Monthly Archives: September 2008

A Letter to Main Street

Dear Main Street,

I understand that you have some reservations about the proposed $700B plan for the US Treasury to buy troubled assets from the banks. I don’t blame you. And frankly, I share your concern. I agree that the bill, as most recently proposed, was inadequate. Moreover, I’m not even convinced that it would solve our credit woes (for reasons I will detail in a later post).

One objection that I have heard some express about the plan is that it bails out Wall Street at the expense of Main Street. Therefore, the argument has been that the plan should be opposed and Wall Street should be left to deal with the mess it created.

It is true that there are elements of the plan that would let the fat cats on Wall Street off easier than they otherwise would; however, let me try to explain why I perceive this situation to be so grave that Main Street would not be spared at all, and that the need for action (even if imperfect action) is absolutely critical.

Don’t get me wrong, in some ways I am glad that the bill was voted down by the House of Representatives today. It needs to be retooled and reworked. But we need to get some version of it through – hopefully with better protection for the taxpayers and more stringent oversight.

But Main Street, let me try to make this clear – this plan is just as important to you as it is to Wall Street!!

Credit markets are currently experiencing unprecented stress. When credit markets are stressed (whatever the reason), banks and financial institutions do not lend; rather, they hoard whatever precious liquid assets (cash) they can get there hands on.

So why does this matter to Main Street?

Well, in the extreme (and this borders on hyperbole for the purposes of exposition), with banks not issuing credit:

Wall Street will be affected, and almost immediately. Imagine jobs disappearing from the financial industry overnight. And who knows how many – maybe orders of magnitude of 20-30% of all financial services jobs. And maybe you think, “too bad, folks on Wall Street deserve to pay with their jobs because they created this mess.” That would be myopic. Think about what mass layoffs on Wall Street would mean for government budgets of all kinds. Without income, there is no collection of income tax. It would immediately put extreme pressure on Federal, State, and Municipal budgets. Those budgets fund services upon which we are so dependent. Moreover, think about the impact on consumer spending. Unemployed people aren’t very good consumers. This would result in stress for retailers, and an additional negative feedback effect on government budgets through the sales tax channel. This is not good for you.

In addition, our federal budget is already running a massive deficit. This would force us to borrow even more from foreigners to fund domestic needs. At what point do those foreign creditors walk away?

Think too about how much stress a complete credit meltdown would put on credit lines of all sorts. Financial institutions would be forced to withdraw credit lines from all borrowers, creditworthy or not. As a result, a whole host of real economy companies upon which you depend for your needs will find themselves without credit to fund their daily operations. For the weakest of these companies, that would force them almost immediately into bankruptcy. For firms with stronger balance sheets, it would result in a huge jump in the cost of capital, severe curtailment of operations, and additional layoffs. How many layoffs, I cannot be entirely sure, but believe me, you would feel it!

So now not only would there be mass unemployment on Wall Street, but it would be coupled by mass unemployment across a swath of industries. Imagine how much pressure such mass unemployment would put on unemployment insurance benefits, which in some states are underfunded, and even if they are not underfunded, they are certainly inadequate to meet those kinds of needs.

In addition to mass layoffs, imagine mass foreclosures (even greater than what we’ve seen thus far). Folks without jobs will not be able to adequately service their debt and will be forced to hand the keys of their house back to the bank. Even those who remain employed will have difficulty meeting their debt obligations as many with adjustable rate mortgages will find their discretionary income squeezed when those rates readjust at higher rates.

If credit dries up, imagine going to an auto dealership to buy a car only to find out that a bank cannot float you the funds for the purchase. Imagine going to a store to make a purchase only to have your credit card denied – not because you are not creditworthy, but because the bank cannot underwrite the purchase. And even if you do qualify for credit, the terms would be so onerous that it would make many purchases prohibitively expensive. If you want to buy goods therefore, you have to pay in cash. But then imagine going to a bank to draw on your funds only to find that they are unavailable

All of these effects will obviously cause a negative feedback effect on the retail industry, whose sales will drop off a precipice. Hence more layoffs, less government income, less consumption, less credit, and so on.

This is why this $700B infusion into financial institutions, while deplorable and disgusting, is absolutely critical.

And as I mentioned in a previous post (see Letter to My Senators), although I can envision the economic consequences of allowing such a credit crisis to bring down our entire financial system, I cannot even fathom the social consequences. So for those of you who are ideologically opposed to this bailout, ask yourself, “Are you really ready to live with the consequences?”

In my view then, the most important thing is not whether or not to the plan should move forward, but how best to construct the plan to protect taxpayer interests and provide strong oversight.

For me, the key is, and has been, equity in exchange for capital. Moreover, I believe that Roubini’s recommendation for capital in exchange for preferred equity is a sound one.

Unfortunately, to me this plan seems like our best/last chance to stave off catastrophe. Sadly, although it provides us a chance to address the symptoms and represents a step in the right direction, it’s not entirely clear to me that it will work. I will explain why in a follow-on post.

To be continued…

Posted in Economy | 2 Comments

Letter to My Senators

I very rarely feel strongly enough to write to my elected officials. For the most part things function relatively smoothly in this democratic nation of ours, even though we might not necessarily agree with specific policies and actions, and even though we (as a nation) have many political and social differences.

I ordinarily see our differences, and the way that they unfold in public discourse and debate, as a strength. However, our economic situation has become so fragile that I believe that there is too much at stake not to take a position and have your voice heard. The potential economic and social consequences are enormous!

For this reason, I am sharing excerpts from a letter I drafted (edited to correct grammatical mistakes and read more smoothly) to my senators last evening. I hope this is the only time I will ever feel compelled to make a political point on this blog.

