Coyote Blog

Kevin Drum quotes the Financial Times:

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury's $1,000bn (£680bn) plan to revive the financial system.

....Wall Street executives argue that banks' asset purchases would help achieve the second main goal of the plan: to establish prices and kick-start the market for illiquid assets.  But public opinion may not tolerate the idea of banks selling each other their bad assets. Critics say that would leave the same amount of toxic assets in the system as before, but with the government now liable for most of the losses through its provision of non-recourse loans.

Wow, no one could have predicted this.  Except for anyone who spent 5 minutes with the numbers:

There is an interesting incentive to collude [in the Geithner plan] between banks and investors.  The best outcome for both is for investors to pay a high price to banks and then have the bank kick back some portion to the investor.

I will confess that I did not take the next logical step and consider that the ultimate collusion would be for banks themselves to be the investors, but the incentives for doing so were dead clear (part 1, part 2).

I will stick by my original conclusion -- Taxpayers are hosed at any price.

By the way, can anyone tell me what the evidence has been for the contention Barack Obama is "really smart," because I sure don't see it.  Yeah, he went to an Ivy League School, but so did I and there were plenty of people there I wouldn't trust to run a lemonade stand.  Sure, he gives a nice prepared speech and seems to have invested in that vocabulary building course Rush Limbaugh used to peddle on his show, but what else?  All I see is a typical Ivy League denizen of some NGO who thinks he/she can change the world if only someone will listen to them, who just comes off as puerile if you really spend any time with them.  I will go back to what I wrote on inauguration day:

Folks are excited about Obama because, in essence, they don't know what he stands for, and thus can read into him anything they want.  Not since the breathless coverage of Geraldo Rivera opening Al Capone's vault has there been so much attention to something where we had no idea of what was inside.  My bet is that the result with Obama will be the same as with the vault.

I had someone ask me whether the results in this post on the economics of Geithner's latest brainstorm were an artifact of the selected purchase price for the distressed asset of 150.  The answer is no.  Investors are willing to buy this asset on these terms at any price under 175, and banks are willing to sell for any price over 100.  Here is the graph of expected values as a function of the purchase price

Note the taxpayer gets hosed at any price  (kind of the Obama-Geithner update on "unsafe at any speed")  Two things I had not realized before:

• Without competition among investors to drive up the price, a very large percentage of the taxpayer subsidy goes to the investors rather than the banks.
• There is an interesting incentive to collude here between banks and investors.  The best outcome for both is for investors to pay a high price to banks and then have the bank kick back some portion to the investor.

Nobel Laureate Joseph Stiglitz has a great deconstruction of the Geithner toxic asset plan in the NY Times.  If you want to see how the new corporate state works, where the government works with a small group of powerful insiders to the benefit of those insiders and the detriment of everyone else, this is a great example.

Stiglitz walks through how the Geithner plan will operate, and I want to do so as well.  I have added a few tables to help illustrate his example a bit better.

Let's begin with a financial asset that was originally worth $200.    To make things simpler, we'll assume that with the current economy there are now two outcomes for this asset -- a 50% chance it recovers and eventually pays off its full value of $200, and a 50% chance it becomes effectively worthless  (more realistically, there is a range of outcomes, but this does not really effect the following analysis).

The average "value" of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is "worth."

This is a classic expected value analysis.  At business school, you spend a lot of your time doing these (trust me).  Expected value is just the percentage chance of each outcome times the value of the outcome, on in this case 50% x $0 + 50% x $200 = $100.

So Stiglitz hypothesizes a situation under the new Geithner plan where a private entity might be willing to pay $150 for this $100 asset.  That's certainly a windfall for the financial institution that owns the asset currently, since the asset is only worth $100 on the open market.  But why would someone pay $150?  Well, it starts with this:

Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses

The actual percentages are 8% from the private purchasers, 8% "equity" from the government, and 84% in a government-guaranteed loan  (Equity is in scare quotes because most investors learned long ago that if you provide 80%+ of the capital in a risky venture, you can call the investment "debt" all day long but what you have really done is made an equity investment).

So let's look at how the purchase cost is divvied up based based on a $150 purchase cost:

But we have already posited how this will come out:  a 50/50 chance of $0 and $200 for the final asset value.  So we can compute the outcomes.

So there is a huge built-in subsidy here.   Now, I don't personally think the government needs to be injecting equity in banks.  But  I understand there are a lot of people who support it.  So perhaps the $50 subsidy of the banks in the above example is warranted.  But why the $6.5 subsidy of Geithner's old pals in the investment world?  This is a pure windfall for them, like finding money laying on the street.   Even Vegas does not tip the odds so far in favor of the house.

I agree with Stiglitz's analysis:

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a "partnership" in which one partner robs the other. And such partnerships "” with the private sector in control "” have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it's the kind of Rube Goldberg device that Wall Street loves "” clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

Update: I posted an update on the plan and these numbers here.

After giving tens of billions of dollars of our money to the auto makers, Obama has now figured out what I and many others knew years ago:

Obama, responding to a question during an online town hall meeting, said the current business model for U.S. carmakers was unsustainable and the Big Three would need to change their ways.

From the article, however, it is still clear that Obama has no intention of allowing GM to go into chapter 11, as they should have 6 months ago.   There is a good political reason for this -- remember what I explained before.   Obama is working to equate chapter 11 with the disappearance of the American auto industry, clearly an untrue and facile proposition.  Many large companies, from airlines to energy companies to equipment manufacturers, have gone bankrupt over the last several decades and continued operations or at least had their productive assets taken over by other companies.  GM's assets are not just going to go poof.

