the CEO's patriotism. The CEO took the cash, did not tell shareholders who have to vote on the deal a few days later, and later told reporters "he did it for the good of the country." As the Bank of America stock tanks on worries that the government will have to nationalize the bank, plaintiffs' lawyers are have a feeding frenzy, suing on allegations of, among other things, insufficient disclosure around the shareholder vote. If the government does nationalize the bank, the government will pay damages, if any, from the shareholder suits.
Man; this is a story for the ages. We will learn more when the inevitable best-selling book comes out on the deal.
The political issues:. 1) Do we want a Treasury Secretary making these kinds of calls on deals? 2) on leadership in major private banks? On the legal issues: 1) How could BofA lawyers give advice not to disclose on the shareholder vote? 2)Why should Lewis pay attention to Fed lawyers on the MAC clause? 3) How can Lewis not put BofA shareholders first (BofA is a Delaware corporation and Delaware has no constituency statute)? The over-riding management issue: Why did Lewis not have the guts to tell Paulson to go to hell -- that he was not closing a deal that would kill his company?
February 4, 2009
Executive Pay Caps: Goldman in the Driver's Seat -- Again
After the Treasury announcement at 11:00 of caps on executive salaries the stock market dropped from positive to negative and Goldman stock price shot up 6 percent will Bank of America stock price dropped like a rock. Goldman is in the catbird's seat; it has already collected $10 or 25 billion that it did not need (at a very low cost of a 5 percent dividend on preferred) and will be free of the salary caps (not asking for more) and able to hire all the best talent in the many companies that will still need money. Those companies that still need funds, like Bank of American and Citigroup, will bleed talent to Goldman (and Morgan, also in good shape) and only those not good enough to leave (to go to Goldman or to a hedge fund or to another financial institution that is not claiming money-- "boutique banks") will be left to deal with a struggling company, which, of course, rises on falls on the talent of its managers. The market sees the salary cap ruling as the potential final straw on the nationalization of the Bank of America and perhaps Citigroup. Well, maybe Bank of America can get the benefit of its old talent working now for Goldman by paying a fat consulting fee, $1 million a year perhaps, to Goldman.
The New Treasury Caps on Salary
Treasury has released new rules on executive compensation for financial institutional that receive federal bailout funds. In essence, those that get exceptional amounts cannot pay executives more than $500,000 in cash and, if they use stock or stock options, the equity cannot vest until the company has repaid all government loans or grants. Those firms that dip into government bailout funds in "normal" ways can waive the caps only if their shareholders vote to approve to waiver. Much ink will be spilled over this new announcement. But I have three comments. First, the government has discovered a very effective way to force companies to repay government grants and loans. These caps will be very unpopular with management, who will rush to escape the provision by repaying the government as quickly as possible. Second, the provisions are not retroactive and they could be. Treasury could have forced companies to repay the "shameful" bonuses already paid and could have forced companies who have already accepted money but will accept no more to adhere to the caps. So a bank that has taken $25 billion and will not take anymore, can pay under the old rules. And third, interestingly, a bank that needs funds could refuse them, go through the take Chapter 11 like reorganization procedure for banks, and still pay executives, in the reorganization and thereafter, more than the caps provide. Is this an incentive to go through insolvency proceedings?
Dow's Busted Deal for Rohm and Haas
Dow Chemical agreed to buy Rohm and Haas and signed a very, very seller biased contract. Now Dow wants out and seeks court sanction to do so. Is there room in the contract language? The Material Adverse Change Clause is very tight, excluding market conditions, even if they have a disproportionate effect on Dow. The remedy clause purports to give Rohm and Hass a contractual right to specific performance. Dow's only nugget in the language is an anti-third party beneficiary rule that may stop Rohm from claiming damages to shareholders from the loss of a purchase premium and that may stop Rohm shareholders from suing under the contract for damages. Dow has three arguments: 1) There was no breach; 2) The specific performance clause is not binding on a court; and 3) Rohm and Haas cannot argue for damages to its shareholders. 3) looks to be a winner; 1) and 2) depend on an appeal to the inherent power of a court to look beyond contract language, an uphill struggle. 2) appeals to a court's "equity powers" to order or not order specific performance that, arguably cannot be limited by contract. 1) will appeal to fringe contract doctrine cases (sometimes from the House of Lords or the King's Bench) that one may find in a first year contracts case book -- frustration of purpose and impossibility defenses (add, perhaps a void as a matter of public policy based on irreparable harm). At issue is an intriguing question for a judge. When is a contract "too tight" to be enforced? Is there some limit to using judges to enforce contracts that, due to events, rip the soul out of one party and put the other party in paradise?
