Author Archives: sdiamond

Judge Posner Joins French Socialist Movement

In a Dog Bites Man story that caused me to shake my head and press rewind on the DVR, Judge Richard Posner last night on Charlie Rose said that the US should look to, wait for it, FRANCE, for a possible model for health care reform.

For those who do not know why this is so shocking, keep in mind Richard Posner is an architect of the theories that underlie the current financial crisis. He is a key founder of the right wing anti-government pro-market-at-all-costs ideology that has taken over most law schools known as “law and economics.” This worldview believes that unions are “cults” and that the US veered into near-totalitarianism with the New Deal.

Apparently Judge Posner is suffering from post-traumatic stress disorder in the wake of the collapse of our financial system and is desperately scrambling for ways to save capitalism from the capitalists. He has rushed into print yet another book and like many of his writings it may reflect that haste but nonetheless he is now on the record supporting a revived role for government in the economy.

The French system he argues is far less expensive and yet results in better health for most French residents. The French system insures everyone and reimburses the cost almost entirely, with 70% from the government and most of the other 30% from other sources. The results are impressive: life expectancy is two years longer than the US and France ranks 5th in league health tables with the US 30th.

The history of the socialist movement, of course, is rife with all sorts of deathbed conversions from previous adherents of capitalism who run in fear when the system blows up, as it does periodically. But I do wonder what the seminar rooms in Hyde Park (Posner still teaches at University of Chicago) are like these days when he walks in. Cold withering stares from colleagues like Richard Epstein??

Tian’anmen – Then and Now…

bodies-of-dead-civilians-0011

Around the world this week millions will remember the brave Chinese students and workers who stood up to the Chinese “communist” autocracy in May and June of 1989 and paid for their courage with their lives. Thousands were likely murdered in the streets around Beijing, while many thousands there and elsewhere throughout China ended up in prison.  The picture above was taken in the days after the crack PLA troops went on their bloody offensive on June 4 – only after regular troops refused their orders to shoot on unarmed Beijing residents.

Influenced by the uprisings of Polish Solidarity the Chinese protestors thought that China, too, could emerge from the era of neo-stalinist authoritarianism and join the global community.

The party/state apparatus that controls China had other ideas. Their implicit alliance with global capital has provided that apparatus with a new lease on life – as long as Chinese workers are willing to comply with the cheap labor/non-union regime imposed by the alliance.

In the west policy makers and intellectuals bend over backwards to justify the alliance with arguments about “progress towards democracy” and an “emerging rule of law.”  Some like David Brody, the eminent American labor historian, contend that the state controlled labor organization can evolve, as did some American company unions, into genuine labor unions. Others, such as labor educators Ken Jacobs and Katie Quan of the UC Berkeley Labor Center, Kent Wong of the UCLA Labor Center and Elaine Bernard of Harvard’s trade union program, work hand in glove with the regime itself in various exchange and “education” programs. They seem to think the American labor movement can actually learn something from the Chinese regime.  You can watch me debate these issues with Brody and Jacobs as well as labor historian Nelson Lichtenstein here. 

Some US labor leaders such as Andy Stern of the bureaucratically controlled SEIU buy the line of Brody et. al and believe an alliance with the Chinese regime offers a chance to counter balance the power of global multinational capital. He seems oblivious to the impact of the alliance that has already been established between capital and the Chinese regime.

What is striking about these kinds of defenses of the brutal labor regime in China by westerners is that the Chinese working class itself has been, on and off since 1989, in near open revolt against the Chinese government and spurns its labor arm, the All China Federation of Trade Unions.  One analyst – Ching Kwan Lee – described this as a veritable “insurgency.”

Even official Chinese statistics admit the level of resistance. According to the China Labour Bulletin, the leading independent labor advocacy group based in Hong Kong and led by 1989 workers leaders Han Dong Fang, there has been a huge increase in labor disputes referred to the official arbitration bodies used by the state to resolve labor conflicts.  There has been a similar explosion in the number of lawsuits filed by workers.

