Obama's Moment of Truth (or the last Black Swan to Fall)

Charlottesville. February 23, 2009 - 4:04 pm

All U.S. pensions are managed to balance short-term riskier investing and long-term “safe” investments. These safe investments come in the form of bonds which are a type of debt. Virtually all managed pensions need to have up to 40% of their asset allocation in these perceived “safer” instruments. However, since 2001, the asset that underpins debt – collateral – has been largely out of the sight or mind of regulators due to what was called a financial innovation – credit insurance.

Tomorrow, the Obama Administration faces an untenable decision thrust upon it by the opaque management of AIG which has led to the largest (and incomplete) charge-off in U.S. history. If it saves AIG in some federally-owned shell, it will delay disclosing to the U.S. citizens that their pensions are technically insolvent due to the erasure of credit insurance and the future failure of the insured bonds. You see, AIG has both primary and reinsurance risk on an estimated 4 trillion dollars of credit risk insurance and in their current default and bankrupt position, they will, with their announcement tomorrow, technically default on the credit insurance obligations meaning that tomorrow, EVERY pension fund will no longer be compliant under ERISA laws and management practices.

If the government allows AIG to fail, the exact same reality will be evident however, it will not have appeared to cover up the problem. Rather, as with the Nixon administration’s decision in departing from the gold standard on August 15, 1971, President Obama can declare an immediate federal adoption of the ERISA obligations under to 2006 pension fund laws and simply use the federal money to create an immediate bond insurance liquidity pool. By doing this he would save his credibility and allow the “intervention” to directly benefit the public rather than trying to bail out an entirely failed financial institution.

Once stabilized, President Obama can then establish a management function (modeled after the FDIC but NOT the illiquid FDIC) which can take the appropriate time and process to assess the true collateral inadequacies in municipal and corporate debt and then adjust the insurance demands commensurate with measured risk rather than impulsive guesses.

To hear the way another President managed this crisis:
http://www.youtube.com/watch?v=iRzr1QU6K1o


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Why Obama’s “Rescue” Misses the Mark and the Coming Financial Collapse Just Got Worse

If the Disease is Misdiagnosed, the Cure Won’t Help

In July 2006 I gave a lecture on the “House of Cards” in which I discussed the certainty of bank failures in 2008[1] and in a subsequent speech in 2007 identified the failure of Washington Mutual and the rest of the TARP recipient banks.[2] In these speeches I discussed the certainty of systemic failures which, barring immediate intervention would lead to certain catastrophes. The forecast was based on data, not hunches and the data was right. Ironically, as recently as this weekend, the Obama Administration continues to parrot the Bush Administration’s error in proposing the purchase of “toxic mortgages” without acknowledging the fact that it is consumer credit defaults on home equity loans – NOT Real Estate – that has created the precipitating event and the Congressional and Administration belief that consumer debt will save us this time is as wrong now as it was in 2001.

As the one voice countering the “no-one-could-see-this-coming” years before the banking collapse I am in the unenviable position of pointing out a bigger crisis on the horizon – one from which we will have greater difficulty in recovering. A number of corporate and municipal bonds and other credit facilities are going to start defaulting in the next three quarters based on the convergence of a new perfect storm. I’ve been encouraged by many dear friends to try to make this understandable and accessible as some of my earlier warnings were “inaccessible”. So here goes.

From 2001 to 2005, the market response to the dot com bubble burst was to migrate investment funds from venture capital for launching new enterprises to private equity and hedge funds to finance merger and acquisition activity so that by 2005, over $8 trillion was being bet against enterprise value. What I mean is that, in the absence of IPOs, “liquidity events” came in either consolidations in public and private firms (out-sourcing costs and labor and gaining market efficiencies) or short-selling in public equities and commodities. Value investing meant finding ways where the market could generate short term gains by extracting longer term infrastructure investment – betting, if you will, against the future.

Unfortunately, from GE and AOL TimeWarner to Quantum and Millennium Pharmaceuticals, large and small companies with access to artificially low cost debt vastly over paid for acquisitions. In June 2001, the Financial Accounting Standards Board (FASB) changed accounting rules to require companies to charge off the goodwill premiums they paid in acquisitions. This meant that a company could debt-finance an acquisition for $500 million and, while holding onto the bond or debt instrument used for the purchase, have little or no collateral backing the purchase it just made. Not to worry, regulated banks, investment banks, and hedge funds were more than happy to provide the capital (typically with 5 to 10 year maturing terms) and fueled speculative pricing that kept the merger and acquisition premiums going up. So part one of the perfect storm is that beginning in 2009, many of the first generation balloon maturities hit precisely at a moment when few companies can refinance or repay their obligations and, they have no collateral to attract new capital.

