The Long Spoon, from Victor Niederhoffer

September 20, 2008 |

V N I wonder naively, with the news of the bailout: will there not be clamors with the $1 trillion of assets that are being bought by the government at above market values, to extract some bits of flesh from those who are bailed out? Peter Public is being robbed to pay Paul Financial Firm, so to speak. But will Peter not complain and get his ounces of flesh? And will that not tarnish the luster of the gains in financial institutions in due course?

This is a speculation about which I have no expertise and no recommendation over and above saying, as I have for 30 years, that when you get out of the market because it's a "bear market," you have to get back in some time to reap the drift, and I don't know anyone astute enough to overcome that drift while he's out.

Alex Forshaw adds:

It reminds me of the October 15, 2007 announcement, except that this time the "Super Siv" (or MLEC) is $1 trillion-plus in size (instead of $75-100bn), the regulations are all the more drastic, the government has thrown $1 trillion away to save Wall Street's richest socialists, and… yeah, that's pretty much it.

If one had actually stuck to one's capitalist convictions throughout all this, one might actually not even be very surprised at the enormity of Bernanke's and Paulson's failure.

Alan Millhone worries:

I wonder if that 'long spoon' cradles castor oil? You hear the term hard to swallow. To me this applies to the bailout as the Bureau of the Treasury is running the presses 24/7 with someone holding the oiling can to keep down the sparks from the printing presses and all that paper may over time become nothing more than shin plasters!

Nigel Davies writes:

GM Nigel On the long term drift: Can someone please show me the data for all these centuries in which stocks went up 1 million percent, or are we talking about just one, the 20th? The last 24 hours have admittedly seen some of the most desperate short covering from a heavily leaning market, but I don't think one should extrapolate too much from this.

About the bailout: Maybe these measures will "save the system," but there's a huge cost involved for Mr Taxpayer. And as Mr Taxpayer is also Mr Voter I wouldn't want to bet against his supporting some heavy handed regulation by those seeking office. Not to mention the fact that he's being hit real hard in the wallet region by this mess.

James Sogi comments:

J Sogi The problem with the rescue plan and the upcoming regulation is that the creators of the plan are filled with hubris. Why should these few men with limited experience and knowledge compared to the smartest people of the entire financial world be able to solve the problems that the entire financial world was unable to? Like central planners around the world, they will just create new problems and backlogs and inefficiencies that were so prevalent in the authoritarian and socialist countries.

The country is sliding into socialism, which is the extension of the moral hazard. Where there is no more risk, there will be little reward. On the television, the prevailing meme seems to be the bailout is for the benefit of the greedy Wall street moguls and is paid for by Joe Sixpack. In any case, it will create new opportunities as cycles change yet again. Today's S&P high from yesterday's low was the greatest up move. This is a signal of new cycles, just as much as February 28, 2007 was a signal to move into a high vol cycle. The definition of cycles resists quantitative testing, so the qualitative will have to suffice.

Alex Castaldo takes a turn to the left:

Why should these few men with limited experience and knowledge compared to the smartest people of the entire financial world be able to solve the problems that the entire financial world was unable to? — James Sogi.

Yes, but don't we also need to revise downward our estimate of how smart the so-called smartest people were? When the Warren Spector's, the Dick Fuld's, etc. etc. issue so much mortgage debt to people who now can't pay, that the entire financial system is put at risk, can we really continue to call them the smartest people?

Irrespective of that (…maybe I would have made the same error…), doesn't it make sense at this point to have the "smartest people" take a time out while the second-rate people in government (and I fully agree that they are second rate) try to patch up the problem so the game can resume again? Or do we just let the system blow up because the mistakes were made in good faith by the smartest people available at the time?

Don't tell me that markets are better than Soviet style central planning, Mr. Sogi, I already know that. Tell me what is to be done under these circumstances.

Someone told me today that the nationalisation of AIG is just like what happens in France and Argentina. I am sorry but again I have to disagree. The French government ran Air France for 40 years. The AIG measure is temporary; rather than a nationalisation in the Argentinian sense I would call it a controlled liquidation of AIG. Rather than be liquidated immediately (as was about to happen) they will do so gradually over two years; rather than receive subsidies from the Argentinian government they will have to pay LIBOR plus 8%, a punitive rate, etc. The differences are major. Let's not put all government interventions on the same plane.

Back to the "smartest people" issue. The analogy I see is the following: you have been operated on by the best available surgeon; unfortunately he made a mistake and left a clamp in your abdomen before sewing you up. It is midnight on a Saturday and the only available surgeon is a semi-retired practitioner of average skills. Would you agree to have him operate on you to save your life? It may well be that you would have not agreed to be operated on by this guy in the first place. But what do you do now?

[Disclosure: Alex is a depositor of Washington Mutual and owns Morgan Stanley stock].