In a recent interview with the Financial Times, party dissident Bao Tang, now under house arrest in Beijing, said:

“China has almost erased the memory of Tiananmen by making it illegal to talk about what happened. But there are miniature Tiananmens in China every day, in counties and villages where people try to show their discontent and the government sends 500 policemen to put them down. This is democracy and law with Chinese characteristics.

“The first sentence of the Chinese national anthem goes like this: ‘Arise! All those who refuse to be slaves.’ I believe there will be real democracy in China sooner or later, as long as there are people who want to be treated equally and have their rights respected.

“It will rely on our own efforts, it will depend on when we, the Chinese people, are willing to stand up and protect our own rights.”

So this week, in the words of the American labor radical, Mother Jones, “mourn for the dead, but fight like hell for the living.”

GM Bankruptcy and Labor: From Sit Down Strikes to Credit Default Swaps

w-1937-overpassThe United Auto Workers gave organized labor a beachhead in the American economy with the great sit down strikes of 1937. Some seven decades later organized capital is looking to expel what remains of the UAW from GM and at the same time complete the isolation of the trade union to low wage immigrant labor based segments of the economy and the public sector. A labor movement that does not have leverage in the most productive center of an economy cannot hope to influence national social policy or progressive politics.

Unlike the bloody Battle of the Overpass pictured above, however, today’s attack on labor is being wielded with complex financial instruments, instruments of fictitious capital.  At GM, bond holders who hold credit default swaps have disrupted the ordinary incentive structure in a corporation entering the so-called “zone of bankruptcy”.

Traditionally, holders of bonds were deserving of protection as the company approached bankruptcy because insiders could be tempted to use their control over corporate resources to loot the firm and leave less for those who had a higher priority for repayment in bankruptcy.  Thus, courts have held recently that as a company like GM looked more likely to need the protection of bankruptcy its board of directors would have a legal obligation to shift its ordinary fiduciary duty to protect shareholders to the bond holders.

But the emergence of derivative instruments like credit default swaps (CDS) has twisted our ordinary understanding of incentives in corporate governance. Credit default swaps are speculative instruments created to offer a way for investors to bet on the value of bonds that ordinarily would not be open for speculation.  The purchaser of credit default swap “protection” pays an annual premium that amounts to several percentage points of the value of the underlying bond (perhaps 2% on a $10 million investment which translates into $200,000 in annual premiums to the “seller” of the protection).  If a “default” event were to occur on the bond – such as the failure by the issuer of the bond to make an interest payment or in extreme circumstances outright default on the bond – then the seller of the CDS protection must pay the buyer of the protection a certain amount (typically the difference between the par value and the current (depressed) market value of the bond). 

Hence, the term CDS: the credit is the original bond, the default is the event that triggers payoff, and the swap refers to the fact that by putting a CDS in place, the risk of owning the bond has shifted from the bondholder to the seller of protection.  One huge seller of protection on bonds was AIG and it sold a huge amount of CDS protection on sub prime mortgage bonds that have now turned out to be worthless. That has obligated AIG to make good on its promises – which they are doing with taxpayer money.

At GM, it turns out that one default event that will trigger repayment to bondholders is the filing of bankruptcy itself. So investors who bought GM bonds at par, e.g., valued at 100 cents on the dollar now hold bonds that are valued at far less, perhaps 20 cents on the dollar. If GM files for bankruptcy then the seller of CDS protection to a GM bondholder would owe the bondholder at least 80 cents on the dollar, if not more as the bond fell in price. So on $10 mn of GM bonds the payoff would be $8 mn plus the $2 mn that the bondholder could get by selling the bonds. If the bonds fell to zero in price, the holders could get the full $10 mn.