Thinking that private investors shouldn’t have all the fun, many regulated banks were more than happy to provide capital to enter this lucrative but increasingly competitive market. A regulated bank, unlike a hedge fund, included in its financing package a “general intangible lien” or “UCC Article 9 lien” which said that all of the intangible assets (patents, brands, copyrights, trademarks, franchise rights, etc) belonged to the senior secured creditor. This means that the only asset retained in the post-outsourcing world, the innovation and brand, belongs to the bank until the note is repaid. What few people considered is the fact that when banks have to assess their reserve adequacy, they are required to look to their borrower’s collateral position. If there is no collateral – or at least none that can be valued – the bank must set aside up to 5 times the reserve funds that would be required if the borrower was appropriately collateralized. To date (save present company), no method exists to value these liens and, as such, banks seeking to stabilize their balance sheets, can create technical defaults requiring their borrowers to accelerate their loan payments or call them en masse. In short, because there is no consensus on how to recognize or value the intangibles, the only collateral that could save borrowers or creditor’s balance sheets, has been written off (due to the FASB rule) and does not exist for all intents and purposes. So part two of the perfect storm is that beginning with annual reports in this quarter (first quarter 2009), record impairments and charge-offs of goodwill will lower creditor collateral adequacy forcing borrowers into default risks well beyond any historical period. At the same time, banks will have no flexibility to have forbearance due to their own balance sheet scarcity.

The safety net behind corporate and municipal debt for the past 5 years has been credit insurance in a variety of forms. Much of this insurance is provided by – you guessed it – insurance companies. Both life insurers and re-insurers (sorry, I can’t make this understandable in this brief) have seen their premium income fall precipitously over the past six quarters both weakening their own business capacity but also rapidly shrinking their ability to guarantee the credits that they’ve insured. Moody’s, S&P, and Fitch – the largest rating agencies – have presumed that credit insurance has intrinsic value but have not been providing adequate risk assessment on the credit insurance providers setting up a calamitous event made worse by recent events. While the market can already see the strain on household names like Ambac and MBIA, what it hasn’t seen is the profound instability in the insurance market in part due to the Federal Government’s intervention in AIG which has preserved the opacity of the firm’s exposures and the collateral damage arising therefrom which reaches deep into the re-insurance markets around the world. And tragically, at the same time when the FDIC is running for cover with growing banking collapses, the Federal Reserve has audaciously suggested creating Term Asset-Backed Lending Facility or TALF which would serve as a quasi-insurance facility to restart securitization. By creating the illusion of insurance – goes the theory – the private sector will buy what they otherwise wouldn’t. Well, the bad news is the TALF may be dead before it ever really lived. So part three of the perfect storm is the imminent failure of credit insurance – either the actual collapse of one or more of the major players or the withdrawal of credit insurance providers from offering guarantees leading to the down-grading of investment grade assets.

Now, that’s the storm. Where’s the levee breach?

The answer is where we’re least prepared to deal with it. If you have a 401(k), you know that you’re retirement fantasies have been pressure tested lately. The sailboat has become a kayak, the trip to far off lands has become TiVo of the Travel Channel, and so forth. However, many people are counting on pensions and other ERISA-styled managed funds. Unfortunately, a number of pension funds have a dual exposure to the coming storm. First, the equity market value erosion of the last four quarters has erased much of the value of managed pension funds. Second, the “secure” investments in corporate and municipal bonds are now about to be severely impaired forcing many pensions into a distressed position where the obligations they have to pay benefits will have insufficient liquidity to meet those obligations. Municipalities and corporate balloon maturities are coming due over the next 6 quarters at a rate as much as three times historical precedent and no one is talking about how to deal with this. These, after all, were supposed to be the safe investments. When President Bush signed the Pension Protection Act of 2006, he did so on the eve of one of the most grievous times for pension security while the equity market was still generally bullish. However, one of the key figures in this legislation – a name that most of us don’t know now but we will soon – is the Pension Benefit Guaranty Corporation or PBGC. By the end of 2008, the top 1,500 companies who have administered pension benefit funds were over $400 billion in the hole. The PBGC is absolutely incapable, at present, of filling this hole and the number is growing. And regrettably, to stave off present capital shortfalls, many corporations (including insurance companies) have actually borrowed from their pension funds to meet current cash-flow obligations. This levy is going to breach and Congress – fresh off of a $800 billion dollar stimulus package – is going to be faced with more staggering liability – and this says nothing about entitlements of Medicare and Medicaid in case you were wondering.

