Wednesday, May 27, 2009

After all – if the government could wipe you out why would you ever invest in low risk margin debt?

TO BE NOTED: From Bronte Capital:

"Do you or did you ever have friends in the FDIC?

"Here in my hand is a list of 205 communists in the blogosphere and the mainstream media."

Well – no actually – but I have a long list of people who – on the record – supported the confiscation of Washington Mutual.

Washington Mutual – by far the biggest bank confiscation in US history – happened during the AIG/Lehman week. It was confiscated despite being liquid and adequately capitalised at the time. Sheila Bair – the head of the Federal Deposit Insurance Corp (FDIC) did the deed – and in my opinion it was not her finest hour.

Washington Mutual was given to JP Morgan who did not need to honour all of WaMu’s debts. Debt holders – who would normally have expected to recover most or all of their investment were wiped out.

After this – and until very recently – no major US bank could raise any debt without a government guarantee. After all – if the government could wipe you out why would you ever invest in low risk margin debt?

The confiscation of Washington Mutual thus forced the entire system onto the government guarantee tit. The cost to taxpayers is thus potentially enormous.

Now at the time the confiscation looked justified to many because they assumed that Washington Mutual was insolvent no matter what their accounts said. JP Morgan – the acquirer – obliged this view by writing down the value of WaMu’s assets by about 20 billion. This write-down also justified the action by Sheila Bair. I said at the time that Sheila Bair was acting improperly despite this – and I said later that JPM was lying.

However if JPM was telling the truth – and Sheila Bair had a decent basis for believing them – then this was not arbitrary confiscation – though it was confiscation without appeal. It would be costly for the system – and it might have been justified.

Alas the facts have a neat way of outing the incompetence of Sheila Bair. JPMorgan is now confessing that almost all of the charges taken when Washington Mutual was confiscated will be reversed through their P&L. Washington Mutual was never insolvent and should never have been confiscated. [Hat tip – Felix Salmon.]

Sheila Bair – a Republican appointee no less – confiscated without compensation and without right of appeal valuable private property. I have argued repeatedly that she should resign – but now my basic thesis is proven her position is totally untenable.

A huge number of people supported her at the time. These are people who supported the confiscation of private property without appeal. Usually such people are called communists. The alternative explanation is that these people are just dopes.

Actually I know a lot of these people and they are not dopes. [Using McCarthyist logic therefore they must be communists.]

But they are not Communists either. Instead they were dopes on this occasion. Panics – be them financial or political do that. They turn thinking – even iconoclastic people like high profile bloggers – into dopes.

Now Washington Mutual was in fact very easy to add up. It was obviously solvent if you ran the numbers properly – but people find it quite difficult to run the numbers on banks. This applies to senior government officials too. And that explains why financial crises happen. People thought there was no risk in financial assets that were obviously risky during 2005 and 2006 and even into 2007. Thereafter they thought that financial assets that were most likely safe were (near) worthless. Government officials seemingly arbitrarily confiscating assets into the height of the crisis just added to that fear. A preferred stock is worthless if the government steals the underlying collateral (as I found out to my cost in the WaMu case).

After the confiscation of WaMu we needed not only to judge the solvency of banks (something which I think I am capable of doing) but also to judge the behaviour of individual officials in crisis (which I am not capable of doing).

The irrational fear in markets was not unlike the irrational fear that other manias (eg Joe McCarthy) engendered. That doesn’t make the fear less real or less destructive.

I thought at the time that Sheila Bair’s resignation would heal that wound– and would be the single best thing that the government could do to ease the financial crisis. Her resignation would break the nexus between fear in the market and the fear of seemingly arbitrary confiscation by government officials.

That nexus is broken now through repeated and consistent subsidy at huge potential cost to the taxpayers. The government – through repeated capital injections and guarantees – has managed to convince most people that American banks are safe.

It would have been cheaper for Sheila Bair just to resign.

However – the immediate and pressing need for Sheila Bair to resign as a matter of policy has past. The market is no longer outright afraid of arbitrary government confiscation of financial assets though they might have some fear about government intervening in Detroit’s bankruptcy.

But whilst the time for Sheila Bair’s resignation as a matter of national priority is past, the time for her resignation for proven incompetence has just begun.


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