However, there is a clear set of winners and losers in a bankruptcy -- and there is enough case law on it that all the players at GM know it and they know into which category they fall.  Those who are lower down the food chain are hoping that putting the restructuring in Obama's hands rather than those of the bankruptcy process will improve their outcomes.  And, to get those higher on the food chain (ie senior debt holders) to accept this they need the government to bring taxpayer money to the table.  The whole point of an Obama-led restructuring, then, is not to somehow preserve the US auto industry but to improve the financial position of certain GM stakeholders at the expense of US taxpayers  (and probably consumers, and some sort of protectionism is likely to be part of this deal).

But here is the most interesting point that was really hammered into me in reading this article.  If you were to rank Obama as to where he stood vis a vis all American adults in terms of his knowledge of business and what it takes for a company to be successful, where would you rank him?  I don't think very many would put him in the top half.  In fact, given that he has never, to my knowledge, had any real job in business of any sort (not even a high school job at McDonald's or something similar), I am not sure I would put him above the 10th percentile.  Anyway, put your own number to this question, and then read these quotes from the linked article

The president said he planned to announce decisions on the future of the industry in the coming days.

"But my job is to measure the costs of allowing these auto companies just to collapse versus us figuring out - can they come up with a viable plan?" he said.

White House spokesman Robert Gibbs said Obama will announce his strategy for the auto industry before he leaves for Europe on Tuesday.

Seriously, would you hand over your business or your stock portfolio for Obama to manage?  I didn't think so.  It takes years of experience to be able to read a business plan skeptically.  And even people who are experienced at it fail a lot.

By the way, for those who suspect that decisions will not be based on actual market realities but satisfaction of pet political goals, you are probably correct:

The president said even as the economy bounces back, Detroit can't focus on "trying to build more and more SUVs and counting on gas prices being low."...

Gibbs said Obama still thinks U.S. automakers build cars that Americans want to buy. Both he and the president own Ford Escape hybrids. "It's a nice car," Gibbs said. "It really is."

So, for example, one can assume its likely the Obama strategy for GM success will include lots of hybrids.  Of course, the market reality is this:

the slowdown has been particularly brutal for hybrids, which use electricity and gasoline as power sources. They were the industry's darling just last summer,  but sales have collapsed as consumers refuse to pay a premium for a fuel-efficient vehicle now that the average price of a gallon of gasoline nationally has slipped below $2.

"When gas prices came down, the priority of buying a hybrid fell off quite quickly," said Wes Brown, a partner at Los Angeles-based market research firm Iceology.

I personally believe that a meer restructuring of GM is unlikely to create a turnaround, as I discussed here.

Postscript- It is a bit apples and oranges for me to say that Obama is evaluating business plans here.  In fact, he is not.  Though he calls them that, if the Chrysler retructuring plan they put on the web is any guide, these are political plans, not business plans.  No real business plan, for example, seeking to attract private capital would prioritize the goals "Commitment to Energy Security and Environmental Sustainability", "Compliance with Fuel Economy Regulations," and "Compliance with Emissions Regulations" ahead of "Achieving a Competitive Product Mix and Cost Structure."  In fact, the section about costs and competitive products comes dead last in the Chrysler plan, almost as an afterthought.

Update: This sad story about athletes and their difficulty in managing their money seems relevent.  These guys, who have spent their whole life getting really good at one thing, don't even have the basic financial vocabulary to understand money management, and absolutely no ability to parse a business plan:

It began in the winter of 1991 when he sank $300,000 into the Rock N' Roll Café, a theme restaurant in New England designed to ride the wave of the Hard Rock Cafe and Planet Hollywood franchises. One of his advisers pitched the idea as "fail-proof, with no downsides," Ismail recalls. He never recouped his money and has no idea what became of the restaurant.

Lesson learned? If only. After that Ismail squandered a fortune funding not only that inspirational movie but also the music label COZ Records ("The guy was a real good talker," says Rocket); a cosmetics procedure whereby oxygen was absorbed into the skin ("We were not prepared for the sharks in the beauty industry"); a plan to create nationwide phone-card dispensers ("When I was in college, phone cards were a big deal"); and, recently, three shops dubbed It's in the Name, where tourists could buy framed calligraphy of names or proverbs of their choice ("The main store opened up in New Orleans, but doggone Hurricane Katrina came two months later"). The shops no longer exist.

You might say Ismail had a run of terrible luck, but the odds were never close to being in his favor. Industry experts estimate that only one in 30 of the highest-caliber private investment deals works out as advertised. "Chronic overallocation into real estate and bad private equity is the Number 1 problem [for athletes] in terms of a financial meltdown," Butowsky says. "And I've never seen more people come to me about raising money for those kinds of deals than athletes."

Doesn't this sound like the current administration in microcosm?  Does Obama have any better chance with his GM investment?

The normal process for bureaucratic allocation of, say, highway funds, does not always work that well.  Seriously, you don't have to convince this libertarian of that.  But it is at least intended to try to balance priorities and allocate the funds marginally rationally.   Which points out the problem with earmarks -- they are overrides by Congress of the normal allocation and prioritization process for political ends.  By definition, the projects in earmarks would not have normally been funded by the usual operation of the prioritization process.

Which brings me, oddly enough, to AIG  (and to GM).  When companies can no longer meet all of their obligations, they generally file for chapter 11 bankruptcy. This is an extremely well-worn process, both in the courts and the business community, that attempts to save as much value as possible and to allocate that value, based on law and a set of rules everyone understands in advance, to the various stakeholders.   The folks who are involved in this process are pretty hard-headed folks, less out for revenge and retribution as for maintaining value and capturing as much as possible for whatever group one might represent.

