Many of you likely saw the following article in the New York Times detailing Bank of America’s plea to the government for a bailout of the mortgage markets (see A ‘Moral Hazard’ for a Housing Bailout). Edmund Andrews writes:

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

This, in essence, would represent a public bailout of the banks. Mike Barnett, a guest blogger to this site, recently expressed his concern about the message that such a bailout sends to the bankers, and some broader implications it might hold for our society at large (see Reward Without All That Nasty Risk).

With that in mind, I asked Mike if he’d like to comment on this piece. Here’s what he wrote back:

Mike Barnett’s comments: The New York Times article talks more about the moral hazard we’ve been seeing in action — few morals, many hazards. The same folks who wanted government to stay off their backs now want government to carry them on its back. It’s like the kid who wants his parents to stay out of his affairs until the bills and the problems mount, and then fully expects mommy & daddy to bail him out. And that’s really the problem here — because mommy & daddy (the government) have an attachment to little Johnny (the banking industry), they’re prone to covering for him; little Johnny knows this, and he abuses this, time and time again. What’s a parent to do?? As the article notes, what’s good for Bank of America is good for America . . . then again, for the long-term sake of America, maybe we need to let little Johnny make his own way for once, or he’ll never learn.

My comments: Mike is pointing out how the moral hazard plays out in this case. In the previous post he pointed out some of the second order effects (aside from saving the banks and incentivizing the moral hazard) that might result from such a bailout (e.g., a larger U.S. populous feeling disenfranchised by a system as that privatizes profits but socializes losses). Realistically, I think it’s becoming clear to most market participants that some form of public bailout is likely to occur. The issue now is what form should that bailout take. We’ve recently seen proposals similar to that of Bank of America floated by Rep. Barney Frank that would allow the government to buy distressed mortgages (see Bernanke Calls Plan to Buy Mortgages ‘Worthwhile’). Likewise, Alan Blinder offered a thoughtful alternative in which the government would revive an agency (HOLC) created during the depression to rescue families from foreclosure (see From the New Deal, a Way Out of a Mess). As I’ve mentioned before, I am not an expert in issues of social welfare; however, I agree with Mike Barnett that if we are to move forward with a bailout, it must take a form that: a) penalizes those who had a hand in creating this debacle, and b) enacts regulatory measures to make sure that we never end up in a situation like this again.

Mike Barnett expressed some serious concern about the functioning of our capitalist economy in his prior post. Nouriel Roubini recently expressed a similar view. He writes:

This is indeed a one-sided game where financial insiders privatize profits while the massive losses of their reckless behavior – searching dangerously for yield, gambling for redemption, being subject to distorted incentive not to monitor their lending and risky investments - are systematically socialized during a crisis. This is actually “crony capitalism” of the worst kind, as bad as the one that plagued emerging market economies and led to their severe financial crises in the last decade.

Any government-led intervention (bailout) must, at all costs, try to avoid being perceived in that way.

Several months ago I blogged about the Miller Coors joint venture consummated between SAB Miller and Molson Coors (see Now Introducing Miller Coors, JV???). At the time I expressed some reservations about the joint venture. I still have those reservations.

My basic argument was that the joint venture would likely encounter serious coordination issues, and that it would be characterized by conflict between the parents. I continue to believe that the deal probably should have been structured as an acquisition, and unless this joint venture is a prelude to such an acquisition, I don’t hold out high hopes for its success.

Given the coordination issues I identified, you can imagine my glee at reading several columns from last week’s newspapers. The first was an article that appeared in the Chicago Tribune suggesting that the likely headquarters for the joint venture would be Chicago (see Miller Coors may Base Venture in Chicago). The second was a piece from the Dallas Morning News claiming that Dallas was under consideration as the headquarters for the joint venture (see Dallas Among Options for Miller Coors Move).

What’s interesting to me was not that a corporation is deliberating where to locate its headquarters. These kinds of decisions happen all the time. What fascinates me is that given the location of the parents’ US headquarters, whatever location they choose (Dallas or Chicago) will necessarily result in increased costs. For example, let’s say they choose Dallas. If that’s the case, what happens when management from the Coors side of the business (located in Colorado) needs to coordinate with management from the Miller side of the business (located in Wisconsin)? It will require a whole heck of a lot of increased travel back and forth to Dallas. That ain’t free. Similarly, what happens when operations folks in Colorado and/or Wisconsin need support from management? You got it. More travel!