So, what’s an average citizen to do? First, be informed. At present the Congress and Administration have allowed unconscionable opacity to persist within the FDIC, the PBGC. These programs are not adequately funded and you, the American public must stand up and demand accountability. Second, prepare for significant adjustments in standards of living. There is no question that 2008 was the opening act on a much longer show. This one is a bit more tragedy than comedy in the first couple acts. Remember that we got here based on the belief that we could out-source our manufacturing, kill off growing enterprises to get rid of their inefficiencies (also known as employees) through merger and acquisition consolidation, and, use our homes as ATMs. Well, none of these messages were true. And now, when we have to pay for the excesses, we need to take stock in what future we wish to have. We must be creative in how we move, how we power our lives, how we consume what is necessary rather than what is excessive, and how we engage with each other. And third, we must be creative. There is a world of opportunity that was passed over in our last eight years of ignoring the innovative front line while we let the colossal get bigger. Your neighbor has a great idea and while you might not be able to invest cash, you may be able to invest your time, creativity, contacts and talents. See yourself as a part of the next solution rather than a victim of the failure of excess. And, if you want to invest in these challenging times, help clean a highway, mow a park, or invest more of your scarce resources in your local grocery store or restaurant. By seeing yourself choosing a destiny, you will be empowered to see the calm after the storm.

[1] http://archive.arlingtoninstitute.org/library/ArlingtonInstituteAddressTranscript_eng.pdf

[2] http://www.arlingtoninstitute.org/tai-alert-11-major-financial-disruption


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In Memoriam: A Scientist and Statesman You Should All Know

Today we join the family, friends and colleagues around the world in celebrating the life and passing of one of the world’s most compassionate scientist statesman – Dr. Naoyoshi Suzuki. Born in 1931, Dr. Suzuki spent his life working to enhance the well-being of humanity through unprecedented, humble pursuit of scientific excellence specializing in protozoan diseases and their detection and treatment. For over 16 years, Dr. Suzuki was a dear friend and collaborator to M∙CAM and its predecessor companies Mosaic Technologies Inc. and IDEAmed. Through a collaboration with the Hakuju Institute for Health Sciences in Tokyo and MariCal in Portland Maine, he assisted in the development of basic scientific understanding of the regulation of calcium at cell membranes – research that has already contributed to improvements in pain management, fisheries productivity, and cancer kinetics. While his scientific contributions were legion, his role as a statesman was even greater. Championing the importance of international technology transfer and collaboration was particularly poignant in his life as his family had suffered the constraints imposed by the national dishonor, including technology transfer restrictions, imposed by the Allies on September 2, 1945 on board the USS Missouri. Without Dr. Suzuki’s tireless efforts and ceaseless enthusiasm, M∙CAM’s pioneering work in international technology transfer and financing would not have achieved its global status and success. From his gentle teachings of Bushido to his warm embrace of his “foreign friend”, we all are indebted to the life of Dr. Suzuki.

When the stories of success are told in the enterprises that I've had any hand in starting, they should always whisper gratitude for this great man. His inspiration and dedication to the intersection of science, industry, and the public good fueled my passion for close to two decades and his spirit will continue to live on in all that we do and conspire to do.

Rest well dear friend. You have given us so much and for that, we are in your debt.

Let but a prince cultivate virtue, people will flock to him; with people will come to him lands; lands will bring forth for him wealth; wealth will give him the benefit of right uses. Virtue is the root, and wealth the outcome. – Confucius

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The Ascent of Money
An Integral Review of Niall Ferguson's History of Money


The (A)Scent of Money

When will Historians and Economists Stop Fueling the Economic Crisis Myths?