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Esteemed Senator XXX,

I am writing you because I am deeply concerned about the fragile state of our economy. In no uncertain terms, our financial system is on the brink of collapse, and it is effectively insolvent.

However, rather than rushing this TARP [Troubled Asset Relief Program] through and giving the Fed a blank check for about $700B of taxpayer money, we should make sure that we get this legislation right. In order to do that, any plan that includes putting taxpayer money at risk should be accompanied by a recapitalization of our financial institutions, at the expense of current shareholders. That is, if we are not going to let institutions fail, then they must be held accountable in other ways. This is the only way to address the moral hazard problem. This also provides the best protection for taxpayers since making them effective owners of the banks allows taxpayers to participate in any upside in bank performance. The intention, obviously, would be to re-float the banks back in the public markets once they are in better health, and at a gain for taxpayers.

If a recapitalization of this sort were to occur, this would represent a quasi-nationalization of the banking system. I know that this is not the ideal solution. After all, we live in a “supposed” free market economy, so taxpayers should not own banks, but if we do not address moral hazard, we WILL have accomplished nothing, and we WILL be in this situation again. Also, since banks will need to be recapitalized anyway, I believe that this is the best solution.

PLEASE, PLEASE, PLEASE do not let Paulson and Bernanke fleece the American people and congress by allowing them to scare everyone into signing the blank check. Make sure that check comes with conditions!

For now then, I urge you to please sign no bill UNLESS a recapitalization plan is in place.

Also, I should point out that I am paying very close attention to the deliberations and how my senators comment and vote. The future of our economy is at stake.

Sincerely,

Robert Salomon

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Please, now is not the time for partisan politics. I know that there are those who ideologically oppose any government intervention into private sector in general (and the banking industry in particular). However, as a concerned citizen and a taxpayer, we stand to lose whether the government acts or not. And I believe the consequences of inaction are far greater than the consequences of imperfect action.

For example, let’s assume we allow a complete systemic financial meltdown. The government will have to step in to protect depositors at many (if not all) of our banking institutions. Once all the funds at the agencies that insure those deposits are exhausted (and it will happen quickly given the FDIC balance sheet), taxpayers are on the hook for the rest.

And that is just the monetary cost of financial meltdown. I cannot even begin to estimate the social cost.

We (taxpayers) lose either way. I don’t know about you, but I would rather pick up the costs ex ante, while providing taxpayers some potential to recoup their investment, than to let financial institutions fail only to pick up the pieces and watch our economy come to a grinding halt.

The time has passed to allow institutions to fail just to prove a point to the few idiots who got us into this mess in the first place.

So I ask you to think carefully about the repercussions of allowing our system to fail and ask yourself if you are prepared to live with the consequences.

Allowing a complete meltdown of our economy would be catastrophic not only from a financial perspective, but from a social perspective as well.

This is why we need to get this bailout, although deplorable and disgusting, right.

Posted in Economy | 4 Comments

Executive Compensation, Chinese Style

While many of us have been scanning financial headlines by the minute to see if the fabric of our financial system has yet to come completely unglued (and who can blame us), apparently there are other newsworthy stories outside of Lehman, Merrill, AIG, WaMu, and the like.

I found an article about executive compensation in China that appeared in last week’s issue of the Economist especially fascinating (see False Options). As the article explains…

How executives are rewarded is one of the many mysteries of China’s increasingly powerful companies. Unravelling it is important, not least because it should help to explain corporate China’s transformation from a state-controlled to a consumer-driven creature.

Research on this question has been surprisingly sparse. A new study by Zhihong Chen and Yuyan Guan, of the City University of Hong Kong, and Bin Ke, of Pennsylvania State University, casts a rare beam of light.

…Senior executives’ cash pay [at 83 large companies operating in China but trading in Hong Kong] was low by global standards: $180,000 a year on average. Almost every firm awarded stock options, worth an average of $140,000, giving bosses healthy top-ups as well as equity stakes—if those options were exercised. Remarkably, a lot never were. At more than half of the firms, no options were exercised within four years of vesting.

The authors of the study pose the following question:

“What forces make them [executives] throw away money [in the form of unexercised options] on the table?”

The article goes on to conjecture that the reason that executives in China do not cash out their options is likely cultural. I agree that there is a large cultural component to the differences in behavior between Chinese and American executives with respect to cashing out in-the-money options.

The authors of the study then add:

“If executives in general do not exercise stock options, how can the option scheme align executives with the interest in shareholders?”

Actually, I think that having management in place that does not exercise in-the-money options is, in some ways, a good thing for shareholders. After all, once executives have exercised their options and cashed out, their interests are no more aligned with those of the shareholders than if they never had shares at all. If executives are forced to hold in-the-money options, they have every incentive to continue working in the shareholders’ best interests to maximize share price. This not only makes their options more valuable, but more importantly for individuals from collectivist cultures such as China, it avoids the the public humiliation that would result from a drop in the share price.

I believe the point that the authors of the study were trying to make, however, is that if executives do not consider options a potential income-generating mechanism ex ante, then options provide no incentives ex post. If executives treat those options as if they don’t exist and never intend to act on them, then in theory, they could care less whether they have options in the first place.

But if the explanation for why Chinese executives are less likely to exercise in-the-money options is truly cultural, then the incentives likely still work as intended. It’s simply that executives are reticent to exercise the options on the way up for fear of how they will be perceived if they do so, and incentivized to continue to keep the share price above the strike price for fear of public humiliation if they do not. In my opinion then, they still serve a purpose.

So in this respect, shareholders of American corporations might be better served if their executives followed the example set by their Chinese counterparts.

For more on executive compensation and options, see my earlier posts A New Approach to Executive Compensation? and Is Restricted Stock the Answer to Executive Compensation?

Posted in Corporate Strategy, International Strategy | Leave a comment