GM, Banks, Bailouts and Incentives

With the GM IPO having succeeded so well this past week, the critics and nay-sayers have had to change tunes.  I don’t know that I really see the government investment in GM’s bankruptcy and restructuring as a “bailout”.  I see more as the kind of strategic government intervention that helps the economy that a good government does.  But, in the interests of brevity I’ll go with the common parlance of the critics and refer to the investment in GM as a “bailout”.  To understand my position better, see my post on the GM Tale.

The critics can no longer claim the GM was a waste of money.  The government has gotten back something near half of it’s original loans and equity money. The publicly traded market has now put a value on the remaining share ownership and  while it isn’t at break even yet, it’s very plausible that within a couple years the government could recoup all and even profit. The critics claimed GM was hopeless. They claimed the UAW was too overpaid and wouldn’t cooperate. Wrong again. A $2billion profit in 3rd quarter 2010 when total auto industry sales are still down 25% from 2007 disproves that charge.  The critics claimed it was socialism.  Judging by the strong investor demand for the IPO, it’s apparently the kind of socialism that capitalists want.

But now the critics claim that the whole GM bailout experience being successful sets up the wrong incentives. They claims that more large companies will seek big government bailouts too.  They’re wrong again. What the critics are suggesting is called “moral hazard” in economics.  It’s the idea that managers or firms, if they know they will be rescued or bailed out when things go bad, will start taking excessive and unjustified risks.  Moral hazard is the kind of situation where the incentives are wrong.  It’s what you intuitively expect to happen if you tell somebody to choose their risks, then tell them that the riskier choices have higher possible payouts, and that if the risk turns out OK the chooser can keep all the profits. But if the risk turns out bad, the chooser won’t suffer at all.  Obviously this is a “heads the chooser wins, tails the chooser sticks the loss to somebody else”.  Just as obviously, it’s not a good scenario.  It leads to wild and excessive risk taking and leaves other people to clean up the mess and take the loss.

The GM “bailout” doesn’t significantly increase moral hazard at all, though.  In contrast, our policies towards the large Wall Street banks has increased moral hazard.  Why does a GM bailout not create moral hazard but bank bailouts do? Simple. Despite legal and Supreme Court claims, corporations are not persons.  They do not make choices.  Managers of corporations make choices.  For a bailout or the prospect of a bailout when things go bad to create a moral hazard situation, the decision-maker, the person making the choice must be the one to get bailed out.  That means the manager(s).  Government bailouts create moral hazard when the managers are kept safe and allowed to profit when bets decisions go well and allowed to skate without consequence when their decisions don’t work.

In GM’s case, this didn’t happen.  Senior management lost their jobs.  Both Richard Waggoner and Fritz Henderson, both long-time GM managers who rose to CEO lost their jobs and were replaced by outsiders.  Further, the shareholders of GM got wiped out entirely.  They got zip, nada, zilch from the bankruptcy and turnaround.  In fact, technically, the “old GM” is being liquidated, it’s life over.  The IPO is in fact a new company.  No rational existing manager of another company wants to go through what Waggoner and Henderson did.  They want to avoid it.  No shareholder in any other corporation is looking at GM and hoping they can do the same – get wiped out. There’s no moral hazard setup here.

Where the moral hazard of bailouts has been created is with the banks.  The big banks, particularly JPMorgan Chase, Goldman Sachs, Citi and BofA, were all saved from disaster in late 2008 by the government investing billions more money than they did in GM.  Yet, not a single senior manager of those banks has suffered negative consequences as a result.  Quite the contrary, Wall Street hit record management bonues in 2009.  They actually learned that losing other peoples’ money and getting bailed out was a good thing for them personally.  Further, no common shareholder of those banks has suffered.  In fact, the government went out of it’s way to make sure the bailout didn’t affect dilute common shareholders when the government choose non-voting preferred stock as the way to make the bailout investment.  The bank bailouts – now that’s how you create moral hazard and keep them coming back for more.


The GM Tale

Earlier this week General Motors, the new post-bankruptcy GM, issued it’s Initial Public Offering.  Initial signs are very encouraging in several ways, which I’ll describe.  But first let’s take  a note.  Only 20 months, less than two years, The conservatives and tea party types were howling for GM to go bankrupt and for the government to not step in – just let it and Chrysler die along with what would probably have been nearly a million good U.S. jobs and the State of Michigan. Let’s revisit those events for a moment below the fold:

Continue reading

Even when banks pay back, they get bailed out.

Just sayin’…

Citigroup’s “Massive” Tax Break

by CalculatedRisk on 12/15/2009 11:11:00 PM

The WaPo has an article about a tax break for Citigroup: U.S. gave up billions in tax money in deal for Citigroup’s bailout repayment

The Internal Revenue Service on Friday issued an exception to long-standing tax rules for the benefit of Citigroup and a few other companies partially owned by the government. As a result, Citigroup will be allowed to retain billions of dollars worth of tax breaks that otherwise would decline in value when the government sells its stake to private investors.

While the Obama administration has said taxpayers are likely to profit from the sale of the Citigroup shares, accounting experts said the lost tax revenue could easily outstrip those profits.

Federal tax law lets companies reduce taxable income in a good year by the amount of losses in bad years. But the law limits the transfer of those benefits to new ownership as a way of preventing profitable companies from buying losers to avoid taxes. Under the law, the government’s sale of its 34 percent stake in Citigroup, combined with the company’s recent sales of stock to raise money, qualified as a change in ownership.