An editorial by Dr. David Martin, Executive Chairman, M·CAM
February 7, 2009

The African proverb reminds us that until the lions have their storytellers, the hunters will remain the heroes. Niall Ferguson’s The Ascent of Money is a masterful case study in the consensus of economists and historians to ignore this admonition from ancient wisdom. To his credit, his financial history is a delightfully rich exposition representing the prowess of an exceptionally talented and expansive inquiry into the stories that support a consensus myth. As a historian and author, a finer compilation may not exist. However, the evolutionary supposition that hails financial innovation (an oxymoron which I will address shortly) as the catalyst for the improvement of the human condition across the millennia not only lends itself to the historical myopia rife in the narrative but endangers those who would seek a deeper understanding to conclude in error that they are gaining a balanced perspective. Not surprisingly, in his treatment of the immediate financial challenge, he joins his Harvard and establishment economist colleagues in lamenting the inability to have apprehended the certainty and depth of the economic collapse, and impending propagation thereof, upon whose precipice our economy now stands.

Ironically, Ferguson dances on the edge of a breakthrough but avoids the temptation to let it take flight. His siren song of innovation fails to contemplate that each hero epic innovation recounted in this sweeping tale was, at its core, the opportunistic leveraging of information asymmetry. Innovation, in The Ascent of Money has the stench of swindle at every turn. From the early risk management swindles of the Scottish clergy to the LTCM swindle rewarded with the Nobel Prize (caution noted to Grameen whose focus on credit rather than profitable industrial output has launched a thousand usurers), it is disingenuous in the extreme to suggest that progressive, willful obfuscation of knowledge and understanding should be dubbed “innovation”. A phone call to a few behavioral psychologists could have made a much-needed breakthrough in unmasking the progressive fervor with which information opacity - rather than the democratization thereof - is the real story underpinning this piece.

It is lamentable that this book will enjoy its own ascent in readership on the eve of even greater financial calamity – an event that with greater care, Ferguson's work could have helped alert and attenuate. On this day, February 7, 2009 – when the New York Times reported the massive U.S. facilitated massacre of innocent civilians in the Democratic Republic of Congo – a reader of Ferguson and the Times could see this and his book as unrelated. A closer (and more informed perspective) could have shown the linkage between the Potosí silver genocide documented in 1638 (page 23) from which Ferguson quotes Fray Antonio de la Calancha, “Every peso coin minted in Potosí has cost the life of ten Indians who have died in the depths of the mines,” and the fact that the U.S. government’s interest in bombing the Lord’s Resistance Army is inextricably linked to the economic interests of those who benefit from the life-blood of regional metals which support our modern portable music necessities. Where is the historical warning calling humanity to consider the alchemy that has turned blood to gold – the only alchemy that the esoterics have mastered and the modern alchemists have rendered infinitely scalable? Where is the clarity of inquiry recognizing that it was the drug addiction of an opium obsessed United Kingdom that cowed China (page 289) such that today’s reader can see that the self-same drug and its new imperial user’s addictions is being used to create the liquidity that flows in the form of the exsanguinated blood of Coalition and local combatants alike in conflicts from the Tigris to the Pacific Ocean? In the argument that it is monetary and banking innovation that alleviates poverty, where will we find discourse about the earnings disparity between Chinese laborers and their consuming U.S. counterparts that has propped up the Chimerica myth (page 335-337) which will fuel the political unrest that makes 1914 look like an afternoon street-fight?

No, it isn’t banking sophistication that has vaulted the world’s elite into their self-congratulatory utopian advancement. It is in the consensus coalescence of the empowered few repeating the pervasive myth that in an era of Google and CNN, we are breaking down “dangerous barriers” that humanity has become more impoverished. After all, despite his laudatory assessment of our improvement, more and more children are falling below the poverty line in the U.S. Regression-based prediction – the elixir of economists from Chicago to Washington D.C. to New York to Massachusetts to London – is not hard or mysterious as alleged, rather it is irrelevant. All of the bubble bursting that has come before was not only known well in advance but, by watching the actual audacious bravado of its co-conspirators, it was fully knowable. The problem is that we all have failed to realize that a system built on knowledge asymmetry and the colonialization of the mind is entirely imbued with self-evident failures. When the nominal trade bets against transparent value accretion (in the form of Credit Default Swaps in Planet Finance) eclipses the total productivity of Planet Earth, we invite certainty, not surprise. 2007 and 2008 were neither meteor nor asteroid. Rather, they were entirely reported, fully characterized maturations of a series of factors that this treatise carefully avoided. I trust in Volume II – The Descent Ferguson can speak with a bit more lion and a bit less hunter.