All they are doing by creating a new headquarters apart from the existing Colorado and/or Wisconsin operations is adding another layer of management costs on top of each of their individual operating structures. 

And forget the part about how costly it will be for the two sets of management to decide on where the actual headquarters should be located. That’s another negotiation altogether. One thing’s for sure: if it remains a joint venture, I bet they do not choose Colorado or Wisconsin for fear of alienating one of the parent firms. However, choosing either Colorado or Wisconsin is precisely what they should do!

Does management really believe that the achievable (notice I did not use the word available) production and marketing synergies through this joint venture structure will really offset the increased coordination and management costs? That’s obviously a rhetorical question. They must since they decided to enact the venture. But I’m not buying it.

As I mentioned in the previous post, if this were an outright acquisition in which one party were able to direct the activities of the other so as to make operating decisions unilaterally and shut facilities down, then sure, I think this marriage of firms would have a fighting chance at creating a formidable competitor to Anheuser-Busch. If it were structured as an acquisition, I’d also be willing to bet that the headquarters would end up exactly where it should - in either Golden, CO or Milwaukee, WI - and not in some silly neutral site palatable to both sets of management.

It should be fun to watch this one play out. Stay tuned!

In a previous post, (see From Old Stories to New) I suggested that it is time to begin turning our attention away from mortgage-backed securities, the decline in M&A activity, and the difficulty that banks have had selling corporate paper. In a sense, this is old news. Sure, there are more write-downs to come for banks and other financial institutions, but it’s time to start turning our attention to the next leg down - non-financial corporate defaults and bankruptcies.

It has been my expectation that corporate defaults and bankruptcies will increase for two main reasons:

1. On the demand side, consumer weakness will reduce profitability

2. On the supply side, the credit crunch has made it more difficult for corporations to raise capital

We are now starting to see what I perceive to be the beginning of this increased trend. Corporate bond defaults thus far for 2008 have surpassed those for all of 2007 (see RGE Monitor). And as I mentioned in a previous post, the total number of bankruptcies filed this year have exceeded those from all of 2006. So let’s take stock of some of the bankruptcies announced so far in 2008:

• Wickes Furniture (furniture retail)
• Sharper Image (retail)
• Lillian Vernon (retail)
• Sirva (moving services)
• Blue Water Holdings (auto)
• Buffets Holdings (restaurants)

What do these bankruptcies share in common? Some are a result of weak balance sheets caused by excessive leverage associated with LBO deals (see Meet Seven Private Equity Buyout Victims). Others are more directly tied to the struggling consumer - housing, automobiles, clothing, and restaurants. A few (Wickes, Blue Water, and Buffets) were hit by the double whammy - weak balance sheets and a struggling consumer.

I will try to keep stock of high-profile bankruptcies and defaults in this blog as this this slowdown progresses. This should be one of the main stories of 2008. In the meantime, expect more of the same, with those firms closest to the consumer (especially in those industries hardest hit - home, auto, retail) and those firms with compromised balance sheets (not just those that are a result of excess leverage from LBO deals) among the first to go.

The beat goes on…

I was recently contacted by Alan Zibel, a reporter from the Associated Press. He asked for my opinion on the credit crunch and its effects on corporate “cash and marketable securities” holdings (see my post Where’s the Stuff Buried for background). He was particularly interested in how short-term, auction-rate securities that non-financial firms (such as Bristol-Myers) hold have been, and will be, affected by the credit crunch.

Alan did a more than admirable job explaining the underlying problem (see the full column Companies Cash-like Holdings Pose Risks). There were several minor factual errors, but otherwise, Alan was spot on. For example, he writes:

…these investments, known as auction-rate securities… [have] become extremely difficult for companies and wealthy individuals to sell…which are backed by mortgages, student loans and municipal bonds.

I could be mistaken here, but my understanding of the auction-rate securities is that they also (if not mainly) include corporate debt. But that’s really just a minor quibble. The more important fact about these securities is that the debt generally has a long-term maturity (20-30 years or so), but they are auctioned off to the highest bidder in a Dutch-style auction every few weeks to 6 months, essentially marking them to market.