James Sogi replies:

J Sogi It is the spoiled child syndrome. Each time the spoiled child is saved from his mistakes, errors, rudeness, tantrums – he is inadvertently being trained to make these mistakes again. Better to mete out a measured negative punishment, time out, a reprimand, or suffering the consequences of bad behavior. Soon the child learns. There are behavioral cycles, adaptive mechanisms inherent in nature and free markets. By tampering with these, we end up with worse and worse swings as the adjusters over-adjust. Better to let Dick Fuld, and the overborrowers, take the hit. The entire financial system will not fail. It will start up again the next day no matter what happens. It may look different. There may be different players, but it will be there.

Remember the bitter pills Volcker dealt out in the 1980s with 24% mortgage rates, 14- 17% bonds. I saw many people take the hit. But inflation was crushed, and we enjoyed 20 years of moderation and prosperity. That was worth the price. Those who make bad choices should not be bailed out. It will encourage wild swings. It's the Greenspan Put all over again. If people know there's no second chance, they won't take the risks. If they do, they should be entitled to their profit or the pain of failure. When you do it your way, there is no cleansing cycles, and the toxin remains. Like Japan. It's just hiding the problems and they'll resurface somewhere else. Better to kill it now.

Let the big banks, big brokerages go down. New ones will take their place, smaller, faster moving. The market will find a way.

Comments

7 Comments so far

Bill Cook on September 20, 2008 6:28 am
Something had to be done because the system was failing to report the full extend of losses being held. All the others knew what they were holding, that is why there was a freeze in borrowing amongst the major players.
If these bailouts lead to greater transparency, then it was worth the temporary government involvement. Inherently, the American public enjoy the privilege of freedom of choice and therefore will do what is in their best interest.
The issue of punishment or dealing with losses is up to the voting stockholders and or the Justice Department.
George Parkanyi on September 20, 2008 10:13 am
Do you “let’em fail” guys understand what a bank run, or multiple banks runs, are like? If the system were to break down totally, you’d be lucky to get our money out of your brokerage accounts at all, let alone sell anything at a reasonable value. Even the smart short sellers might not be able to get their profits out. ATM? Forget it. You don’t think what happened in Russia could happen here? They were only saved by the psychological lift from the U.S. moves.

This bailout is pretty ugly, but the mess is huge, and in fact WAS created by smart financial guys. And the whole trillion may not be lost, depending on whether the real estate market can stabilize, and the assets sold off over time in an orderly fashion. Still some big ifs.

You let major financial institutions simply fail right now and you will have a guaranteed world-wide depression. I’m surprised there hasn’t been a run on WaMu. If I had money in there, I’d have yanked it long ago.

Cheers,
George
Bill Cook on September 20, 2008 11:36 am
Its not just mortgages which are the problem, what about other CDO's which don't comprise of mortgages? With 65 trillion of outstanding CDO's, $700 billion from this bailout just doesn't cut it. So the banks finally are going to be able to mark to market their balance sheet, then we will truly know the extent of the credit disaster.
Maybe just maybe its time to restructure the system and start over. Countries have defaulted on their loans before, the US is not any different. Remember its just a fiat currency anyway!

[Editor: the figure you gave for outstanding CDO's is controversial to say the least. Sources differ, but Lipsky of the IMF talked about $900 billion in July 2007. Let us stay calm and rational and do a little checking of our figures please].
Evan McKeown on September 20, 2008 12:58 pm
The Chair comments on staying in a Bear Market in order to catch the upward drift when it eventually turns upward is the smartest piece of investment advise that I think too few people follow during challenging times. Myself included. The temptation to cut losses and preserve capital and ones way of life is overwhelming. As I watched the VIX hit 44 and see the SPY touch down at $116 last Thursday I couldn’t help but reflect that in November of 1998 the SPY also was around $116. In ten (10) years the market has done nothing. One will read where the average return of the market is 8% to 10% over the past 50 years yet one would never know that stocks is the place to invest from the actions of the last ten (10) years. I hope Mr. Sogi is right that last week was a cycle change. I will feel much better when the SPY 50 day moving average has a crossover of the 200 day and the trend seems to be moving in that direction to occur sometime around election day. I love to hear Larry Kudlow say he believes in America and the capitalist society of a free market. The free market doesn’t seem to be working so good these days. The next “bazooka” blast Mr. Paulson may fire over the bow will be to invest social security into the stock market. Just kidding of course but it is amusing to hear Washington speak of this in the past when the market is booming and not so much as a wisper during the challenging times when we should be following Baron Rothchilds advise of buying low and investing for the long haul. The markets are a humbling experience yet my outlook remains high for if it is true that markets revert back to the mean and the average is 10% annual return than the next cycle should take out the old highs and be up 200% (accounting for a flat 1998 thru 2008 period) or a little over 6000 on the S&P over the next decade. Perhaps the sage old advise of “This too shall past in time” applies to Bear Markets as well! Now that I think about it…let’s invest that social security money in the market afterall, make “All” short selling illegal and give tax credits to any American that invests in the market. Mr. Paulson, please reload and fire up that Balzooka if you will and show the world that America knows how to jump start a sagging economy!
Eric Blumenschein on September 21, 2008 7:08 pm
As I peruse around the internet seeking out greater minds then myself in an effort to place into perspective the events from the last week and the proposed solution being negotiated, three things strike me. First of all, reading about Japan’s credit perspectives by Koyo Ozeki on the Pimco site, I believe that the bailout is the right tack in quickly resolving the present finacial crisis in a timely way rather then the ten plus years that the Japanese financial markets languished. Briefly summarizing Ozeki’s writings you will see the exact parallels of events during the Japanese financial crisis and the one today in the US market:

