Global Banking And The Bizarro World

Are you aware of the Bizarro World?

It was first described in a 1960s story line in the Superman comic book series. The Bizarro World was a reverse image of Earth, a place where good people could meet their bad equivalents. Superman and Lois Lane, for instance, were always platonic friends and colleagues on Earth, but they consummated their relationship, had children, and fought relentlessly on the Bizarro planet.

The key plot device that drove the popularity of the story line involved the sheer implausibility of separating the good from the bad. The good Superman, for instance, would inevitably recognize some degree of goodness in his (supposedly) bad Bizarro counterpart. He would also recognize some degree of badness within himself.

Wouldn’t it be nice to purge all that is bad, and keep all that is good? It’s a pleasant concept, but Superman and his Bizarro counterpart demonstrate that such efforts generally prove to be futile.

And yet if that is true of people, then why are our government leaders continuing to discuss the creation of good and bad corporations?

Organizational Behavior

You may recall U.S. Republican Presidential candidate Mitt Romney’s famous assertion that corporations are people, my friend. Although his Democratic rivals pilloried the comment as a “shocking” caricature of a heartless business tycoon, Romney was attempting to explain that corporations are embodied by people and managed by people, and then distribute profits to people. In other words, they manifest the behavioral tendencies of people.

Thus, if organizations “behave” like complex human beings, a good corporation that is managed by ostensibly good people will nevertheless sprout bad characteristics. Conversely, a bad corporation will sprout some good characteristics.

The issue of good and bad corporations was hotly debated during the 2008 / 09 global financial crisis, when all three of America’s automobile manufacturing firms approached the federal government and warned of the collapse of the domestic industry without some form of public support. What was the result of their lobbying initiative?

See The USA In Your Chevrolet

Chrysler was acquired, with the support of explicit governmental financing, by the Italian automaker Fiat. And although Ford did not receive direct government support, it indirectly benefited from the support that was extended to various suppliers of the three automakers.

But what of the bankrupt General Motors? The federal government divided it into a Good GM and a Bad GM. All of the productive manufacturing and brand assets, including the Chevrolet and Cadillac franchises, were placed in the good corporation. And all of the unproductive and toxic assets were placed in the bad one.

In the short term, many praised the Obama Administration for saving the American automobile industry, while candidate Mitt Romney was ridiculed for having proposed that the government should  “Let Detroit Go Bankrupt.” But four years have now passed since that transaction occurred; what are the long term outcomes?

A Mixed Bag

On the one hand, the Good GM has indeed emerged as a viable firm in the global automobile industry. Industry experts have praised the hybrid Chevrolet Volt and the fuel efficient Chevrolet Cruze as indicative embodiments that the new GM can compete in the world markets.

But on the other hand, there are increasingly troubling signs regarding the Good GM. The Volt’s sales volume has been consistently weak in comparison to the Pruis, Toyota’s bestselling hybrid vehicle. And after a strong start, sales of the Cruze have plummeted, perhaps as a result of GM’s decision to establish prices that are $2,000 higher than those that are offered by their primary competitors.

High prices? Unpopular automobiles? Those were the bad characteristics that afflicted the pre-split General Motors! They now appear to be re-emerging in the new Good GM as well.

The Banking Strategy

In the United States, the federal government designed the Citigroup bail out in the same manner as the General Motors bail out, dividing the firm into a good bank and a bad bank. But this strategy did not set the stage for sustained success at the institution.

Meanwhile, in the European Union, the Irish government established the National Asset Management Agency to serve as its national bad bank. And just last week, Bank of England Governor Mervyn King proposed that the Royal Bank of Scotland be divided into good and bad entities.

So how has the Irish economy fared under the good bank / bad bank strategy? The results, once again, can best be characterized as a mixed bag. On the one hand, the Irish economy is expected to grow more robustly than the remainder of the European Union during the next two years. But on the other hand, Ireland’s growth rate is expected to average a meager 1.65%, while the EU economy actually shrinks in size.

Thus, one might wonder why Governor King continues to support the bad bank concept. If the good cannot be segregated from the bad in Ireland, in the United States, or in the Bizarro World, why does Governor King believe that it can be achieved in Britain?

Creating Bad Banks … On Purpose!

We Americans know that we need not look very far to find a bad bank. 140 of them, in fact, failed in 2009, and another 41 recently failed during the first quarter of 2010.

