Lehman, Redux

The looming failure of CIT offers the real possibility of a repeat of the Lehman Brothers shock.

The reasons that Lehman Brothers was permitted to fail in a disorderly fashion aren't worth visiting in any detail, mostly because of the storm of post-hoc CYA bullshit that cascades forth from otherwise decent people at the first inquiry into those reasons. Suffice to say that no one adequately appreciated the consequences of the Lehman bankruptcy, and everyone immediately (okay, it took the House two tries) sprang into action when those consequences were understood.

Does the CIT failure have the same potential for systemic risk that Lehman did.

The answer is simple. No, if you are concerned only with the stability of the financial services sector. Within the financial services sector, Lehman was more systemically important.

Unfortunately, if you are concerned with the general economy and not the casino, the answer is also simple. The answer is, Yes. CIT is systemically more important to the flow of credit in the general economy than was Lehman, which was, after all, merely a capital markets player.

CIT provides financing to businesses that operate in the general economy. You can call that financing liquidity, working capital, floor planning, receivables factoring, whatever. It makes no difference how you describe it, the financing provided by CIT and its competitors is critical to the continued operation of a huge swath of the economy.

It is easy from a certain perspective to dismiss this swath as a bunch of Dunkin' Donut franchises. After all, we could all do with a few less donuts, right?

It is more accurate to describe this swath as the Main Street mom-and-pop merchants who have survived the onslaught on the Walmarts and Targets and Costcos. The businesses who are CIT's customers are hardware stores, furniture outlets, franchised tire dealerships, music stores, boat dealerships, etc. Anybody who has to finance inventory or receivables.

And times are tough for these businesses. The consumer has retrenched. Not so many big ticket consumer durables are being bought (the auto industry may be the poster child for this observation, but it extends to clarinets and baby furniture, too). Many, many of these businesses are operating on the forebearance of their lenders, they aren't making the inventory turns the floor planning arrangements contemplate, the receivables are a little hairy. Some of them have waiver letters, others are simply letting it ride. And lenders, like landlords, are working with their good tenant/borrowers.

Only a mandarin safely entrenched from the realities of the marketplace and the credit markets would blithely assume that following the failure of CIT, companies like GE Credit, Litton and Wells Fargo will step into the void and meet the credit needs of former CIT borrowers. Two reasons they won't. First, they are too busy rebuilding their own balance sheets to do much more than give lip service to meeting the broader social needs that provide the only conceivable justification for the special privileges the government has accorded them. Second, the reason CIT is teetering is that its customers are teetering. Those customers aren't very attractive credits. As new business, they are non-starters.

So, this is likely to be a learning experience. While Vikram Pandit wanders across the landscape proclaiming that the future of Citi lies in global adventures, the credit needs of Main Street will be unmet. Small and medium size businesses will fail at an accelerated rate. Unemployment will rise, the economic 'recovery' will stall. In some ways it will be like last Fall's commercial paper adventure, except that the administrative challenge of providing credit to thousands of small to medium sized business will probably prove insurmountable.

Clearly, the economy will not tank on the failure of CIT. From a cool and dispassionate perspective, it almost seems like an experiment worth running. But that perspective may be hard to maintain if bankrupt small businessmen start dousing themselves in gasoline and setting themselves on fire on the Washington Mall.

Get Ready for the Kooky Ideas

Because here they come. A veritable flood. Certain to be dismissed initially. But some, like Sarah Palin, will gain traction.

Right now we (the collective 'we') have framed up our economic, political and social issues with a shared set of assumptions that are themselves becoming a casualty of the current unpleasantness. A mainstream articulation of that framework can be found in the Larry Summers interview in today's Financial Times. From one flank a more offbeat expression is offered by Nouriel Roubini on a very regular basis. On Summer's other flank, (if any still survive) can be found the pollyannish house economists of various organs and organizations promoting real estate purchases and equity investment (current faves, 'this is a stock picker's market', and 'buy and hold is a dead strategy'). Up above, from the academic highground, Krugman lobs his contributions down on us (to his credit, asking rhetorically last week who defines this framework and why there are 'unpersons').