The most important piece of the story Alan gets quite right. Specifically, that

Hundreds of auctions have failed over the past week…

This implies that there were no buyers for some of these securities. Now, for non-financial firms (and there are many) like Bristol-Myers this suggests that a portion of their “marketable” securities no longer have much of a market. So now what?

I am not an expert in accounting, however, my understanding is that firms can switch the securities from short-term holdings to long-term holdings to the extent that they believe that the securities that they hold from a failed auction still have value. However, to the extent that the underlying asset to which the auction-rate security is tied is non-performing (e.g., insolvent, not just a result of temporary illiquidity in the market), then the firm should write those down. The question then becomes - How do you determine which auctions failed because the market is tough right now and buyers are scared and therefore scarce (temporarily preferring the security of Treasuries), versus, those that failed because the underlying asset to which the securities are tied really do not have value so buyers are rightly not interested? For non-financial companies holding such assets, there is a fine line between the two, …and this is a gray area in reporting.

I spent a good amount of time with Alan talking over various aspects of the issues. I must say that I was impressed. He was a pleasure to talk to - very kind, very humble, and with a genuine curiosity about the underlying phenomenon. I certainly wished he had chosen a more flattering quote of mine to use, but I do not dispute the content. I certainly did say what he claims that I said, and I’m sure those of you who know me could verify that, in fact, that’s the way I speak. Zibel writes,

Still, Robert Salomon, a professor at New York University’s Stern School of Business, said many executives likely were unaware of what they were buying. “I would expect to see corporate treasurers raise the question of: well, what the heck is in our portfolio?” he said.

What I was trying to point out was that corporate treasurers likely did not have the time to perform the due diligence necessary on the assets they were buying. They are too busy on a day-to-day basis trying to manage corporate cash flow. They therefore most likely relied on the ratings agencies and assumed that if the paper was rated AAA, they were buying high quality securities. We’ve since learned that although they were buying AAA-rated securities, the quality of the underlying securities did not deserve such a rating. In that sense then, many treasurers were probably left wondering what, exactly, their portfolios contained, and their true exposure to “risky” securities. And if they hadn’t started asking relevant questions about their portfolio in August, they certainly are now.

To the question of what will happen next. My answer was to expect more, and greater, write-downs.

I’ve recently exchanged e-mails with Mike Barnett, a friend and colleague from the University of South Florida, who has not taken too kindly to the socialization of losses as a result of the credit crunch. Issues of social welfare are not my forte, but it is right up Mike’s alley - as one of the foremost young scholars in the field of corporate social responsibility. So I decided to give him a forum to express his ideas as a guest blogger. Hope you enjoy his perspective. I’m hoping he will chime in from time to time with his thoughts.

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I hate losing money – can’t stand it. On the other hand, I love gaining money – nothing better than a major windfall. Problem is, you typically have to risk losing money in order to get the opportunity to gain money; be it a trip to Vegas, a wild ride on the stock market, or the financing of a new firm. Most people, like me, are risk averse. Our hatred of losing money outweighs the joy we get from winning money by enough that we seldom take big risks, and so we don’t usually lose big, but we also don’t usually win big. However, we respect the risk takers, and we don’t begrudge their windfalls, because we know that the winners had the courage to bear the risk of losing big, and so they deserve the rewards of bearing that risk.

Now let’s modify that a bit; more accurate is that I hate losing my money. I’d be glad to lose someone else’s money all day long. And I especially love gaining huge sums of money for myself while risking losing someone else’s money. Imagine if a casino offered you the opportunity to gamble without the risk of loss; all losses would be forgiven, but all gains would be yours to keep. If you’re playing with house money, why not bet the house? It’s only rational.

We should expect exactly this type of behavior – moral hazard – when the government bails out failed risk-takers. In recent decades, the government has pulled back the taxes on large gains, giving the risk taker more and more of his reward; and so we get more risk-taking. That’s typically good for an economy in the near term (though it can harm tax bases & middle classes over time, and so be bad in the long term; a whole other issue). But the government has not pulled away the safety net, and so the risk-reward ratio has become asymmetrical – the rewards are high and the risks are low. If you fail, the government (through the taxpayer) bails you out. So why not take a lot of risks?

