Monday, October 6, 2008

What’s Changed since Bailout Passed?

President George W. Bush shifted from “It’s a crisis and we have to act” to “It’s going to take awhile.” While he talked turkey, the S & P fell to levels not seen since 1999. America lost a decade of financial growth.

The week of September 15th credit markets froze up. The big money boys stopped trusting each other, requiring huge sums to cover the risk of default. Now exchange traders are close to locking up their credit system of moving stocks. What contributed to the meltdown?

1. Executive incentive compensation is set by the Board of Directors. Studies show incentive plans cause management to undertake riskier strategies, to swing for the fences and that financial home run.

2. Leverage or borrowing can magnify returns in a growing economy, but it turns into an asset shredder on the way down.

3. Off balance sheet items
hide the risk of traded assets for months at a time. As the value of these innovative products grew, it provided a larger base from which to borrow. When the resale markets collapsed, balance sheets eventually bled from the writedowns.

4. Credit derivative investments are the junk clogging the credit system. They provided the means to insure against default. Pricing of credit default swaps soared as large financial institutions tried to cover the risk of default. Effectively big Wall Street firms faced pay day loan rates to move their debt. That stopped credit in its tracks.

5. Profit growth expectations of 15-25% contributed to risky strategies employed by management teams and approved by boards.

None of the above has gone away. The sorry management practices, that brought America to its knees, are still in play.

So what’s the response as stock indices continue to crater? American and European business pundits suggest interest rate cuts to save their flagging economies. Whoa! We got into this problem from not pricing risk adequately. Now, central banks want to cut rates?

Interest rates need to reset to reflect credit risk. That reset will be smaller if Uncle Sam pockets past risk errors. But who will prevent the next round of excesses? Private equity, with its 20-25% annual return expectations, is touted as the savior of struggling banks. All the elements remain as America doubles down on the taxpayer’s account.