Too Big to Fail, Too Well-Connected to Jail: The Economic Underworld of Bankruptcy for Profit

In her brilliant essay, NY Times Pulls Punches on Wall Street Bubble Era Pay, Yves Smith at Naked Capitalism quotes a 1993 research paper from the Brookings Institution titled Looting: The Economic Underworld of Bankruptcy for Profit.

"Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints.

To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values...

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, (such as Enron, and even the 'deep capture' of agencies like the SEC, and the placement of your people in key government positions - J) causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses...."

We wonder if the authors Akerlof and Romer realized that their paper of appropriate warning would become a prophetic, virtual guidebook for an historic looting of the United States economy by a few financial institutions under the government guarantee of 'too big to fail' and 'too well-connected to jail.'

Impossible? Who would have believed that a paper from a neo-conservative think-tank, The Project for the New American Century titled Rebuilding America's Defences: Strategies, Forces And Resources For A New Century would become a blueprint for a program of deception and invasion?

The conclusions and the title of this blog are our own. Yves is one of the most level-headed of economic commentators. Her site is a 'must read' for the serious every day. We do not wish to put words in her mouth.

Having said that, the solution for non-US investors is simple. Do not hold US dollars or dollar assets to any significant degree until it proves itself to be responsible again. Bring your money back to your home economy. Build something useful for yourself and your children. Do not be a renter in your own house. If you are not for yourselves, who will be?

Do not allow your own bureaucracies to enforce an industrial policy of domestic deprivation and low wages to support an aggressive expansion of exports in return for increasingly worthless paper. When will the benefits come if not when times are good?

If your country is large enough you may become self-sufficient. If not, you can join one of the regional trade associations such as the European Union.

Commodities such as oil and industrial raw materials will continue to be pivotal, highly manipulated and disputed, for quite some time until the world regains its economic and political balance. Why would you allow one country to essentially set all the prices with its own paper?

For US investors the solution is not as easy. The dollar is an essential component of any portfolio and almost all day to day transactions.

There is promise in the new administration, despite early disappointment in some of the appointments to date. Let's give them time to show progress and programs. One needs capable individuals in place to act quickly. How can we forget the stumbling missteps of the Jimmy Carter administration?

However, too many of the appointments are cyncial verging on the outrageous for a government with a mandate to reform. Actions will speak much louder than words.

Excessive secrecy is incompatible with a democracy. More transparency in government is a reform of the first order.

It took years to lose our integrity, and to regain it is the work of a generation, one day at a time. There has been an ongoing program of overturning all the reforms and regulations of the 1930's, one by one, to discredit and repeal them, and to ultimately put the country under the control of an oligopoly. The pattern is unmistakable.

If you would like to give your children and grandchildren something worthwhile and lasting at this holiday season, then resolve to reform and replenish the Republic that your parents and grandparents gave to you, and not trade it away for some short term security and profit.

Deutsche Bank Surprises Bond Markets By Failing to Redeem its Bonds

It really doesn't seem all that bad to us, compared with the US banking tradition of throwing yourself on the doorstep of the New York Fed and ringing the bell, threatening to collapse the economy until you are bailed out.


The Financial Post
Deutsche stuns market by delaying bond redemption
By John Greenwood and Jonathan Ratner
Wednesday, December 17, 2008

A move by Deutsche Bank to go against industry practice by passing up an opportunity to redeem a chunk of subordinated debt has escalated the level of turmoil in financial markets as investors worry that problems at the German financial services giant might be greater than imagined.

Meanwhile, at least one analyst is speculating that Canadian banks could follow suit on a portion of the more than $3-billion of bonds that they have coming due in the next few months.

Deutsche Bank stunned the market when it said on Wednesday it will not redeem 1-billion euros of callable bonds at the first opportunity. The debt does not mature until 2014, but it has a call date of January 2009, meaning the debt can be paid back as early as next month.

It is a long-time industry practice for banks to redeem such bonds on the earliest possible date, as proof of the soundness of their balance sheets.

Analysts said Deutsche is the first major player to break the tradition.

The move "raises some awkward questions about [the German bank's] financial position," said CreditSights analyst Simon Adamson. "But more than that, it is a signal that banks do not see a return to more normal funding conditions in the foreseeable future, and that is a damaging statement for the banking sector."

"This is a big deal in the bond market," said another analyst who asked not to be named, pointing out that investors have always taken for granted that such debt always gets paid back at the earliest opportunity.

Banks around the world are under the spotlight as investors try to figure out how this episode of the credit crisis will play out, whether other banks will copy Deutsche or whether it will end up as an isolated occurrence.

"We will see if any of the Canadian banks follow suit," said the analyst, adding that they will do so if they believe they can gain by it.

He said there could be several reasons for Deutsche's decision not to redeem. One possibility is that it simply needs the cash and is willing to pay the penalty for later payment in order to hold onto the money longer. A second possibility is that it already has sufficient funding to keep it going for a considerable period and can afford to take a step that would make it much more expensive to access the credit markets. (Oh yeah number two sounds likely - NOT - Jesse)

"Do you want to shut yourself out of the market, which is what you would do?" the analyst said.

You would also shut your competitors out of the market because the whole sector would likely be tainted....

Nasdaq 100 March Futures Hourly Chart

Here is a simplified screenshot of one of the futures charts I watch during the day. This one is for the Nasdaq 100 futures basis March.

I am not showing the other trends I watch on this chart for the sake of simplicity, but you will get the idea if you look at the nightly updates.

The trends with support and resistance may be a little clearer when one looks at them this way.

For short term traders I would recommend the AlphaTrends website which is listed on the left under educational links. Brian is a very good technical daytrader.