The IRS notice issued Friday saves Citigroup from the consequences by stipulating that the government’s share sale does not count toward the definition of an ownership change.

Who benefits? The value of the shares the U.S. owns should increase, but only 34% of the share price increase accrues to U.S. taxpayers The other current shareholders receive the rest. So this doesn’t seem to make sense … – BreakingNews – New bubble created by U.S. policy

Steven Pearlstein of the The Washington Post explains via this story in the Hamilton Spectator why the run-up in the stock exchange of the last 6 months isn’ t necessarily a good thing.  Instead of being a predictor of good times to come, the run-up in the stock market is more likely the latest in a series of financial bubbles.  We started with real estate & S&L’s in the 80’s, then it was dot-com’s and tech stocks in the nineties, then back to real estate and houses until 2006, then oil and commodities in 2007-8 (remember $130 barrel oil?).  We still aren’t reforming our financial system and we’re still letting speculators, bubble-blowers, and Wall St drive our policies.

Less encouraging is what’s happening on Wall Street. It turns out that all those bold and necessary steps by the Federal Reserve to prevent the financial system from collapsing wound up creating so much liquidity that it has now spawned another financial bubble.

Let’s start with the $1.45 trillion that the Fed has committed to propping up the mortgage market – money that, for the most part, was simply printed. Effectively, most of that has been used to buy up bonds issued by Fannie Mae and Freddie Mac from investors, who turned around and used the proceeds to buy “safer” U.S. Treasury bonds. At the same time, the Fed used an additional $300 billion to buy Treasurys directly. With all that money pouring into the market, you begin to understand why Treasury prices have risen, and interest rates have fallen, even at a time when the government is borrowing record amounts of new money.

At the same time it was printing all that money, the Fed was also lowering the interest rate at which banks borrow from the Fed and each other, to pretty close to zero. What didn’t change was the interest rate banks charged for everyone else. As a result, “spreads” between what banks pay for money and what they charge are near record highs.So who is doing the borrowing? By and large, it’s not households and businesses, which are reluctant to borrow during a recession. Rather, it’s hedge funds and other investors, who have been using the money to buy stocks, corporate bonds and commodities, driving prices to levels unsupported by the business and economic fundamentals.

I recommend reading the full story at the link.

The Geithner-Summers Plan: Let the games begin

In economics, “games” are not about recreation and fun.  Instead, “gaming” a system is figuring out how to get around the intent and profit by out-smarting the rules.  It looks like the Geithner-Summers plan to bailout the banks and get rid of their “toxic assets” is ripe for gaming. From Jeff Sachs of Columbia Univ via Huffingtion Post and the Calculated Risk:

Two weeks ago, I posted an article showing how the Geithner-Summers banking plan could potentially and unnecessarily transfer hundreds of billions of dollars of wealth from taxpayers to banks. The same basic arithmetic was later described by Joseph Stiglitz in the New York Times (April 1) and by Peyton Young in the Financial Times (April 1). In fact, the situation is even potentially more disastrous than we wrote. Insiders can easily game the system created by Geithner and Summers to cost up to a trillion dollars or more to the taxpayers.

via Jeffrey Sachs: The Geithner-Summers Plan is Even Worse Than We Thought.

“Ersatz Capitalism”, a.k.a. Crony Capitalism, aka Lemon Socialism, aka Obama Plan for Banks

Joseph Stiglitz (Nobel economist) writes in the NY Times (registration may be req’d) how the the Obama/Geithner plan is bad for taxpayers and ordinary citizens.  This is not real capitalism folks, it’s gamed capitalism for the oligarchs.

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time. Continue reading

Why GM will almost certainly go bankrupt.

Right now, for GM to avoid a bankruptcy filing, it has to get concessions or “sacrifice” from the “stakeholders”.  In plain terms this means the union and the bondholders.  The union has already stepped up to the plate. It has sacrificed and offered additional sacrifice contingent on the bondholders.  So far, though, the bondholders haven’t agreed to anything. It is the bondholders who are blocking a “restructuring”.  Ultimately, the bondholders will force the company into bankruptcy.    Why?

To understand why, we need to look at the negotiation process. There are thousands of GM bondholders: some large, some small, some individuals, some banks, some are bondfunds like PIMCO, and some pension funds.  But while there may be thousands (perhaps even millions) of seperate bondholders, the vast majority have no voice in the negotiations.  Instead, there is a “bondholders’ committee”.  Who is on the committee?  The “experts” and the large bondholders: primarily banks and bondfunds.  These banks and bond funds presume to speak for all bondholders. But their interests are not in line with all bondholders.  We know that there are very large number of outstanding Credit Default Swaps (CDS) contracts on GM.  So who likely holds the CDS’s?  The very same large banks and bond funds that are negotiating.  So, in effect, if GM goes BK, then the bondfunds/big banks are hedged and get full payment via the CDS.  If they agree to a restructuring, they get less than full payout.  So there’s no chance they’ll agree.  Of course, the little bondholders (like Joe Retiree with his $10,000 of GM bonds) loses.  He’s not hedged and he has no real voice on the committee.  The little guy gets no voice until after the committee approves sending a tender offer.  Not likely to happen.

This is doubly true since AIG, the likely writer of many of those CDS’s, continues to get full bailout from the gov.

The only chance of avoiding BK for GM is if the Obama administration either:  makes a credible threat to stop bailing out AIG  –OR– the administration decides to make CDS’s null and void.  Neither is likely.