Wall Street blues: Four lessons learned

by Urs E. Gattiker on 2009/03/05 · 6 comments 10,051 views

in d business regulation,d business wef davos

These days the financial crisis even affects Milan’s Fashion Week, which began last Thursday (2009-02-26) (see also Milan Fashion Week – 2008). IT Holding, the owner of Gianfranco Ferré and other famous labels was given bankruptcy protection, after racking up heavy losses and failing to find a buyer for its brands (see also Paris Fashion to organize Davos 2010).

It is obvious, the world is suffering a crisis of excessive indebtedness. To make matters more worrying, many governments, including the US, are too highly leveraged, as are many corporations such as banks. Moreover, US households are groaning under unprecedented debt burdens. So are there any lessons we may be able to learn from these economic woes? Read more below.

Lesson 1 – Protectionism and nationalism rule
Everybody agrees in public that protectionism and nationalism, while appealing to voters, will not help resolve the crisis. Nevertheless, French president Nicolas Sarkozy’s suggestion that Peugeot close its plants in Slovakia to save jobs in France tells another story.

    World Economic Forum WEFdavos2 Danube #crisis |Bank Austria, Erste Bank & Raiffeisen |lent €210bn = 68% of Austrian GDP|2 main trouble-spots Romania/Ukraine

As the tweets suggest, if debtors default, the main Austrian banks will be in serious trouble. While Austria can expect support if needed from Eurozone authorities before having to approach the International Monetary Fund (IMF), things are different for EU member states outside the Eurozone such as Bulgaria, Romania and Latvia. Will this result in an interlude of nationalization, followed by reorganization of new, narrowly focused retail banks in these countries? Nobody knows for now.

It is justifiable if a factory of Renault is built in India so that Renault cars may be sold to the Indians. But it is not justifiable if a factory … is built in the Czech Republic and its cars are sold in France” – Nicolas Sarkozy, president of France.

2009-03-08: Without global co-ordination, ‘stimulus’ and ‘protection’ are two names for the same thing. The controversial ‘Buy American’ section in the US stimulus bill requires that only US-made steel and concrete be used in infrastructure projects.

Lesson 2 – Even government-owned zombies are unpleasant

In a bid to avoid several bankruptcies among the bigger financial institutions, the UK and US governments have been swayed to take over a sizable share of private debt and provide billions worth of loan guarantees to RBS and Citigroup, respectively. But as the chart to the left shows, this did not stop those banks’ share prices from continuing to freefall.

In AIG’s case, the government took over 80 percent of the company, but this does little to avoid other tough choices. There is another $300 billion in net exposure that must be resolved. Obviously, even government-owned assets that are considered junk, are still trash and smell unpleasant. AIG’s insurance operations are buried by losses spewing from troubled parts of the business – $100 billion for 2008 alone.

Investors understand this dilemma and this past Monday, stock markets dropped like rocks in conjunction with recent announcements made regarding dividend cuts (see charts below).

Banks lead the fall in share prices as Wall Street hits lowest levels since 1997

Banks lead the fall in share prices as Wall Street hits lowest levels since 1997.

As the graphic to the right shows, US equities have been dropping for quite some time and this week does not give the impression that this trend may be changing anytime soon, whether for better or worse.

Lesson 3 – Capitalism for profits, socialism for losses
Besides that, even if government takes over stock or extends massive loans as described above, having all profits be distributed to managers while losses are absorbed by taxpayers is not only a potentially bad strategy, but no strategy at all.

Instead, managers must be offered the carrot and the stick. For example, failure to perform could be made to have consequences through deferred payment schemes or ‘claw-backs’.

    World Economic Forum WEFdavos #trend2watch #ethics | SwissRe writes off Sfr6bn bad debt Sfr25bn remain on the books | pays mgmt/board Sfr50mio bonus #greed
    World Economic Forum WEFdavos #trend2watch #ethics |Sir Fred RBS |loose £24bn |get $325bn of gov loan guarantees |get £693000-plus yr/pension | #greed

It cannot be that neither Vikram Pandit (CEO of Citigroup) nor Oswald J. Grübel (new CEO of UBS) nor Peter Forstmoser (Chairman of the Board of Directors Swiss Re) do not partake in further losses, while reaping the rewards from future profits.

Lesson 4 – Paying cash for trash
The above illustrates that neither governments taking over bad debt nor losses is a good move for taxpayers. Unfortunately, it also does not make sense to invest in ventures whose futures are bleak, to say the least.

    World Economic Forum WEFdavos GM Opel | with Vauxhall UK, financing| €3.3bn gov |1.2bn investors |0 cash from GM ➡3.3bn in patents, licenses | 0 #risk for GM
    World Economic Forum WEFdavos GM Opel |market share 2007=8.4% 2008=7.9%|produc. 1.5mio sub-compact/mid-size cars|too little to survive on its own !| #downturn

Opel cannot survive on its own; producing 1.5 million cars is considered too low a number to survive in its market segment. But Germany carrying all the risk for GM (i.e. giving the cash it needs to survive while GM provides little, if anything), is not the solution.
Still, Germany is not alone: Canada has been asked to invest CDN$900,000 for each job that might be saved by GM.