But, the framework exists. And it exists for good reason. Nobody wants to have to listen to the kooks who think there is a pill that can turn water into gasoline, or who believe they've invented a perpetual motion machine (the call for economic salvation through a War on Global Warming comes close to these, IMHO, but it enjoys bizarre credibility that I personally chalk to the need even in a secular society for public demonstrations of faith).

I think the framework may be about to shred, in part because it's losing its objective utility, and in part because the participants are losing their faith in it. On the one hand, it may be possible to salvage the intellectual fabric and construct a workable, if makeshift set of policy responses using the salvage. On the other, it may be time to put the 'political' back into 'political economics'. And if that's the case, the current lineup and the current teams need to be recast.

"Paging Dr. Reich? This is central casting. Governor Palin would like to meet with you. We know you've heard of her, and are probably skeptical, but she's an empty headed vessel just waiting to be filled. You be da guy."

Personally, I've immunized myself (more or less) to all this by spending the last few months reading the Cantos of Ezra Pound. Pound was a guy who gave kooky economic theories the full monty. (Other kooky theories, as well--notably, anti-semiticism). He fell for a guy named Clifford Douglas, who was sort of an unhousebroken Hyman Minsky. Yes, folks, when it's broke it gets a great deal more baroque that H.M.

And EP ended up under indictment for the capital crime of treason, finally going over the edge sitting in a prison cell near that of a fellow named Till (who was one day led from his cell and hanged for 'murder with all the trimmings'). That Till was the father of the Emmet Till who was murdered in a racist incident in the mid-50s that contributed mightily to the emergence of the Civil Rights movement (and whose coffin is currently playing a bit part in a rather lurid bit of graveyard crime in Chicago).

You can immunize yourself however you want to. Just don't go deaf to reason listening to the siren songs of Bristol Bay.

Financial Reform A.D. 600

"Bankers shall not file coins,
nor make false ones
Nor put a slave . . . in charge of their business
. . . .
if they do not notify counterfeits that come in
and from whom
shall be flogged, shaved and exiled
And in this there can have been few innovations"

Pound, The Cantos of Ezra Pound, Canto XCVII (p. 687, New Directions Edition)

That being a rough translation (per Pound) of the Code of Justinian, coming after the rules for the notaries, goldsmiths and bakers and such.

It does tend to put the current rather modest proposals for financial reform in perspective. And the suggestion that there need be few innovations resonates of the observation that the only indisputably beneficial financial innovation of the last generation has been the ATM. But do not despair, ye serfs of finance, at least Justinian's Code did not proscribe branding, blinding or cropping (as in amputating the offending hand) for your transgressions.

The Forty Percent Problem

In 2007, approximately 40% of the earnings of the S&P 500 were attributable to the financial services sector. It is difficult at this point to estimate with any assurance the extent to which those financial services sector earnings were inflated by fraud, aggressive accounting practices, overleverage and a cyclical spike in levels of transactional activity, but all of those factors contributed. And it's difficult to say the extent to which appropriate regulatory reform and consumer protections initiatives will undermine the core earnings power of the predatory franchises on which so much hope for sector recovery in pinned.



If you remove that 40% of the earnings from the price earnings ratio of the S&P 500, and you look at the 40% decline in the price level of the S&P 500 since 2007, one nicely offsets the other. That is food for thought.



There are other factors at work, of course. Earnings in 2007 outside the financial services sector were at a cylical high, and can be expected to deteriorate sharply in a recession (just as recovery from recession-depressed levels to some idealized norm can be expected). No one really knows what the price/earnings ratio of a stock, much less of a market index 'should' be--though much ink has been spilled on the subject.



It's sufficient to say that the market has discounted the collapse of the financial services sector, though the sequence of events through which that occurs has yet to unfold. And the ramifications of that haven't yet been fully felt--nor, perhaps, fully discounted by Mr. Market.



My own guess is that unemployment will continue to rise, the magnitude of commercial real estate problems will be revealed with ghastly consequences for any number of traditional bank lenders, house prices will, in the aggregate, continue to decline until residential real estate has roughly half the value prevailing at the peak in 2006 or so, credit card delinquencies will rise, and so on. And an already crippled financial services sector will founder. Someone along the way, it will lose its place at the table.