There are also a wide variety of ailing banks that would have failed if not for bailouts by the federal government. Citigroup, for instance, owns many failing subsidiaries that are dragging down a purportedly healthy commercial banking core; that’s why CEO Vikram Pandit is striving mightily to shed those weak divisions. Bank of America also asserts that it manages a relatively healthy core banking operation, but that it has been weakened by a government induced shotgun wedding with Merrill Lynch.

Then there are the tiny Special Purpose Entity banks acquired by investment institutions like The Hartford. These banks are tiny specks of commerce that barely conduct any business activities at all; they exist for the sole purpose of positioning their financially unstable corporate parents to qualify for federal bailout funds. And investment houses like Goldman Sachs and Morgan Stanley may be strong financial institutions, but they are undeniably bad banks because they take no consumer deposits and make no consumer loans; they also chose to become bank holding companies for the sole purpose of qualifying for federal bailouts.

None of these banks, though, were intentionally created to be bad in nature; their descent into “badness” was a regrettable outcome of the Great Recession of 2008. So why would any one decide to create a bank that is intentionally bad?

Ask the Irish!

To whom shall we turn for an answer to this question? Let’s ask the Irish government! This past week, they decided to create a government owned bank that will purchase 16 billion euros of terribly risky assets for a discounted price of 8.5 billion euros from five domestic financial institutions that are desperate to be rid of them. The official name for this intentionally weak bank is the National Asset Management Agency, but the Irish have dubbed it Bad Bank to reflect the nature of its asset base.

Why would the Irish government make such a startling decision? Apparently, they believe that they’ve run out of alternatives. They’ve already invested a huge amount of capital in two giant insolvent Irish banks, the Anglo Irish Bank and the Bank of Ireland, but have failed to resuscitate them because of the poisonous impact of these toxic securities on their asset portfolios.

So the Irish have decided to create a new government entity that will purchase these securities from the Irish banks, thereby removing a fiscal cancer from their books and providing them with fresh capital with which to repair their operations. The hope, of course, is that these banks will continue making loans and stimulating the Irish economy.

Only in America

Before we Americans start to criticize this strategy, though, we might want to take a closer look at our own government’s decisions. Indeed, Washington has also opted to create intentionally bad organizations, albeit with uniquely American flavors.

For instance, were you aware that only one General Motors fell into bankruptcy, but two GMs actually emerged from it? The good GM is now manufacturing automobiles, but a bad GM is now functioning as well, liquidating the suffocating obligations that dragged the original GM into bankruptcy.

The American federal authorities arranged for the creation of Bad GM for the same reason that the Irish government created NAMA: to allow an organization that was deemed too big to fail to shed itself of toxic assets and/or overwhelming obligations. Such accounts are customarily written off in bankruptcy court, but creditors of the bankrupt organizations are traditionally required to write off their investments as well.

In the case of GM and the Irish banks, governmental authorities clearly believed that they couldn’t ask GM retirees and Irish passbook savings account holders to write off their entire retirement pensions and cash account balances. Thus, they stepped in and allowed these obligations to live on, secure in the hands of government sanctioned entities.

A Road Not Taken

Interestingly, during the early days of the 2008 banking crisis, the American government did indeed authorize Treasury Secretary Hank Paulson to spend hundreds of billions of dollars to establish a federal bank that would purchase troubled assets from failing banks. In fact, that’s why the controversial TARP bail out program was called the Troubled Asset Relief Program; it was designed to adhere to the same model that the Irish government implemented last week.

Paulson created quite a ruckus when he used those TARP funds to inject capital directly into bad American banks instead of purchasing their bad assets from them. He explained, at the time, that direct injections could be processed more “quickly and forcefully.”

The Irish government itself caused a minor ruckus last week when it established purchase prices that were significantly less than the levels originally forecasted by banks. Because Paulson opted to take a different road to bailing out American banks, we may ultimately be able to assess the relative wisdom of these alternative approaches by comparing the long term health of American banks to Irish banks, and of the American economy to the Irish economy.

Financial Engineering: Cure For General Motors?

Three days ago, after tens of billions of American taxpayer dollars were used to bail out the auto industry under the supposition that a bankruptcy filing would lead to the catastrophic liquidations of General Motors and Chrsyler, the audit firm of Deloitte & Touche nevertheless expressed substantial doubt that GM would survive in its present form.