Consider what’s going on with the mortgage meltdown. The banking industry made huge profits off of writing risky loans, often in very creative fashion. But now that defaults are on the rise, and profits have turned to losses, bankers seek to shift the losses to the government. For example, Credit Suisse is pressing HUD to have the FHA guarantee mortgage refinancings (see Worried Bankers Seek to Shift Risk to Uncle Sam). Should we, the taxpayers, guarantee a bad mortgage that Credit Suisse probably should not have made in the first place? And sadly, Credit Suisse is not the only culprit. Other examples of shifting losses to the government abound.

We can admire the tight rope walker who spans the skyscrapers. He deserves the attention; he’s crazy enough to take this risk. But if we come to find out that it was a camera trick, and left outside of the frame was the fact that he was only three feet in the air, with a cushioned mat below him, then we lose respect. And this is how we lose respect for the free market system, too. If gains are privatized but losses continually socialized, we run the risk of disenfranchising many in society who will come to perceive the system as “rigged”. Socializing losses can be likened to a form of corruption, and in the long-term this is risky to the stability of our society.

Ultimately, we can’t justify huge winners unless they’re risking huge losses. So when we find out that they got their huge gains in prior years without walking a tightrope, we do begrudge their gains, and we don’t feel sympathy for their losses. And now they want us to absorb those losses??

We all love a free market, so long as we get to control it. The folks making obscene gains in some years gain the power to pervert the regulatory system and build a personal safety net for lean years. And, as taxpayers, we share less and less in their gains and bear more and more of their losses – the losses are increasingly socialized while the gains are increasingly privatized. Yip, it’s as corrupt a system as it sounds – Robin Hood in reverse.

There are two ways to go – go with a true free market and let folks fail, not just win; or put in a safety net via regulation that does not provide incentives for market participants to take reckless risk in the first place. Like I said, I’m risk averse, and so I don’t like the volatility of the former. Going for the latter would remove the asymmetry at the root of today’s turbulent market and create sound rules for a “fairer” game. So let’s not pull the net; let’s just lower the roof and use the excess material to build a stronger net. In Senate testimony today (Feb. 14), Bernanke reaffirmed the role of the Fed in providing “adequate insurance against downside risks.” It’s a question of who pays the premiums, who provides the reinsurance, and who acts as the ultimate backstop that determines the fairness of the system.

I came across an interesting article by Floyd Norris in Friday’s edition of the NY Times (see Corporate Auditors Focusing on Cash and Securities). What I found most interesting about the article is that Floyd seems to be echoing many of the concerns that I’ve expressed in recent posts (see From Old Stories to New, Where’s the Stuff Buried, and Strategy in a Recessionary Environment). The ideas he advances represent an amalgam of those that I’ve discussed. This is not to say that Floyd got his inspiration from my work. In fact, I’d be willing to wager big that Floyd has no idea who I am and has never read a single word I’ve penned. I was just struck by the similarity of opinion.

Consistent with my piece on “Where’s the Stuff Buried” Floyd asks:

What happens when cash really is trash?

He then goes on to acknowledge:

This is important…because there could be more write-downs similar to the $275 million impairment charge taken last week by Bristol-Myers Squibb…

Floyd also recognizes that raising capital has become difficult for corporations recently, and that this will make the operating environment quite difficult for firms with weak balance sheets, consistent with my piece on “Strategy in a Recessionary Environment“.

But what’s most sobering is the trend toward increasing corporate defaults and bankruptcies. I’ve been predicting this for almost a year now (most recently in “From Old Stories to New“). Floyd writes,

The number of corporate bankruptcies filed by leveraged borrowers so far this year is greater than the total filed in all of 2006 and 2007…

I expect defaults and bankruptcies only to increase for the remainder of 2008 and into 2009 (see Analysts Formally Predict Uptick in Defaults). I likewise wouldn’t be surprised to see more than a few high profile bankruptcies (of the household name variety). In my opinion therefore, corporate defaults and bankruptcies will command a good portion of business press attention over the coming months. This is just the beginning…

We’ve all read (and heard) a lot recently about the troubles that firms have had raising capital from investment banks as a result of the credit crunch (see M&A Activity on the Decline). It’s quite simple really - with less money coming in as a result of a variety of bad loans, the banks have less money available to go out to their banking clients. We’ve also heard a fair amount about how investment banks have had trouble selling the corporate debt that they’ve already committed to and/or underwritten. Calculated Risk has written much about this, likening these loans to piers. They were supposed to be bridge loans (temporary loans warehoused until they could be sold), but now they have become pier loans (bridges to nowhere, stuck on the banks’ books for an indefinite period of time). Investment banks have had great difficulty selling that paper without steep discounts. In fact, some of that paper is fielding bids at as little as 60-70 cents on the dollar (see Anyone for Used Corporate Debt?). And it’s not just the markets for leveraged loans on the banks’ books that are in retreat, but also the larger market for existing corporate debt (see Watching the Corporate Bond Bubble).