January 30, 2009

The Defibrillator is on the WRONG patient

Why Obama’s Advisors Need Triage Training

By: Dr. David E. Martin, Executive Chairman, M∙CAM Inc. and Fellow at the Batten Institute of the Darden Graduate School of Business Administration, University of Virginia


The government bailout of AIG failed to attract the notice that it deserved for good reason. Few economists and fewer informed citizens have any clue about the complex role the insurance industry plays in the global financial scene. This lack of visibility may cost tax payers in excess of the combined Obama Administration stimulus plan plus the carelessly constructed TARP legacy of the Bush Administration. Why? The answer is quite simple. Every pension fund in the United States, most corporate bonds and debt, and a huge amount of commercial product and service flow relies on its credit rating and performance insured by little understood credit guarantees. Take these guarantees away or impair the companies that issue them and no retirement account in the U.S. could maintain its codified obligations for investment grade assets. And, by the way, if rating agencies in the U.S. actually rated risk inclusive of the balance sheet risks of these guarantors, we would already have a rating crisis equal to, or larger than Japan’s 10 year ratings draught.

The International Credit Insurance & Surety Association or ICISA may have painted the happiest industry consensus growth statement of any industry association in the past 3 quarters when, in their November 18, 2008 press release they stated, “By insuring payment risks and guaranteeing the performance of third parties we support our policyholders in maintaining and growing their business.” For an organization whose membership carries over US$2 trillion in exposure, this was certainly a cheery message. This press release came on the same day that Market Watch reported Hartford Financial Services Group, Genworth Financial Inc. and Lincoln National applying for capital support from the Office of Thrift Supervision begging the question, if the risk performance professionals can’t manage their own risk, what are they actually selling to their clients?

A review of ICISA members’ balance sheets and 4th quarter earnings reports reveals a more troubling observation – one that has missed all but the subtlest of media attention. The Chairman of one member stated in his interim report to shareholders the fall of 2008, “The crisis on international capital markets intensified in the third quarter on a previously undreamt-of scale.” Investment income was halved and earnings in some members fell by over 90%.

FDIC Chairwoman Shelia Bair – head of a distressed insurer in its own right – has been promoting the “bad bank toxic asset purchase” solution for good reason. If the FDIC actually had to do what insurers are contracted and paid to do (yes, the FDIC is paid premiums to manage risk), the financial crisis would be seen in its full glory and that would be calamitous at best. Get the paddles where they belong Mr. President and Secretary Geithner. The manikin never was alive and the patient is dying!

Bailout Solutions Use the Wrong Economic Model:
Correctly Valuing “Intangibles” the Solution to the Crisis

Dr. David Martin, Executive Chairman, M∙CAM
Fellow, Batten Institute, Darden Graduate School of Business Administration, University of Virginia

Let’s review a few simple facts that our policy-makers are missing. The current credit crisis is not a real estate mortgage crisis. The banking liquidity problem is not caused by collateralized mortgage obligation devaluation. And pumping large amounts of taxpayer dollars into a ‘bailout’ will not solve the problem. Why? Neither consumer goods purchased using home equity second mortgages nor inflated “goodwill” premiums paid in leveraged M&A commercial debt transactions reflect collateral value. Congress and the Treasury are ignoring tools that they used less than 5 years ago to save the U.S. taxpayer $10 billion and in so doing are risking an engine failure of our national economy. By enabling regulated financial institutions to monetize the value of existing General Intangible Liens which exist in all forms of credit agreements, taxpayers will be spared unnecessary, and economy threatening bailouts.