Deloitte & Touche, as well as other public accounting firms, call this a going concern opinion. But investors, lenders, suppliers, customers, and employees of GM might ruefully call it a kiss of death.

The primary cause of Deloitte’s pessimistic conclusion is the heart-stopping crash of automobile sales volume since the global economy collapsed in late 2008. GM has seen a 53% sales decline in the month of January 2009 alone, and an overall 40% decline since sales peaked in 2007. But what can companies like GM do to boost sales in such times of crisis?

Jaded business professionals might retort, with a bit of sarcasm in their voices, “How about selling better quality automobiles for more affordable prices?” Yes, that is always a good idea …

… but many companies, including GM, have often resorted to financial engineering strategies as well.

Gary Winnick: The King Of Financial Engineering

Shortly after the technology bubble of the late 1990s burst, for instance, the telecommunications firms Global Crossing and Qwest Communications engaged in a series of swap transactions that were designed to boost declining sales numbers. Though the transactions were not designed to significantly increase net earnings, they were required to maintain revenue levels and thus persuade investors that the firms had bright futures as high growth businesses.

Such high growth businesses, of course, usually trade at high price/earnings multiples; thus, these swap transactions helped senior executives maintain personal levels of compensation that were determined by their firms’ stock market valuations. Global Crossing and Qwest were publicly excoriated by a committee of United States Congressmen, who accused them of conjuring up “sham transactions” for the private benefit of their senior executives.

But Gary Winnick, the head of Global Crossing at the time, protested that these transactions were perfectly legal acts of financial engineering; he said that they were developed and booked in order to keep his firm competitive in the financial markets. Although he was raked over the coals during Congressional public hearings, he never spent a single day in jail.

Other Tales of Financial Engineering

Similar types of swap transactions have been developed and implemented throughout recent American corporate history. Many firms engage in sales and leaseback transactions, for instance, that appear to have no valid business purpose other than the financial engineering of balance sheet and income statement items. By the time that the original owner of an asset leases it back from its purchaser in such a transaction, there is usually no discernable impact whatsoever on the business operations or overall cash flows of either firm.

And Enron, for instance, used internal transfer prices between its own divisions to establish extremely high market rates for a series of commodity transactions that were traded on its own system; they then used these data points as benchmarks for revenue transactions with third parties. The revenue rate setting process itself was considered perfectly legitimate (and even quite clever) at the time; Enron quite possibly would have escaped any criticism about these practices if not for the collapse of the firm for other reasons.

And what of GM and its fellow automobile manufacturers? Well, the automobile industry has actually engaged in internal transactions of questionable economic value for decades. In 1996, for instance, the Ford Taurus only managed to hold onto its “Best Selling American Automobile” title because more than half of all its sales that year were made to rental car companies. Ford, not coincidentally, had been a partial owner of Hertz and Budget for many years, while GM was a partial owner of Avis and National for many years as well. In other words, the automobile rental agencies that purchased Ford and GM automobiles were often partially owned by the manufacturers themselves.

What’s An Auditor To Do?

So what is an auditor to do when confronted with an income statement of an organization that claims to produce the best selling automobile in the nation, but that sells 51% of its output to special entities? Or an energy company that marks-to-market its asset values on the basis of transactions that are placed on a private system that it directly owns and, in fact, thoroughly dominates? Or a firm that has removed significant amounts of debt from its books with a series of sales-and-leaseback transactions that have no underlying economic value whatsoever? What, exactly, is an auditor to do?

Unfortunately, even government regulators are not opposed to the use of financial engineering transactions that serve no discernable underlying business purpose. For instance, many regulators are still espousing the development of a gigantic government-owned “bad bank” to purchase problem assets from our wobbly private financial institutions, an idea that Paul Krugman derides as “the belief that fancy financial engineering can create value out of nothing.” And, in a sense, each tax incentive that has ever been passed by a governmental entity is designed to encourage businesses and individuals to engage in transactions that they would not have otherwise considered if not for the incentives themselves.

So what’s an auditor to do? Sadly, the conventional wisdom appears to encourage them to sign off on the financial engineering activities of their client organizations. And what is GM to do? If it continues following the same conventional wisdom, it may continue engaging in these very activities as well.

Unless, of course, our society finally realizes that the individuals and firms who followed the conventional wisdom are the ones who are responsible for creating our present economic crisis to begin with …

… and with that realization, in the blink of an eye, we might finally start down the path to a sustainable recovery.