Now Congress and the Administration are getting themselves involved in the bankruptcy process, by trying to avert actual chapter 11 filings by AIG and GM.  By doing so, they are effectively overriding the bankruptcy process.  Just as with earmarking, they claim this override is for some good of the country.  But, just as with earmarking, you can assume it is to benefit some politically-favored group.  At GM, the feds are saying that we don't want employees or the equity holders to take a haircut, as they would in Chapter 11, so we will transfer the loss to taxpayers, and perhaps bondholders (could there be any politically less favored group than taxpayers?).  Same at AIG.   Is it any surprise that the number one beneficiary of the Pauslon bailout of AIG was Goldman Sachs?  The Left thought they smelled a rat when the administrations contracted with ex-Cheney-run Haliburton in Iraq, but no one is going to bat an eye when the Treasury department, populated with ex-Wall Street types, is bailing out all its employees' old firms?

On the subject de jour, the AIG executive bonuses, many of these were just as guaranteed, contractually, as were payments on AIG policies and bond guarantees.  I don't know how such obligations are treated in chapter 11 (are they treated as more or less senior than other obligations?) but I do know the decision to keep them or ditch them would be made against a goal of maintaining long-term value, and not public witch-hunting.

This is the real problem, even beyond the taxpayer cost, of this new form of Congressional or Administration-led pseudo-bankruptcy:  Winners and losers are determined by political power and perceptions of short-term political gain, rather than against a goal of maintaining value and following well understood and predictable rule.  This process throws all the old predictable rules and traditions out the window.  Investors and folks with contracts used to know just how senior their obligations were in a corporate failure.  Now, they have no idea, as their position in the bankruptcy may in the future depend more on how much they donated in the last presidential election, or how good their PR agent is.

Once upon a time, most entrepreneurs organized their business as what is called a C-Corporation.  Most of the publicly traded corporations you can think of, from Avon to Zenith, are essentially C-Corporations.   Such corporations had any number of advantages, but they had (and still have) one big, big disadvantage.  C-Corporations paid federal income taxes at the corporate tax rates.  And then, if after-tax profits were dividended to owners, those dividends would be taxed again.  This double taxation of earnings is something Congress talks about all the time, but never does much about.  And the implicit government tax subsidy for debt over equity does a lot to explain various waves of merger and LBO activity we have seen since the 1980's.

Now, entrepreneurs were not stupid.  No one wants their hard-earned income taxed twice.   So, entrepreneurs who owned C-corps would do one of two things.  One approach was to have the owner pay himself a large salary, thus reducing corporate income and converting the dividends to more tax-advantaged wages.  The other approach was to have the company issue the owner loans rather than dividends.  I have seen many closely-held C-corps with huge accumulated corporate loans to their owners, which may only be unwound years or decades later when the company is sold or liquidated and profits can be taken out a lower capital gains rates.

Over the last 20 years or so, a new corporate vehicle called the sub-chapter S or S-corp has become popular.  With a few limitations, the S-corp offers all the same liability protections as a C-corp, with a big tax advantage:  S-corps are not subject to corporate taxes -- corporate profits of the owners flow straight through the corporation to the owners' 1040 personal returns, eliminating any double taxation  (Limited Liability Corps or LLC's operate roughly the same, but with slightly different rules).  For this reason they are also sometimes called pass-through entities.

It is interesting to note something I never hear mentioned when discussing aggregate personal income data, which is that the switch over time from entrepreneurs using the C-corp to the S-corp creates something of a discontinuity in the income data.  Thirty years ago, much of the annual corporate earnings, and all of the retained earnings, of business owners would not show up in the IRS personal income data  -- it shows up as corporate income, but not personal income.  Today, nearly all of that corporate income of small business owners shows up as regular income on personal tax returns.  Absent any other changes in income trends, business owners as a group will appear to have large increases in taxable income, when in fact economically nothing may have changed save the corporate structures of their businesses.

But the real point I want to make is that all of the retained income and potential investment capital of a small business using S-corps or LLCs (which is nearly everyone nowadays)  shows up on the owner's personal income tax returns.  Let's hypothesize an entrepreneur whose S-corp earns $250,000 in profits after-tax.  Let's say he typically puts $150,000 of that to savings and living expenses, and the other $100,000 is reinvested in the growth and/or productivity of the business.  Now let's look at proposed increases in upper income tax brackets.  With these higher proposed rates, the business owner will have less than $250,000 in after tax income.  Let's say it goes down to $220,000.  Odds are that the owner will retain his lifestyle (he will as a minimum still have the same size mortgage and school and other payments).  The slack, then, comes out of the retained earnings.  Essentially, higher taxes result in less investment capital.  In fact, we can see an increased tax rate on wealthier entrepreneurs and business owners could easily result in a dollar for dollar reduction in business investment among small businesses, acknowledged to be the place where most all new jobs are created.

I think readers know that I don't fully accept the Obama administration's analysis of this recession.  However, let's take them at face value for a moment.  They are concerned that savings of average people won't currently translate into more business investment, as they fear the credit crisis causes banks to hold the savings rather than re-lend it.  If this were the case, then it would mean that as a policy, we would want to preferentially route tax savings to entrepreneurs and business owners who invest their own money directly, because their is no intermediary of a bank to interfere with the process.  But in fact, this is exactly opposite of what the Obama administration is doing through tax policy, instead taking away the investment capital and retained earnings of entrepreneurs through higher taxes.

This is the European-style corporate state in a nutshell.  In Europe, entrepreneurship is made extraordinarily difficult.  This is part of the deal that the political elite have with the largest companies in their countries -- we will protect you from potential new competitors, we will bail you out when times get tough, and you in turn will support us politicians.  One only has to look at the turnover of the top 30 companies in the US since 1970 vs. the top 30 in Germany or France to see this at work.  Political turnover is even slower, as an elite group of ministers run the country, almost no matter the party voted in office.  The economy as a whole suffers, but for the top 1000 or so men in power, the system works to protect their position, be it in government or in the largest industries.