Phase 1 (1991-94) The real estate bubble collapsed, triggering an economic shock.
Phase 2 (1995-96) Signs of instability appeared in the financial system. As banks failed due to financial difficulties, the government failed to come up with a comprehensive policy package that would address financial system issues.
Phase 3 (1997-99) The bankruptcy of major banks triggered a financial emergency. Even though the government nationalized failed banks and injected taxpayer money into large financial institutions, it was still unable to resolve the situation.
Phase 4 (2000-04) The system reached a crises point due to the massive volume of excessive debt held by corporations. The Finacial Revitaliztion Program (“Takenaka Plan”) promoted the disposal of non-performing loans and these measures finally helped bring the crisis to an end.

Sound familiar? It is interesting to note Ozeki answering the question “Is rapid disposal really the key to early resolution of problem?”, Ozeki states”…It is difficult to identify the precise causal relationship between financial system measures and a bottoming out in asset prices, but one lesson that can learned from Japan’s financial crisis is that delay in recognizing the problem during Phases 1 and 2 (1991-96) made the subsequent fallout even worse, and an underestimation of the situation’s severity and the authorities’ trial-and-error approach in Phase 3 (1997-99) caused the delay in settling the problem.” Clearly there is something to learn from the Japanese experience. What is also interesting is the ratio of bad debt and public cleanup costs. The bad debt of Japan’s banking crisis was 25% of GDP and the public cleanup costs were 9% of GDP or about 36% of the bad debt. The bad debt portion of US subprime loan crisis is estimated at 5-10% of GDP and while the US S&L crisis of the late 80’s required public clean up costs 75% of the bad debt, time will tell if $700 billion will be enough but I believe they are on the right track. My second point is where I have a problem. As reported in the blog Think Progress, the proposed bailout legislation currently states the following in Section 8: Decisions by the secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency. Now if that doesn’t scare you then think about the 10 billion in Iraq reconstruction the was classified as wasteful or poorly tracked [GAO 2/15/07] or the 2.4 billion in contracts doled out by FEMA that guaranteed profits for big companies. [Center for Public Integrity investigation, 6/25/07] or the 1 trillion unaccounted for by the Pentagon, including 56 airplanes, 32 tanks, and 36 Javelin missile command launch units. [GAO, 5/18/03]….Well I am sure you can see the potential problem here as clearly no over-site is intended for this action. My third point in all of this is that today I read that the US pays out 400 billion dollars in interest payments for government debt and the amount of interest is growing each year. Now if balanced budgets, finacial over-site and debt management are not relevant to the US government…then where can this all possibly end? I guess that is why Cheney says that deficits don’t matter because I assume that if the US is too big to fail then the only way out for the creditor nations will be the exact road established by the historical precedents being set when entities too big to fail…fail. I wonder how the Chinese will react to writing off US debt 50 years down the road? Maybe they will they just ask for Montana in exchange?
Nic Chalmers on September 22, 2008 1:25 pm
Would the “bailout” have looked any different if this market dislocation had taken place 6 months after an election rather than three months before?

Can the taxpayers whos funds have been used to purchase these distressed bank assets not eventually profit after the market has normalised and the debts are re-sold back to the market at a profit?

Is there anybody better to manage this crisis other than Mr. Paulson?

Is Gordon Brown not hoping to use the Bank of England’s limit to protect his own political longs?

Is the system not working well if it can protect depositors whilst at the same time allow shareholders to realise the full risk of their investments?

Is the saver not suffering more than the taxpayer by having his/her deposit rates cut to the bone to save shareholders while the taxpayer is buying cheap assets that may eventually reap handsom rewards?
Eric Blumenschein on September 26, 2008 4:23 pm
I got it now…the Chinese don’t want Montana…they want US foreign policy. That is why they will finance the US…they want to hold the mortgage.

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