That is just a simple example and there are lots of complexities in this situation. In fact, for example, GM bonds are trading at a different price points – somewhere between 6 and 12 cents on the dollar. There is a net exposure for sellers of CDS protection of about 2.4 billion dollars on a total of 34 billion dollars of outstanding CDS positions (sellers of CDS protection sometimes buy CDS protection themselves to hedge against events such as this, but unlike regulated insurers they do not have to have any actual cash reserves to use to pay off in case of such a catastrophic event.) CDS protection also requires an upfront payment that increases as the bond falls in value, so at GM it costs $5 mn a year to protect $10 mn in bonds today (4.5 mn upfront and then a payment of 5% a year or $500,000).  Of course, that makes the bonds illiquid today or at least uninsurable.

But here is the key point: GM under US government pressure has offered current bond holders the “opportunity” to exchange their current bonds for common stock in a restructured GM. The bond holders would end up with 10 percent of the equity with the government owning 50% and the UAW’s VEBA owning 39%. Current shareholders would end up with one percent.  Apparently, though, bond holders with CDS protection believe that their CDS payoff if GM files for bankruptcy is worth more than the eventual value of the 10 percent common stock position. 

Now look at this deal from the viewpoint of current GM managers. If the bond holders turn down the exchange offer, GM files for bankruptcy which leaves the managers in control (they become in bankruptcy parlance a “debtor in possession”) and they get several months to put together a plan of reorganization. That may lead to the wipe out of the bond holders anyway but they won’t care because they will have received their CDS payout!  But here is the magic: the payout to bond holders is not made by GM or GM managers – it will be made by the sellers of the CDS protection, perhaps AIG or JPMorgan, and perhaps with taxpayer dollars! Thus, GM is freed of its bond obligations paid off with “other people’s money” and they remain in control of the company now free to use the power of a federal judge to tear up the UAW contract and their remaining obligations to pay billions into the healthcare VEBA.

And once they have cleared their books of the bonds, the VEBA and the UAW, they are free to ramp up offshore production to India and China, as they have been planning for several years.

By the way, GM bondholders were warned of bankruptcy risk at GM when they bought their bonds. They got the benefits of mandatory disclosure of risk factors affecting GM when the bonds were first issued. But the rank and file members of the UAW who “bought” the proposed multi-billion dollar VEBA to manage their health care plan were told by UAW President Ron Gettelfinger that their health care would be safe from GM bankuptcy “for 80 years.” So no CDS protection was purchased by the UAW to protect its payment obligations from GM.

The Financial Times has more on this issue here.  There is some interesting discussion of the issue on the blog Naked Capitalism here. And here is a video of an investor explaining how CDS protection is wreaking havoc in another bankrupt company.

Valley a-twitter about Hulu v. YouTube Grudge Match

The Valley is finally taking the competition between Hulu and YouTube seriously. Our home town rag, the San Jose Mercury News ran a pretty decent story the other day summarizing the key developments.  

In a nutshell: YouTube has the page hits but Hulu has the professional content and content is king, right?

As the Merc puts it:

Hulu has shown that users will tolerate video ads — at least if they are paired with the right content — and are interested in watching longer-form videos on the Web, said Graham Bennett, YouTube’s strategic partner manager.

But YouTube has a small fraction of the full-length, professionally produced content that consumers can find on Hulu. Even if YouTube can broaden its selection, it may have trouble luring consumers because many now think of the site as the place to get user-produced videos, noted Robert Passikoff, president of Brand Keys, a consulting firm. For Hollywood-produced ones, they’re turning to Hulu.

“When your brand is so deeply entrenched in that kind of milieu, it’s real hard to turn around,” Passikoff said.

That doesn’t mean the fight’s over. The online video market is still a nascent one, and neither YouTube nor Hulu has everything viewers or advertisers want.

This makes the recently concluded negotiations between Hollywood and the major entertainment conglomerates so important. The new contracts establish union jurisdiction for the online world for the first time. Hulu isn’t making much money yet but it likely will as time goes on and that will money in the pockets of actors, writers, directors and crew who make the content possible.

Who Will Really Own Chrysler? (Hint: Initials are “U.A.W.”)

Despite widespread reports that the United Auto Workers union will emerge as the controlling shareholder of a restructured Chrysler, that is not formally true. But a closer look suggests that UAW President Ron Gettelfinger’s recent comments that the UAW will not own a majority stake in Chrysler are not exactly right either.