And now we bring this system to the US.  Small business owners and entrepreneurs are punished with higher taxes in order to bail out politically powerful but failing companies like GM or Citicorp.  Welcome to America, the new corporate state.

Postscript: A lot of folks erroneously associate corporate states with right-wing governments, and certainly that was the case in Mussolini's Italy.  But the closest brush the US has ever had with such a system (prior to today) was implemented by leftish FDR via the National Industrial Recovery Act, and governments of both left and right have supported the corporate state approach of France and Germany.  In Britain, it was the left that built the corporate state and the right, under Thatcher, who tore it down.

Remember that time, after the Enron bankruptcy, when gas trading and transportation came to a halt in the US?  Or when air transportation ground to halt after Frontier, ATA, Aloha, Delta, Northwest, United, and US Airways all filed for bankruptcy in a 3 year period?  Or when half of California lost power when PG&E went bankrupt?  Or when car production came to a halt when parts supplier Delphi went into Chapter 11?

Yeah, neither do I.  That's because we have a system, that works pretty well and is certainly well-rehearsed, for corporate bankruptcies.  And the number 1 design consideration of this system, the most important assumption behind the whole process, is that creditors will ultimately get more value if the company continues to operate.

GM has painted a picture that the US automotive industry will come to an end if they have to declare bankruptcy.  This is complete BS.  As I wrote the other day, this is an effort by management and certain other constituencies (labor, equity holders) to get the government to intervene not because it is better for the country or the industry, but because it promises to advance their interests at the ultimate expense of taxpayers and bondholders.  This is a power play.  Holders of the senior debt have the power and call the tune in Chapter 11.  If management can get Obama and Congress to substitute themselves for a Chapter 11 judge, then management can hold onto their power.

I feel like the press has done little to call BS on this whole argument, and has generally supported the auto company narrative  (don't discount the fact that auto dealers are the #1 advertisers, by far, in local TV stations and newspapers).  But I was happy to see this in the WSJ, via Carpe Diem:

GM continues to argue that it couldn't survive a Chapter 11 proceeding, but the truth is that bankruptcy could boost its ability to survive. As the Obama administration considers its response to GM's request for more cash, it should be mindful of the advantages of bankruptcy that haven't been highlighted -- certainly not by GM's management.

GM executives have been saying that in Chapter 11 its network of suppliers would collapse, dragging down the rest of the auto industry with their company. But Chapter 11 has well-established procedures to deal with this concern.

Bankruptcy may be the only way for GM to fully confront its operational problems, deal with its legacy costs, reconfigure its dealer network, and achieve a viable labor agreement.

But one issue that has not been discussed much is that bankruptcy usually leads to a sharp change in management. There are turnaround teams expert at restructuring troubled companies, and they may well be more effective than GM's current management. It's no surprise GM's management isn't advertising this fact, but taxpayers and the government should know about it.

In the end, the administration needs to keep in mind that vital elements in GM's restructuring -- recapitalizing its large bond debt and keeping what cash it has flowing to key suppliers -- are often dealt with successfully by bankruptcy courts. A bankruptcy could save GM -- though maybe not its management.

The Chrysler web page for their restructuring plan they presented to the Feds is here.  The summary pdf my comments are based on is here.  Thoughts:

1. It is criminal that this is going to Congress, not a bankruptcy judge.  This is a conspiracy of management (looking to hold onto their jobs and equity), equity holders, and employees to usurp value from the senior debt holders, who would normally be first in line in a bankruptcy.
2. There is no WAY I, as a private investor, would put one additional dime into Chrysler based on this plan.  All the Same-Old-Incremental-Sh*t, with no explanation of what they are going to do differently.   Somehow they are going to cut half their models and lay off tens of thousands of employees but hold fast on market share, somehow reversing years of steady decline.  No explanation of how.
3. In section one, they blame it all on the credit markets.  Specifically, the lack of ability of the Chrysler finance arm to lend to customers.  But I showed the other day that consumer lending is still strong by banks.  What they are really saying here, but they are smart enough not to utter the actual words, is that their sales depended on a finance arm that was willing to lend at below-market rates to people with bad credit scores, and the lack of this hidden subsidy is what is making it hard to sell their cars.  Credit exists -- what no longer exists is zero-percent-interest-to-anyone-who-walks-in-the-door-no-questions-asked financing.   Instead of figuring out how to make cars that don't require hidden subsidies to get off the lot, they are trying to get the government to fund their hidden subsidies.
4. The present value calculation is a joke.  I could spend 3-4 business school classes discussing problems with it, so I won't now.  But one element that stuck out at me was that they come up with a terminal value in the calculation as a multiple of EBITDA  (Earnings before Interest, Taxes, Depreciation, and Amortization).  Really?  EBITDA is a common metric, but it is beyond meaningless when looking at a company going bankrupt under the weight of interest costs and capital spending.  Besides, they have the gall to assume that net cash flow (excluding financing activities) will be positive for the combined years 2009-2010.  Im-freaking-possible.  Remember, if any private investor in the country believed these numbers, Chrysler wouldn't have to be begging at Congress's door.  Congress is their last chance to find a sucker who will give them more money.
5. OK, I can't totally leave aside the NPV calculations yet.  They have a table of NPV's at different rates of return  (which is meaningless because their cash flow assumptions can't be believed).  The rates of return are 5%, 10%, 15%, and 20%.  This is ridiculous, though many may not recognize it.   20% is a low rate for the discounting of about any large equity investment, but it is absurdly, ridiculously low for a high-risk investment in a company that has been burning cash for decades and is facing its second near bankrupcy in 30 years.  Any savvy investor in the world would smell a dead fish here, but Congress won't because Chrysler is waiving electric cars at them
6. And speaking of electric cars, any intelligent restructuring plan would recognize that electric cars, even if they are successful in the marketplace, are not going to be anything but a cash drain for years.  This kind of thing has to be put on hold while the company gets back on its feet.  But instead, since this is a political and not a business document, Chrysler is practically leading with it.  In fact, the sections "4:  Commitment to Energy Security and Environmental Sustainability", "5:  Compliance with Fuel Economy Regulations," and "6:  Compliance with Emissions Regulations" all come in priority order ahead of "7: Achieving a Competitive Product Mix and Cost Structure."  In fact, this section about costs and competitive products comes dead last in the plan.  LOL, a "business" plan, indeed.
7. I thought it was funny that on the cover of the report, they have all kinds of happy politician-grabbing stats about how many red-blooded Americans they employ and how much of their production is made in the good old USA.  But their entire restructuring plank #3, which is labeled "strategic alliances," seems to boil down to a bunch of outsourcing to foreign partners.  Which is fine with me, but probably would freak out the Dems they are selling it to should they figure it out.