It will be interesting to see what the new world looks like. I suspect that the transition issues and difficult adjustments of the formerly middle class, the elderly, upside down homeowners, the structurally unemployed, etc., will dominate the discussion, and strategies for restoring the global edge of the American financial services sector, if any, will have a distinctly archaic ring. My gut feeling is that the developed world is in for a prolonged period of painful adjustment, and deteriorating public sentiment will be fueled by reports of relatively progress in those parts of the developing world that have sufficiently large domestic demand that their economic growth in not dependent on the American consumer. I'm not predicting blood in the streets, or even bread riots. Just an opaque and heavy economically glum environment that sours the social mood, and contrasts with the innocent happiness of the furriner on holiday, using the cheap dollar to rub it in.

Not Quite Ready for Prime Time

Let's get real. There seems to be a great deal of dissatisfaction with and disappointment in the Obama Administration's approach to the reforming the financial services sector and and outlawing the current (admittedly toxic) executive compensation practices. I think the disappointed are confusing cognitive recognition of a problem and identification of potential solutions with the actual process of change.

So why isn't meaningful reform in the cards for the next year or two?

Team Obama did not exactly enter the 2008 presidential race focused on the economy or the financial services sector in particular. As I recall, the global hot button was the Middle East (a/k/a Islamic terrorism, the wars in Iraq and Afghanistan) and the domestic hot button was reforming the health care delivery arrangements. Not much bandwidth was devoted, until around Labor Day, to the general economy, much less Wall Street (except when it came to fundraising).

So, if the first reason expectations should be low at this point in time is simply that financial reform wasn't on the agenda, the second has to do with that second little fact--the fund raising business. The financial services sector has bought and paid for the government and its regulators for at least a generation. It is easy to get angry about this, but it is also pointless to do so. Big campaign contributions and the machinery of retained lobbyists buy access and mindspace, and influence policy and regulation. But there is a limit to their impact. The Marc Rich pardon notwithstanding, it is very difficult to actually buy an outcome. When the result is controversial and the groups opposing it have made their campaign contributions and hired their own lobbyists, the impact of it all is, if not neutralized, at least offset (and can lead to truly bizarre outcomes and terrible policies with unbelievable real world outcomes--viz., the attempted privatization of military services by the like of Blackwater).

Right now, sitting here today, the financial services sector retains its seat at the table and is still regarded as a participant in the process, a patient whose informed consent is required for the procedure. Soon, enough, unless there are magic reversals in the unemployment rate and the direction of commercial and residential real estate prices, the financial services sector will come to be regarded as a corpse to be harvested for useful organs and dissected for the enlightenment of future generations of medical students. Not yet.

Then there is the issue of executive compensation. Given the extent to which Summers, Emmanuel and Geithner's wife have all suckled at the Wall Street teat over the last decade, I think it is impossible for those guys to approach the issue without trepidation. What made Larry Summers worth over five million dollars to Wall Street or Rahm Emmanuel worth over fifteen million? Politicians are not notoriously introspective, but it would be hard not to question yourself under the circumstances, and that is disregarding entirely the public embarassment and political advantage to one's adversaries of the situation, and without even reaching the ethical implications of either betraying a constituency you have allowed to buy you or failing to act in the public interest while in public service.

There are three reasons not to have high expectations. They are all grounded in the realpolitik of expediency. In the short term they are insurmountable. In the intermediate to longer term, they fall away, depending on the course of future developments. But for the time being, expect experimenting with the cosmetics and some serious rearranging of the deck chairs. And don't get mad or excited about it. Just wait patiently.

Flavors of Players

To understand the state of play, you need to know the players. Right now, as the economic crisis unfolds in the United States (and, for that matter, globally), there are three flavors of players (Stateside). They are:

1. The Financial Elite.
2. The Political Class.
3. The Technocrats.

The financial elite, formerly known as the Masters of the Universe, are the varied and assorted hedge fund managers, traders, merchant bankers, etc., etc.--the whole of the seven-figure income and eight-figure net worth (formerly) herd bulls/alpha males of the financial services sector, their direct reports, and those who report to those direct reports. They are convinced they've done nothing wrong, that they've been overwhelmed by unforeseeable circumstances that have similarly impacted everyone else within the ambit of their world view, and they are collectively responsible, directly, proximately for the global economic crisis. They are clueless, and the incomprehensible ineptness of their responses to their current situation is slowly sinking in.