    World Economic Forum WEFdavos GM Canada | asks Gov for CDN$6bn ➡ keeping 7000 out of 21000 jobs = CDN $900000 subsidy/job UNREAL cash for trash |#downturn

So will European governments be strong and smart enough to resist the car-maker’s urgent appeal for state aid so they can avoid closing three out of 10 factories to get rid of overcapacity in Europe? What is really needed to avoid closing plants and save jobs at GM in both Europe and Canada, is further voluntary redundancies, pay cuts and implementing part-time work. Even then, the survival of the Opel and Vauxhall brands as well as Canadian plants in their current form seems unlikely.

So why throw good money after bad? Is it to pacify the public? Certainly, it is not to save money, considering how much will have to be spent for each job to be saved.

    World Economic Forum WEFdavos #WEF REFLECTIONS What was NOTsaid #Davos ➡ Pressure on governments to protect jobs may make it harder to push through structural change

Here’s my suggestion for today. What is your take, how do you perceive this situation as a shareholder or taxpayer?
Please share your insights and write a comment below. Thanks and I look forward hearing from you.
More resources:
Financial crisis – what shall we do?

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    @hiker @geogeller | pls consider ’stimulus’ and ‘protection’ =2 names for the same thing | see Lesson 1 | http://ad.vu/dktv | #WEF #Davos

  • http://owenbrunette.com Owen Brunette

    There needs to be more justification of the comment that stimulus is protectionism. Stimulus is definitely an option which is only viable in scale for those with major currencies. In particular the US’s ability to use its reserve currency as a bottomless source of debt, is an option which those with a greater need of credit do not have, and is an ethical unfairness which can’t sit well with anybody forced to think about it.

    On the other hand stimulus is paid for largely by the tax base of the country involved and is definitely a many edged sword in that it reduces the speed of restructuring across the domestic economy and distracts business from its greater purpose of providing value to people. There is an ethical issue in that the stimulus is also paid for by devaluation of the currency in which foreigners have purchased debt. This is only mitigated by foreigner’s ability to foresee the devaluation before purchasing the debt. The fact that politicians find it so easy to please people in their election based timeframe at the expense of both their and other countries peoples is a fundamental challenge in democracies and requires effective, strong governance to overcome. The history of debt for the last fifty years indicates that we haven’t yet got the governance of national debt resolved.

    The rapid slip into nationalism in the US bill by introducing buy American clauses indicates not just the lack of understanding of the WTO but the political weakness of the current federal model in the US with lobby groups and thoughtless flag waving preventing a rational policy in even national interests let alone for the greater good of us all. While the battle to inform has to continue, the problems are structural in the culture as well as the governance models, leaving all of us all very exposed. These are complex problems and the more we understand and discuss the better for all of us.

  • Urs E. Gattiker

    Owen thanks for the comment.

    I think we have to also admit that the bulk of the adjustment would be borne by the world’s largest exporters such as Germany, China and Japan. And while Opel is relevant for Germany’s export-oriented model bailing the GM subsidiary out of bankruptcy is not necessarily smart. A German bail-out of Opel combined with French car subsidies will contribute to massive overcapacity in the sector. In turn, this will slow down the economy’s adjustment to export shock.

    I have mentioned before:

      For foreign creditors, such as China and Japan, buying US government debt is like paying cash for trash and it promises to get worse. If these countries stop paying for US overspending we will have a real economic disaster.

    Also I have pointed out firing people working with an H-1B visa in the US is not a good suggestion made by Chuck Grassley, the Republican senator from Iowa to Steve Ballmer of Microsoft

    Unfortunately the passed $878bn stimulus bill prevents financial institutions that have received money from the US government from applying for H1-B visas for highly skilled immigrants, if they have made US workers redundant. Bank of America is such a case. BofA acquired Countrywide, the mortgage broker, and Merrill Lynch resulting in several thousand positions being made redundant.
    Hence, Bank of America rescinds job offers to foreign MBAs this year. The question is if that could cut US from foreign talent and encourage tit-for-tat countermeasures by trading partners such as UK and Germany?

    I still believe that unless we coordinate stimulus packages, these might just end up preventing us from reform that is being needed. Unfortunately, without some reform, recovery will take years to come. As things look on this side of the pond, the forthcoming Group of 20 summit in London is likely to deliver less than it promises.

    PS. in an L-shaped recession as we seem to be getting into one starts with a steep decline, followed by very low growth for several years to come. I fear that political decision-makers are not ready to make the reforms we need for getting us out of this recession faster. Fasten your seat belt we are in for a long recession.

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