First the ‘main street’ crisis: heralded as a real estate bubble casualty, the current explosion in defaults on both mortgage and the pooled investment vehicles built thereon has very little to do with the housing market. Encouraged to bolster the economy by using their home equity for consumer credit (to buy cars, appliances, TVs, and other goods) in response to the market confidence collapse following September 11, 2001, consumers created an aberration not previously seen in the real estate market. In a market where default statistics are measured against 30-year mortgages collateralized by homes, banks and credit rating agencies pretended that second mortgages were just like first mortgages. The problem is that consumer credit defaults spike in 18 to 24 months – not in 10 to 15 years. When home mortgages are rated using 30-year real estate default statistics (much longer onset and much lower incidence) rather than consumer credit default statistics (much shorter onset and much higher incidence), you see a recipe for disaster created by the perfect application of the wrong model. “Fixing” the real estate market would require deleveraging consumer behavior with home equity – a message that is not mentioned because it requires a potentially unpopular call for fiscal accountability during an election. Using the personal bankruptcy reform initiatives passed by Congress in 2005 linking means testing to consumer debt, cessation of credit card and real estate equity pooling would avert further instability.

The same lack of collateral adequacy is causing the Wall Street crisis: The lack of banking liquidity today has virtually no linkage to junk mortgage securities and their non-performance. The real problem is that reserve accounts (the money a bank needs to hold to be capable of issuing credits) are calculated based on a long-forgotten concept of collateral. Rating agencies have been allowed by Federal and international banking overseers to misstate asset values and investment performance when measuring the leverage for bank and insurance reserves. The collapse of the mortgage-based securities triggered a drop in ratings catalyzing a chain reaction.

In 2000, the Financial Accounting Standards Board (FASB), influenced by hearings lead by Senator Phil Gramm (R-TX), required companies to modernize their accounting for merger and acquisitions. When one company purchased another, they were required to immediately write off the premium paid for the purchase and only report the value of the actual assets they had acquired. Many of the assets which led to the premium price are so-called intangibles (contracts, trademarks, copyrights, patents, franchises) which are not adequately reflected on balance sheets. While this accounting change attempted to add transparency to shareholders, it created a conflict of interest for banks. In leveraged debt acquisitions, the acquired company’s value has both a purchase price and a much smaller booked value. The difference between the price and the book value frequently represents over 50% of the gross transaction leaving the acquiring company’s balance sheet both asset poor and debt burdened. On the one hand, banks knew that immediately following a debt offering, the book value of collateral would collapse. However, they also were incented to inflate the value of transactions to maximize commissions. When the bank then had to assess its own lending capacity, it now must measure the financial risk of the loan based on payment history and collateral (which in most cases doesn’t include the intangibles purchased in the company) thereby immediately leading to a greater perception of debt risk. Neither the FASB nor any other oversight body actually defined how to recognize the true value of intangible assets. This is not a small point: these assets are estimated to be over 80% of the actual value of acquired companies. The result of all of this is that banks have vast sums of commercial credit issued where the recognized collateral assets represent less than half of actual market value. It is collateral insufficiency, and the associated reserve costs, which are freezing the credit markets – not real estate. When something which costs $1 billion only produces half a billion in collateral, and that in turn damages the rating of the bank that loaned the money, something is wrong.

Tragically, what is missing from the furor over the current “crisis” conversation is an honest assessment of the problem. By failing to recognize the intangible assets that can serve as additional collateral for credit using the General Intangible Asset Liens existing in every credit agreement, Congress and the Administration are failing to see the problem clearly and making the solution much more difficult.

This solution has already been legislated and the financial tools necessary already exist in law and accounting standards. The Treasury has made use of this solution in the past. 5 Years ago, when corporations were taking advantage of IRS loopholes by fraudulent donation of intangible assets, the treasury recognized that it was unable to properly evaluate these intangibles and sought the help of private sector expertise to do so. They put to work a methodology that properly evaluated intangibles and enabled them to recover or retain over $10 billion dollars in revenue. Despite this experience, the Treasury Department has failed to apply the same solution to the current crisis, which is also caused largely by huge numbers of intangible assets not being properly accounted for. The solution for stemming the tide of bank failures is to allow for immediate, ratable recognition of the value of intangible assets, and to establish oversight to insure appropriate rigor in the process. The immediate consequence of rating actual intangible collateral in commercial debt portfolios would more than adequately infuse confidence into bank reserve accounts making costly taxpayer financed liquidity unnecessary. It would be a shame for historians to reflect on 2008 and lament that, though we had all the technology of our modern markets, we were still using accounting tools last innovated for levying taxes in the Napoleonic Wars. The problem is clear, the solution is available. Let’s hope that the Congress and Treasury have the wisdom and courage to use it.