The 55% stake that current Chrysler owners propose to issue will go to the Voluntary Employee Beneficiary Association, or VEBA, set up as a result of collective bargaining negotiations between the UAW and the Big Three in late 2007 and early 2008. To secure ratification of those dramatically concessionary deals, the UAW and Big Three promised auto workers their health care plans would be secure for “80 years” under the new off balance sheet VEBA. 

It turns out that may not be the case. Originally, the Big Three promised to put sufficient assets into the VEBA to pay health care obligations and to secure those assets from any risk of bankruptcy. But over the last year the companies got into further trouble and have now sought agreement with the union and its retired members to substitute equity for cash payments. Of course, that means the VEBA is directly linked to the financial health, or rather lack thereof, of the Big Three.

(By the way, to be clear, there is only one VEBA, for all three auto companies but it manages three separate health care plans with separate asset contributions owed in different amounts and structures from each of the auto companies.)

So who will be calling the shots at Chrysler with that huge 55% share – assuming a federal bankruptcy judge confirms the proposed deal (and that is far from certain)?

In theory it will be the board of trustees of the VEBA, also known as “the Committee” in public filings of the agreements behind the new structure. It is supposed to consist of 5 UAW representatives and 6 independent members.

But very little has been heard from this group. Despite their fiduciary obligation to protect retirees they do not seem to have objected to the very risky exchange of cash payments for equity in Chrysler. And the terms of the new Chrysler deal do not bode well either: despite owning more than half the company, apparently the VEBA will only get the right to appoint one board member out of nine.

In fact, it is a little unclear who really is on the VEBA board but one reliable source (Pension and Investments online magazine) lists the following individuals (since there are 6 listed here and none are UAW members this is likely the list of the so-called “independent” members):

Robert Naftaly, a former Blue Cross Blue Shield of Michigan executive, who will serve as the VEBA’s chairman.

Olena Berg-Lacey, a former assistant secretary of labor;

Marianne Udow-Phillips, director of the Center for Healthcare Quality and Transformation, Ann Arbor, Mich.;

Teresa Ghilarducci, a retirement policy guru at the New School for Social Research, New York;

David Baker Lewis, founder of Detroit-based law firm Lewis & Munday; and

Ed Welch, director of the Workers’ Compensation Center at Michigan State University’s School of Labor and Industrial Relations in East Lansing, Mich.

Of course, “independent” is a relative term. All six were presumably appointed with UAW President Ron Gettelfinger’s approval. They know that, he knows that. And the UAW controls the remaining five seats. In other words, the UAW only needs one vote from this group of six to completely control the VEBA itself and, in turn, Chrysler!

Now, how the supposedly independent Committee of 11 is supposed to defend the fiduciary interests of now and future auto worker retirees under such pressure is anybody’s guess.

Auto workers – meet the new boss, same as the old boss? We’ll see.

(You can read more here and here about the VEBA structure and the risks the UAW took with their retiree benefits.)

Fictitious Capital Update: Super Seniors and the Credit Crisis

A very nicely written excerpt from FT writer Gillian Tett’s new book Fool’s Gold on the origins of the credit crisis appears in the weekend edition of the FT. You can access it online here.

This excerpt shines a light on the original synthetic CDO structure, the so-called BISTRO, set up by JP Morgan in the late 90s. Morgan originally ran 9.7 billion dollars worth of loans through their first BISTRO. This became the model for hundreds of billions of loans in the new synthetic market.

The key to understanding the power of the synthetic CDO is the so-called “Super Senior” tranche. How do these work?

As a simple model, consider Shady Bank A that has made a billion dollars worth of loans to sub prime borrowers. The Federal Reserve Bank requires the Bank to keep a certain amount of capital as a cushion against losses on that portfolio of loans. Ten percent is the usual standard. So if Bank A has 100 mn in equity (it’s more complicated but let’s just assume a simple balance sheet with equity and debt) it must raise more equity if it wants to make new loans.