2. The Political Class, happy in the good times to take money from the financial elite and rein in the technocrats in exchange for the lucre, which much rather be prattling on about gay marriage, narco terrorism, green energy and any other available hot button that doing the heavy lifting of making decisions about the government's role in the economy. Unfortunately for them, the screw ups of the financial elite compel official notice. The earliest inclination of this group was to punt the problem to the technocrats, but we may well have reached the limits of that strategy. Past that point, these guys will engage, and the results of their engagement will be stunning. Time will tell whether that means good stunning or bad stunning.

3. The Technocrats are suddenly in the uncomfortable situation of getting what they've been wishing for--an opportunity to perform front and center, on stage, with power (or influence, depending on their niche). There are limits to this opportunity, and it's rather opaque at this point, since they pretend to serve their masters in the political class and the public sensibilities (not to mention to the innate conservative stupidity of the political class) require adherence to the convention that the private sector (read, financial elite) is capable of managing its own affairs. That is a convention which the political class is finding daily more laughable. Unfortunately, at the very moment these have been given to shine, they're finding that most of the tools in their kit are, er, inoperative. Though whiny, they are collectively quite bright, and if appropriately engaged with the political class they have the potential to make a positive contribution to the situation.

Odd Resonances

A current question in economic circles is why the massive expansion of the money supply as aresult of the Federal Reserve’s strenuous efforts to deal with the financial crisis and ensuing general recession has led to utterly no discernible inflationary pressures, at least in the short term. After all, it’s a generally accepted fundamental precept of modern macroeconomic theory that, ceterus paribus (ah, such as old fashion phrase, a whiff of napalm in the morning), an expansion of the monetary supply will generate inflationary pressures, and we have witnessed over the last year a veritable explosion in the money supply.

The succinct and apparently indisputable answer is that the expansion of the money supply has occurred in tandem with a slowing in its velocity, dressed up with the occasional pontification about appreciating the difference between statistics that are expressions of first derivatives and those which express second order derivatives. Without honoring the mathematical window dressing, let’s accept that observation as simple, gospel truth.

What is stunning to me is that the idea resonates with the long-discarded ideas of an English engineer-civil servant-social theorist named Clifford Douglas who in the early 20s developed an idea of Social Capital. I am currently reading a magisterial exegesis of the poetry of Ezra Pound, and, before falling in with Mussolini’s fascism, Pound was temporarily captivated by the ideas of Douglas.

Douglas was not talking about the money supply. Douglas was not a Marxist (he felt the attribution of all value ultimately to labor and toil of the contemporary working classes and peasantry was fallacious). He was not an economist (not even by the more flexible standards of his day). He may have been a crackpot. But his diatribes on cost accounting and contempt for the reliance on markets to both price and value goods and services are seductive.

In a nutshell, he argued, with respect to capital, not the money supply, that the velocity of capital, not the quantity of it, explained the vicious grip of banks and the financial interest on the general economy. His argument echoed that of the American populists and progressives of a generation earlier that Wall Street held the country in its talons, crucifying Man on a Cross of Gold as surely as our Savior suffered on a Roman cross of timber. In a wonderful analogy, he made the argument that to ignore velocity would lead one, in the context of demographics, to claim that, because everyone who is born eventually dies, the birth rates and the death rates must be identical, and so the population must be stable, which it patently is not. These statistics are matters of rates, not absolute quantities (and it hardly required the invocation of Calculus to understand it).

I’m not sure if Douglas is worth exploring, or not. He was a whacko, and, like Pound, more than a whiff of anti-semeticism pervades his writing. But clearly, all of the post World War II macro orthodoxies are being found wanting. Hence, you have Paul Krugman reading Hyman Minsky. Thus, the endless invocations of the same few phrases of John Mayard Keynes (efforts to restore ‘animal spirits’ by fiat seem to me about as likely to succeed as efforts to repulse the Mongols by sending the patriarch and his bishops beyond the city walls to parade the icons before the approaching horsemen).

It’s enough to make me wonder if these issues are, at bottom, really issues of the economy, at all.