While these stylized facts speak to the difficulty that banks are facing in the current environment, it also presages a forthcoming rash of corporate defaults. To readers of this blog, this information is not new (see Analysts Formally Predict Uptick in Defaults or The Future of Corporate Performance). It should therefore come as no surprise that Ed Altman, the bond guru (and a colleague of mine at Stern), formally predicted a significant increase in defaults (see A Year of Reckoning).

But what I’m trying to get at with all this is that I think that the story of the bond markets is now an old one. Instead, I think it’s time to turn our attention to the next leg down in this cycle - the corporate defaults themselves. We should therefore get used to seeing cases similar to that of Wickes (see Wickes Furniture Files Chapter 11 Bankruptcy - hat tip, Mish). After all, the bond market spreads have been predicting this for awhile now. Buckle your seat belts…

I came across this blog entry in the WSJ last week (see The Credit Crunch Hits Bristol-Myers). The article details how BMY was forced to write-down $275M on an $811M investment in subprime holdings.

I’m not intentionally trying to single out Bristol-Myers. I recognize that firms need to do something with excess short-term liquidity where they anticipate some near-term need for their cash. In such cases it is better to hold onto the funds than it is to disburse them in the form of dividends. However, holding pure cash is counter-productive. Firms therefore often invest their cash in money markets, treasuries, or other “tradeable” securities.

I understand that it has been standard practice for some time among many firms to hold auction-rate securities. These holdings, like money market funds and treasuries, generally fall under the “cash and marketable securities” line items. However, this episode stands out as a poignant example of what happens when supposedly “marketable” securities suddenly are no longer marketable. I therefore wonder:

1. Was the extra return promised by these auction-rate securities worth the added risk? BMY acknowledged holding securities of this sort for the better part of a decade (see Bristol-Myers, Ciena Losses Show Subprime Infection). So, did the additional interest revenue that they captured over those 10 years (the spread between auction-rate securities and its next best alternative, like treasuries or money market funds) exceed the $275M write-down?

2. Were corporate treasurers adequately equipped to assess the risks associated with the securities they were purchasing? One of the arguments made by many economists was that the subprime-backed derivatives were opaque and difficult to accurately value. If professionals in finance who’s job it is to actually trade and value these assets had difficulty doing so, could we reasonably have expected corporate treasures to be qualified to do so?

3. If a large pharma firm such as BMY holds securities such as these, that begs the question - what other firms are holding such securities, and does this simply represent the first of many such announcements? We’ve heard about the bank write-downs. We’ve heard about the hedge funds. We’ve heard about the monoline insurers and counter-party risk. But now this??

And finally, with respect to corporate strategy…

4. How will this impact the operations of firms moving forward? With fewer discretionary resources at their disposal, it certainly hinders their ability to pursue their strategies (see Strategy in a Recessionary Environment). And I have to admit, although I readily expected business conditions to deteriorate as a result of tightening credit on the supply side and a struggling consumer on the demand side, I was not quite anticipating this spillover mechanism. If this effect is more the norm than the exception, I anticipate the outlook for corporate performance to be even bleaker than I had suggested in previous posts (see The Future of Corporate Performance).

Again, I do not mean to single out Bristol-Myers. Their only fault is that they just happened to be among the first firms to acknowledge the problem, thereby drawing attention. Come to think of it, maybe we should actually be applauding BMY for being proactive in recognizing the problem and writing-down those assets as quickly as possible in an effort to move past it. As such, they are likely ahead of the curve. Should that be the case, we certainly shouldn’t be surprised to see others follow in their wake (in fact, see Bristol-Myers, Ciena Losses Show Subprime Infection for corroborating evidence).