In the new corporate state, this is what business plans will look like.  Because were aren't selling returns and wise investment of capital, we are selling the care and feeding of political constituencies and pressure groups.

Postscript: OK, I realize I criticized the plan without suggesting what should be in it.  Here is what I would demand as an investor:  An achnowlegement and discussion of the reasons for past market share slide, and targeted actions to reverse these trends.  As Chrysler has said they have been working on this problem for 30+ years, the proposed solutions will need to sound radical, not incremental.  Further, they need to stop complaining that below-market rate consumer financing does not exist, and explain how they are going to sell cars at a price that covers their costs as well as a return for shareholders.

Well, while I was gone this week, GM asked the government for another $21.6 billion, on top of the $17.4 billion taxpayers handed them just two months ago.   Reading between the lines of GM statements, it is probably not crazy to assume they are burning cash at the rate of $5-$8 billion a month, which means this new infusion would likely get the company only through May or June.  This burn rate should not be surprising, as GM was burning $2.5 billion a month before the recession even really started, and they have really done nothing substantial to restructure the company.  By throwing the company to Congress to help save its managers and equity holders, the company has subjected its restructuring not to hard-headed bondholder representatives in a bankrupcy, but to the vagaries of the political process:

When the president's auto task force meets today to begin trying to fix the broken U.S. auto companies, it must balance dozens of competing demands.

Yeah, I am sure that will go well.  GM can have its money as long as it puts a factory in West Virginia and names it after Robert Byrd. The bondholders are pissed, as well they should be.  The senior debt holders have first claim in a bankruptcy, so another way to look at this political process is that it is the action of all the other constituents of GM (employees, equity holders, managers) who are trying to get Congress to interrupt the typical subordination of interests in a bankruptcy and allow them to get ahead of the senior debt holders in the line for what limited value remains in GM's shell.

I am tired of Keynsians and their assumptions setting the tone of the economic debate.  Here is the question I would ask them:

I understand that you Keynsians think that there are under-employed assets in the country, and that you think the government can redeploy prvate investment capital to more productive use.

Ignoring the individual liberties issues assosiated with this approach, as well as the fact it has never worked in the past, answer me this:  How are we going to turn around the economy by forcing capital to flow to the assets, industries, and management teams that have proven themselves to be the least productive?

We send money preferentially to the industry (autos) that has been showing some of the worst returns on capital in the entire country, and in particular to the company (GM) that has performed the worst in the industry.  If we really wanted to create auto jobs, wouldn't we send the money to the company that has historically invested money the most productively? It would be as if venture capitalists were about to complete their 27th round of financing to keep Pets.com afloat.  I have been in a company that eventually failed and couldn't get new financing.  At the time we were trying to convince the investors that they should give us just one more round, one more chance to prove the thing out.  In retrospect, I am embarrased they funded us as long as they did.  They should have pulled the plug way earlier.  Investors have a saying "your first loss is your best loss."

And don't even get me started on housing.  A deader, less productive investment asset can't possibly be identified.  A million bucks spent on a house produces 30 jobs for 6 months.  A million bucks spent on a factory expansion produces 30 jobs indefinitely.  For years, Democrats have hammered the Republicans over the jobless recovery of this decade, which in fact has shown a fairly unique jobs profile.  I wonder how much of this could be traced to the myriad incentives that were put in place to pour our available capital into these dead assets?  And now, with the bailout and the new mortgage bailout, the government is investing even more money to prop up the value of these non-productive investments.

The post title is a quote from this video on the bailout, which is not a deep analysis of the financial crisis, but spot-on none-the-less. Via the Liberty Papers.

I have written on this topic quite a bit, but via Cato comes another great example of how licensing and regulation, while promoted as consumer protections, much more frequently are incumbent protection against new competitors.  Cato has a video of some folks in Oregon who started a moving business, only to find that sate law effectively requires them to get permission of current moving companies before they can operate  (apparently, someone in Oregon is enamored of medieval guild systems).

How the law works is that when a new mover submits his application for a business license, existing movers can file an objection (which apparently is pro forma).  The new company must then justify to the state why another moving company is justified by the marketplace.  Of course, absolutely no guidance is given how such a thing might be proven.

I would have found this unbelievable, had not my company faced the exact same requirement in another context.  In Shasta County, California, we wanted a liquor license to sell beer at the store we run at McArthur-Burney Falls State Park.  We were told that we could not have a license until we had proven to the County that there was enough demand for another liquor outlet.  It was for our protection, they told me -- we wouldn't want you to get in a situation where you might fail.