Or it can use a synthetic CDO to make people believe it has moved the risk associated with those loans off its balance sheet. To do that it sets up a separate entity known as a Special Purpose Vehicle or SPV. The SPV raises money from third party investors like hedge funds and pension funds. The secret, though, of a synthetic CDO with a Super Senior tranche is that it does not have to raise a billion dollars in order to transfer a billion dollars of risk off its balance sheet.

Instead it might raise $150 million. That $150 million is used by the SPV to buy, for example, U.S. Treasury bonds which then sit in a trust fund to be used only if there is an impairment to the value of the first $150 million of the $1 billion of loans. The SPV sells equity, mezzanine, and senior pieces of the SPV to raise that $150 million.  The equity tranche has the highest risk because it will be wiped out first if the original loans run into trouble. Thus, equity investors in the SPV will get the highest interest rate. 

To make sure that Shady Bank A no longer has the risk associated with the billion dollars of loans, the SPV sells the Bank protection in the form of a Credit Default Swap (or CDS: a swap (the “S” in CDS) of the risk of default (“D”) on the loans (“C” for credit).

But it turns out that the SPV investors only have $150 million in collateral raised to actually pay off on the risk of default. So that 150 million slice is considered “funded.” The CDS protection on the other $850 is “unfunded” and CDS protection on that larger piece is provided by a separate group, often AIG’s Financial Products unit, as in the case of the original BISTRO.

And therein lies the magic. Because AIG’s FP unit was not regulated by insurance regulators it had NO obligation to set aside any cash reserves to back up its promise to pay off if any of the $850 million went bad. Back in 1998 default rates rarely would eat through the first 15% so the risk on these pieces of the SPV/CDO were considered “super seniors” – safer than even the AAA rated senior tranches of the funded (i.e. collateralized) $150 million piece.

On the other hand, if default rates did hit the 850 mn piece then AIG would be in real trouble and sure enough they are and had to come running to us, the US taxpayers to be bailed out to pay off on their super senior obligations!

Meanwhile, of course, Shady Bank A has allegedly “moved” a billion dollars of risk off its balance sheet by raising only $150 million! That frees it up to make new loans without raising any more capital for its own balance sheet (well, not quite, the Fed just reduced the reserve requirement for the super senior tranche to a fraction of its older requirements). And it is free to repeat this exercise dozens of times and many banks did. To the point when, in essence, our carefully crafted reserve requirements were essentially obliterated by financial and regulatory arbitrage.

As Tett writes: “The implications were huge. Banks had typically been forced to hold $800m reserves for every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The Bistro concept had pulled off a dance around the international banking rules.”

In memoriam: Virginia Leary, stalwart supporter of international labor rights

Intlawgrrls has posted a much deserved tribute to my friend and colleague, Virginia Leary, who died this week in Geneva, Switzerland, of a heart attack at the age of 82. Professor Leary had battled cancer recently and her passing comes as sad news to those of us who have engaged in scholarship and political support of international labor rights. Virginia contributed a paper to the collection I published with Lance Compa and was always a valuable friend in the law school world. She taught at SUNY Buffalo for many years, as part of the admirable intellectual culture at the school, and then later at Hastings College of Law in San Francisco. She was also, of course, part of the Geneva international labor culture which is where she had retired.

Signs of trouble for TARP 2

April 2 – Dow Jones:

“Bridgewater Associates has decided against participating in the Treasury’s plan to get private investors to buy banks’ toxic assets, The New York Post reported… Bridgewater’s Ray Dalio cited economic and political concerns with the Public-Private Investment Program.’When the program was first announced, we were originally interested’ because the leverage the government was promising made the assets cheaper, Dalio wrote. ‘However, as things now stand, very little leverage is actually being offered via the ‘Legacy Securities Program,’” he wrote… He also said the program is ripe for conflicts. ‘The managers are clearly in a conflict-of-interest position because they have both the government and the investors to please and because they will get their fees regardless of how these investments turn out,’ Dalio wrote. He also questioned the program’s political risks, saying the limited number of managers ‘raises possibilities (or at least perceived possibilities) of them colluding because they all know each other.’”