February 3, 2009
Gantler v Stephens: Delaware Chancery Court Struggles Con't
An en banc panel of the Delaware Supreme Court recently overruled a decision by Vice Chancellor Parsons in a notable case. See Gantler v Stephens (Jan. 27, 2009). The Chancellors usually circulate their individual opinions to the full court before they are filed and therefore the lower opinion has passed muster by the other Vice Chancellors. How could they all be so wrong on such a fundamental application of a well-known standard? At issue was whether the board of directors of a Niles, Ohio bank breached their fiduciary duties in not accepting a friendly takeover offer. The Ohio bank had solicited offers to buy and attracted three interested suitors. The board apparently had second thoughts about selling to another bank and asked shareholders to approve a going private stock reclassification plan (which they did). In the first opinion, a Vice-Chancellor dismissed the case under the business judgment rule. In the en banc opinion, the Court agreed that the Unocal threshold was not applicable but refused to apply the business judgment rule nevertheless, stating that the bank board and its officers violated their duty of loyalty by acting under conflicts of interest. Similarly, the proxy was flawed for not revealing the conflicts and any board ratification was tainted by the conflicts that were not revealed. Two directors were conflicted because they were associated with companies or firms that did business with the bank and could lose a client. One director (also an officer) was conflicted because he refused to respond in a timely fashion to requests for information in a due diligence investigation. A second officer was conflicted because he was loyal to the first and worried about losing his job. Focus on this last fellow: The Court is coming very close to saying that a board or an officer is inherently conflicted if he or she is worried about losing a job. Once again, this would put all takeover decisions in the duty of loyalty category. The Delaware Court had never defined carefully what conflicts count and what conflicts do not count in board decisions in takeovers. The Vice-Chancellor's decision that was overruled is evidence of that. Why should outside directors worried about losing a client be different that an inside director worried about losing a job??? Why is a refusal to supply information evidence of a conflict (a director could just think it was a bad deal) neutral of a director's concern over a loss of his job? Unless the loss of the job is the conflict. A careful resolution of this issue is long, long overdue and this case does not help much. Corrected.
The Hidden Issue in the "Bad Bank" Solution: Rotten "Good Banks"
The press is reporting that President IBM's advisor's are considering a good bank/bad bank solution to financial institution crisis. The government will buy the "toxic" illiquid assets held by banks, leaving a good bank, and put the assets in one or more "bad banks" run by the government. The press is worried about the price the government will pay for hard to value illiquid assets: Pay too high a price and the taxpayers lock in a loss and the bank's shareholder's get a windfall gain; pay too low a price and the banks will not sell their toxic assets. Banks have begun strategically delaying write downs to hold out for the government offer, hoping the government will pay current balance sheet prices. If the government does pay balance sheet prices the honest pay and the dishonest win. But all this hides a significant underlying problem assuming the prices paid are plus or minus ten percent of the toxic assets fundamental value (whatever that is). Geithner knows that paying even approximate prices for toxic assets will force many banks, several very large, to declare that they are effectively insolvent. In other words, the cash paid will not be enough to meet capital reserve requirements and there is no more hiding behind delayed write down policies on the balance sheet to conceal the problem. After the purchase of the toxic assets we will have banks that either need to be wound up or receive immediate cash grant infusions from the federal government. What do we do with those banks? Give them cash before the purchase of toxic assets to cover up their distress but then suffer the bleating of their shareholders who will not want to share their windfall with the government? Give them cash to bail them out after the purchase and take shareholder equity without a complaint but worry about the "insolvency" word? Or wind them up anyway, cashing out shareholders and firing management, without any sale of their toxic assets? I prefer the latter, but government will choose the first of the three, giving shareholders a windfall.
TARP Terms: Obama Could Get Bonus Clawbacks
Banks, reading the small print in their term sheets after having received TARP funds have discovered that the federal government "unilaterally reserved" the right to make changes in the conditions that accompanying the acceptance of the money. In other words, if President Obama is genuinely upset about bank bonus payments he could order Treasury to force banks to get the bonuses back if the banks want to keep the TARP money.
Sobering News: The French Reject Our Socialist Stimulus Plan
The Prime Minister of France, Fillon, has rejected a call for an "Obama-style" stimulus plan that gives cash directly to blue collar workers and the unemployed. France has opted for a modest stimulus of $10b to infrastructure projects and another $10b in "early" business tax refunds. This rejection from Fillon comes in the face of huge demonstrations and some riots. France, calling us too socialist and too soft. Ouch.
Daschle and Geithner: The Damage to Tax Collection Has Been Done
Whether the President appoints Daschle or not, the damage has been done. Anyone close to tax enforcement knows that voluntary compliance with tax laws is necessary and essential for the system to work. The IRS does not have the resources to track down tax cheaters if the percentage of cheating climbs up to, say, the level of tax cheating in Italy. What Daschle and Geithner have done is convince ordinary citizens that paying taxes routinely and carefully every year is for suckers. Talk shows, newspapers and morning news shows are all over the tax "mistakes" of Daschle and Geithner and they all ask the same question -- "Is it that easy to cheat and not pay a penalty (or even interest on owed money)?"
February 2, 2009
Protectionism and Crisis
World leaders at Davos expressed concern over American protectionism in our new economic crisis relief packages. They are worried about 1) "Buy American" policies in Public Works projects; 2) "Loan American" pressure on banks recieveing bailout money; 3) Tax subsidies to exporting businesses that give aid in competition with foreign businesses; and 4) "Borrow American" or "Buy Only American Treasuries" effect on government debt issued by other countries. They are correct to worry.