I have written about liquor licensing before - if ever there was a regulatory regime whose time was long past, this is it.  The extensive fingerprinting and background checks one must go through to get a license are outdated remnants of a concern for the return of organized crime, a problem that was obviated by legalization  (so that, as usual, the government regulatory regime to fix a problem was instituted at the same moment the problem went away).  Now, the liquor licensing process is used as a club by existing competitors to keep new entrants out.  My bet is that organized crime is now on the other side of the fence, using the liquor licensing process to hammer honest competitors.  And if you really want to see abuse, read the whole Rack 'N Roll saga by Radley Balko.

I bet you are just overcome with suspense wondering if we got our license.  In Shasta County, we eventually succeeded, mainly because the store was in a gated park with an entrance fee, and we could make the argument that competition did not really cross the gates of the park.  Years later, we lost a similar battle in Lake Havasu City, AZ, where a group of local business people have really organized the town to their benefit and use every tool they can, from zoning to licensing, to keep competitors out.

CEO's of companies struggling on the brink of failure often make happy, confident public statements that all is well.  Is that a crime?

Well, it depends on how you look at it.  It comes down to a CEO's fiduciary responsibility to the company's investors, and how that is regulated for public companies.  We think of fibbing to inflate the company stock poorly serves investors, but what about when the company is facing a liquidity crisis?  Isn't public optimism in a liquidity crisis exactly what is needed to serve shareholder's interests?  Consider Treasury Secretary Paulson, and his near criminal declaration of a financial crisis, and the effect these ill-considered statements have had on the economy.

It is hard for me nowadays not to think about Jeff Skilling, who sits in jail for making what the jury thought to be overly optimistic public statements about the company's financial health  (I know you are thinking that he was put in jail for all that off balance sheet accounting and gimmickry, but in fact the prosecution never chose to bring these charges in the trial).  Even Skilling's jury, which was pretty clearly predisposed to convict, seemed to acknowledge that he did not make these statements for personal gain.

So why is Skilling in jail and not, say GM CEO Rick Wagoner?  Wagoner was making a lot of happy-face statements just a few months before his company acknowledged they were facing chapter 11 if Congress did not bail him out.  For extra credit, Wagoner told Congress $15 billion would be enough of a bailout, when he had to have been pretty confident it was not going to come close to cover the hole he faced.

Tom Kirkendall asks some of  the same questions, and looking at the cases he cites, it seems fairly clear that the difference between prosecuted and un-prosecuted CEO's has more to do with their like-ability, celebrity status, and general PR position than their specific actions.

Postscript: I have actually been thinking about the Enron bankruptcy a bit lately for another reason.  Remember that massive natural gas shortage we had when Enron went bankrupt?  Neither do I.  That's because chapter 11 is a pretty well-oiled process in this country.  Enron shareholders, bondholders, and management lost most their investment (and their jobs) but Enron's productive assets and skilled employees didn't disappear.  Enron's assets were bought by other companies who hopefully will employ them more profitably and productively than Enron had.

The same goes for GM.  We have a well-understood and proven process for taking a company like GM through bankruptcy.  However, we are instead replacing this well-understood and practiced process with a new process, called something like "Congressionally-managed restructuring funded with taxpayer dollars."  Does anyone really think this new process is better than the one we have?  Its only advantage, at least to some, is that it may preserve some management jobs, and shareholder and bondholder value, at the expense of taxpayers and any real effort for long-term reform of how GM's assets are managed.

Even with the government throwing money at it in multi-billion dollar chunks, GM seems to be sinking too fast for even the Treasury department to keep it afloat:

The target date for General Motors Corp. to get its second installment of government loans passed last week, but a top company executive says he expects the money to arrive in the next several days.

Fritz Henderson, GM's president and chief operating officer, said without the second installment of $5.4 billion, the company would run out of cash long before March 31.

In December, the Treasury Department authorized $13.4 billion in loans for GM and another $4 billion for Chrysler to keep both automakers out of bankruptcy. GM received $4 billion late last year and was to get $5.4 billion Jan. 16 and another $4 billion on Feb. 17, the day it is to submit its plan to show the government how it will become viable.

Henderson told the Automotive News World Congress in Detroit that the money is critically needed to pay its bills. He attributed the delay in receiving the second installment to the Treasury Department's workload and the change in administrations.

"If we don't get our second installment of the funding we'll run out of cash, it's that's simple," he said. "We've been finalizing what we need to do. We anticipate receiving it. But it's critical that we receive it."

The AP article above actually softpedals GM's money burn rate by saying GM received the first $4 billion "last year."  While technically correct, the fact is that GM received the money "last month."  So it appears that GM's burn rate may be as high as $4 billion a month, and that is before we necessarily even hit bottom in the recession. This should be absolutely unsurprising, as GM was burning through about $2.5 billion a month of cash pre-recession, when times were good.

It is just incredible that Congress and the Administration (old and new) are spending this much money to help GM management hang on to their jobs and to protect GM bondholders.  GM assets are not going to go away in a bankruptcy, but they may end up in hands that are more capable of using them productively.  Just to get one tiny glimpse of the incompetence at work here, note this:

Henderson also disagreed with United Auto Workers President Ron Gettelfinger who said on Monday that that a mid-February deadline for General Motors and Chrysler to complete their restructuring plans may be "almost unattainable" and that the automakers may have been set up to fail.

So, through the fairly strong economy of the last several years, GM has been burning through cash but did not see the need to have a restructuring plan (for most companies, having an operating cash flow deficit at the top of the business cycle is a pretty big red flag, but apparently not so at GM).  GM managers showed up in Washington to demand taxpayer money, and still didn't have a plan.  Chagrined, they showed up again to beg humbly for money, and they still didn't have a plan  (and frankly lie about their likely cash burn rate).  Three months later, in February, they may still not have a restructuring plan.

Wow!  How far out of touch with reality can you be?

General Motors Corp. Vice Chairman Bob Lutz said he is looking forward to having a "car czar" in place so U.S. automakers have someone sympathetic to its needs in Washington.