Fictitious capital and mark to market accounting

FASB, the accounting entity responsible for setting basic rules of the road for financial statements, bowed to political pressure today and in a 3-2 vote gave breathing room to the same bankers who caused the mess we are in.

Let me explain.

Currently, banks must “mark to market” their assets including now toxic loans they made to subprime borrowers. Thus, if the bank made 100 in loans and then found those borrowers defaulting or late in their payments the value of those loans would fall, as it has in some cases to, let’s say, 30.

Now if a sample Bank A had borrowed 60 and secured equity financing of 40 to make the original loans of 100 then if those same loans are valued according to their market price – the price a willing buyer would pay for them – that is, 30, then Bank A is insolvent, would have to file for bankruptcy (slightly different for banks than, let’s say, GM) or be taken over by the FDIC.

Then the bank would get new management and be resold over time to another bank or broken up and sold off in pieces. It happens every week in the US and has been going smoothly as in cases involving WaMu and IndyMac.

But with the new FASB rules, Bank A can do its own internal analysis and tell investors that voila the loans made at 100 are worth 70 because their own analysis suggests some time in the future those loans will get paid off with interest.

According to The New York Times: “One of the dissenters, Thomas J. Linsmeier, argued that accounting rules already allowed the ‘fiction all banks are well capitalized,’ adding that the changes would ‘make them seem better capitalized.'”

Now apparently the FASB rule which allows this form of fictitious capital to be created (from 30 to 70 despite what the market says) is balanced by better disclosure to the market of the content of the bank’s analysis. That means that outside lenders and shareholders of the bank can have greater transparency into the bank’s real financial condition.

In theory then the market could do its own mark to market accounting of the overall value of Bank A if it thought the internal analysis were overly optimistic.

But notice what happens here: whereas under the current mark to market rules Bank A would be insolvent and the managers of that Bank would likely lose their jobs, under the new rules the managers get to stay in place!

FASB has just rewarded the very people responsible for getting us into this mess in the first place! And along the way the banks now lose their incentive to sell off the now inflated toxic assets to private firms as proposed by Secretary Geithner.

Does the right hand know what the left hand is doing here?

Geithner plan is a wasteful delaying action – nationalization inevitable

I made an attempt to explain to my international finance students today why the Geithner plan won’t work, relying heavily and gratefully on the wonderful analysis of Salman Khan of the YouTube based KhanAcademy.

Turns out Khan is thinking along the same wave length as Nobel prize winning economist Joe Stiglitz who wrote a devastating critique in the New York Times today indicating that the Geithner plan is nothing more than a “Rube Goldberg” machine that “has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.”

What is at the heart of the Khan/Stiglitz argument? That the banks are sitting on assets that have a market price that is far less than the money those banks owe to their lenders and shareholders. If they can’t sell those assets at a much higher price they are effectively insolvent.

So the Government is proposing to buy those assets for more than they are worth with the US taxpayer putting up 93 percent of the purchase price and the so-called private “partners” putting up only 7%. That amounts to a huge subsidy to current creditors and equity holders of the banks that caused the problem in the first place. Oh, and probably allows their top managers to keep their jobs.

But wait there’s more.  If the assets turn out to be worth more than that juiced up price paid by the new Public-Private Partnerships in the Geithner reworking of the old Paulson TARP plan then the US Government gets only 50% of the upside, since most of the money put in by the Government is in the form of a loan not equity. The other 50% goes to the private partner, including big financial groups like PIMCO and BlackRock.

And the loan to the partnership from the Government is a non-recourse loan which means if the entity loses money the Government has no ability to go after the assets of the private partner, even though they will have managed the business into a loss!

No wonder groups like PIMCO and BlackRock said they would participate and no wonder Wall Street rallied on the announcement of the plan. It’s a win-win for the banks and for the private partners. The real risk is taken by the US taxpayer.