"We will have someone to talk to about the pain being inflicted on use [sic] for no unearthly [sic] reason," Lutz said Sunday on the sidelines of the North American International Auto Show.

Via the Libery Papers

Phoenix's agreement to give a $100 million handout to a shopping mall development in north Phoenix was struck down as illegal.

A major economic-development agreement between Phoenix and the CityNorth development has been ruled unconstitutional, meaning the project may not grow into the once-envisioned second downtown on the city's north side.

The Arizona Court of Appeals said Tuesday that the $97.4 million agreement violates the gift clause of the Arizona Constitution, which prohibits governments from granting money or credit to private entities in most cases.

In 2007, the city agreed to give the developer half the sales-tax revenue from the site. The developer, among other provisions, agreed to denser construction and to provide free parking and special spaces for park-and-ride use.

Excellent news.  This handout was engineered in a fairly smart bit of rent-seeking on the developer's part.  There are two competing shopping mall development sites about a mile apart in a wealthy area along highway 101.  The two sites are close, but on different sides of the Scottsdale-Phoenix border, so the developers managed to get Phoenix to pony up tons of taxpayer swag out of fear that stores like Nordstrom would move to the Scottsdale development (more here).  The parking subsidy came in at around $30,000 per parking space, and the only public benefit was supposedly that other locals could use the lot, though there are no other structures not within this particular development in walking distance of the proposed lot.  Here is the enormous downside that Phoenix now faces for not being able to hand $100 million to the developers:

Representatives of the Thomas J. Klutznick Co. declined interviews but issued a prepared statement saying that, without the agreement, they will be forced to cut the density of the project.

Less density would mean fewer shops, restaurants, hotels and offices and fewer jobs, the statement said.

The company said a "less capital-intensive design" would include surface parking lots covering more than half the development. It also warned that the project will face delays.

Uh, okay.  I think I will survive.   Their problem is they wanted the taxpayer-funded garage so that they could convert surface lots in their plan to more buildings they could rent or sell.  Boohoo.  Either it makes economic sense, and they can pony up their own money, or not.  Speaking personally, fighting Christmas shopping traffic, I am just fine with lower density shopping.

Via the AZ Republic:

Fritz Henderson, president and chief operating officer of GM, said that choosing the bankruptcy route would further erode consumer confidence in the automaker and "we want them to be confident in their ability to buy our cars and trucks."

In order to save the value of their executive stock portfolios, which are a large part of their compensation, auto executives are promoting the line now that consumers will for some reason stop buying GM cars if the company is operating under Chapter 11 protection.

The auto-makers real strategy is to get some kind of money, almost any amount will do, from the government ASAP.  It really doesn't matter how much, because with their cash burn rate almost any amount Congress gives them right now will not last much more than 6 months, and certainly will not be enough to reach recovery (their requests go up by a few billion each time they appear in front of Congress).  Automakers are facing potentially several years of recession, and any real restructuring would take 5 years or more (and even that is doubtful since the industry has had 30 years of notice on these issues and have not done anything).  But if they get some cash, then there will be a psychological pull for Congress to put in more.  They will say -- well, you've already put in $5 billion.  If you don't put in another X billion, that first 5 will have been wasted  (few people understand that "sunk costs are sunk" and Congress is no exception).  This is how expensive transit projects are funded.

The position that customers will stop buying the product due to some loss of confidence in chapter 11 doesn't hold up.  Most every airline traveler has flown on an airline operating under chapter 11 in the last 10 years or so, and if I can have enough confidence that an aircraft is being adequately maintained in bankruptcy, I can probably muster the courage to buy a car.  I presume the issue here is downstream warranty support.  But this is about the last thing that would ever be slashed in a chapter 11.   For God sakes, airlines have never even substantially disavowed frequent flier miles in a bankruptcy, surely a much more obvious target than warranty repairs.

I would argue that it is uncertainty that is driving any loss of confidence  (in fact, sales have plummeted already, ahead of any chapter 11).  A chapter 11 filing would actually increase certainty, as those running the receivership could quickly communicate principles to be followed in the bankruptcy, such as protection of warranties. Right now, people have a perception that in a bankruptcy, GM would go *poof*.  Once it actually files a chapter 11, the media and executives would switch modes from fanning panic to actually explaining how receivership works.

In fact, if there is any fear on the issue of long-term warranty support, it is being created by executives like Henderson who are fanning the flames of fear in a brinkmanship game to try to avoid chapter 11.  If he were really worried about this loss of confidence, he and other auto executives would be out there assuring people that their cars and servicing and dealers will also survive a chapter 11 filing.  But he is not.  This is totally disingenuous.

More on why GM should be allowed to fail here and here.

GM, as reported by Reason's Hit and Run, has actually already had something of a breakthrough in labor costs, at least for new employees:

The current veteran UAW member at GM today has an average base wage of $28.12 an hour, but the cost of benefits, including pension and future retiree health care costs, nearly triples the cost to GM to $78.21, according to the Center for Automotive Research.

By comparison, new hires will be paid between $14 and $16.23 an hour. And even as they start to accumulate raises tied to seniority, the far less lucrative benefit package will limit GM's cost for those employees to $25.65 an hour.

So this puts GM in the position of shoving experienced employees out the door as fast as they can, to make way for lower cost employees hired under this new deal.  Apparently GM also has more flexibility to manage costs in a downturn.  Good news, assuming they can accelerate a 20 year demographic transition to about 6 months, avoid giving away too much to these newer workers when times are good again, and arrest market share declines with better cars. Oh, and I presume the UAW has not abandoned seniority, which means that in recession-driven layoffs over the next year, GM must being by laying off these much cheaper younger workers.  Layoffs will actually mix their labor cost upwards.

I still don't want to bail them out.  Like numerous other industries, from steel to airlines, there is no reason GM shouldn't have to pass through Chapter 11 on the road to recovery.  However, the argument that GM is turning a corner if we just give them a little help seems to be persuasive with many folks around me, so much so I am tempted to buy some GM stock as a way to go long on my prediction of the creeping corporate state.

Update: On the other hand, this is a sign that GM may be scraping the bottom of the barrel for cash:

Cash-strapped General Motors Corp. said Monday it will delay reimbursing its dealers for rebates and other sales incentives, an indication that the company is starting to have cash-flow problems....Erich Merkle, lead auto analyst at the consulting firm Crowe Horwath LLP, said GM wouldn't delay payments if it had enough cash.

In the third quarter of this year, GM's operations burned through $7.5 billion in cash, offset somewhat by asset sales and financing activities.  But this is really a pre-recession burn rate.  What will the burn rate be over the next 6 months?  There is an argument to be made that $25 billion is not going to last even a year, particularly given the dynamic that layoffs will hit mostly the lower-cost workers, and a Democratic Congress and Administration that is handing over the money may well restrict GM's freedom of movement on layoffs anyway.  I can see the Obama administration now -- don't lay them off, lets put them all in a factory making green energy, uh, stuff.

"I don't even think they've got 60 days," Merkle said. "Their cash position is probably getting pretty weak right now, and it's cutting into those minimum reserves that they need on hand."

The Seattle Times has done a ton of work on earmarks, and has a report here.  Nothing here will be much of a surprise for earmark critics.  This was probably my favorite bit:

Last year, Congress promised to shed light on the secretive process. But the lists of earmarks are still buried in obscure documents that are difficult to find and search. Until Congress put them online a couple of weeks ago, the House disclosure letters, linking lawmakers to companies, were thick volumes of paper kept in a cabinet in the offices of the House Appropriations Committee.

When a reporter for the Congressional Quarterly pointed out how difficult it remains to pull all the information together, Rep. John Murtha, D-Pa., chairman of the committee that drafts the defense bill, had a quick answer: "Tough shit."

Murtha, for those who don't know, consistently leads the earmarking numbers, and came in #1 among Congressmen in reaping campaign donations from earmark recipients, bringing in over $1.6 million.  They have a database here where you can look up your Congressman (mine, John Shadegg, was one of the few with zero).  My sense is that this database is only from the military appropriation and that there are many more earmarks hidden out there in other bills, but it is a good start.  (hat tip Hit and Run)

The new, but not surprising, information for me was how Congress easily sidesteps the new disclosure rules.

After months of investigating the $459 billion 2008 defense bill, The Times found:

• The hidden $3.5 billion included 155 earmarks, among them the most costly in the bill. Congress disclosed 2,043 earmarks worth $5 billion.
• The House broke the new rules at least 110 times by failing to disclose who was getting earmarks, making it difficult for the public to judge whether the money is being spent wisely.
• In at least 175 cases, senators did not list themselves in Senate records as earmark sponsors, appearing more fiscally responsible. But they told a different story to constituents back home in news releases, claiming credit for the earmarks and any new jobs.

The Times includes several irritating but entertaining stories of rent-seeking.  Take Cyberlux, for example.  What do you do when your company has sunk $50 million into a new product, has a $18 million a year burn rate, and only has $300,000 is revenues for the first six months of the year?  Why, you call your Congressman and generate revenues via earmarks, with a quick thank you in the form of company-sponsored fundraising for said representative.

And this certainly is a feel-good story for those rooting for the government to re-engineer the American auto industry:

Latrobe Specialty Steel of Latrobe, 40 miles east of Pittsburgh, makes specialty steel for aircraft parts.
In 2006, its parent company, Timken, spent $2.9 million lobbying Congress on various issues and persuaded lawmakers to ban the Defense Department from buying any products using foreign-made specialty steel. As the sole U.S. producer of certain kinds of specialty steel, Latrobe saw its orders climb. Timken then sold Latrobe to a group of investors in a $250 million deal.

But the buy-American restrictions for specialty steel caused serious problems for the Air Force, creating a 17-month lag in getting spare parts for aircraft used in the wars in Iraq and Afghanistan.

In May 2007, Latrobe said it needed to expand but complained of high electric bills and publicly threatened to build a new plant in Virginia or West Virginia instead. Pennsylvania offered grants and tax credits to the company worth $1.2 million.

In Congress, lawmakers were quietly lining up a much sweeter package.

In the defense bill passed in December, someone had inserted language that ultimately directed $18.4 million for "domestic expansion of essential vacuum induction melting furnace capacity and vacuum arc remelting furnace capacity."

"Latrobe Specialty Steel is the only domestic producer of that steel," Army Lt. Gen. William Mortensen said at a hearing.

A month after the bill passed, Latrobe began a $62 million expansion in its home state.

No one in Congress has admitted sponsoring the Latrobe earmark.

One congressman's fingerprints, however, weren't so easy to conceal. Latrobe sits in the congressional district of Rep. John Murtha, a Democrat who chairs the subcommittee that drafts the defense bill and wields the most power over defense earmarks.

Latrobe's officials have given $5,000 to Murtha's re-election fund in the past two years.

Also, Murtha had talked about giving taxpayer dollars to Latrobe. "We're trying to get together to see how we can work out an increased capacity for that particular company," Murtha said at a subcommittee hearing in April 2007. "I've talked to that producer. And what I'd like to see is them put some money in, us put some money in, and reduce the time it takes to get those spare parts out."...

The company would not comment on any discussions it had with Murtha. A spokeswoman defended getting the grant, saying it had been competitively bid. Even so, she acknowledged that Latrobe is the sole U.S. producer of certain specialty steels, a requirement for getting the money.