Sunday, February 22, 2009

It Doesn't Have To Be This Hard

Solving our economic problems? Big task. So let's start at the beginning. When I began my career at Fuqua Industries the CEO there told me there were two things you needed to know to be an effective planner: where you are and where you want to go. If you can figure those two out the rest came down to effective execution on your plan. Execution is the hard part, but without a good plan, there is nothing against which to test your actions and measure your progress.


So where are we? Without getting too analytical, the economy's in a tailspin, caused in large part by a financial system in disarray. Conventional wisdom (which is often right) is that easy credit, particularly to the subprime housing market, has caused a rash of defaults which, when multipled by leverage at 30:1, has caused our banks to become insolvent and stop lending. Lack of credit causes consumers to stop buying and businesses to contract, increasing unemployment and causing equity values to plummet. At the same time, earnings contract and the otherwise "performing" loans on bank balance sheets become troubled, further eroding a bank's ability to lend. Vicious circle, and if our portfolio of about 20 middle market companies is indicative, just at it's beginning. Most of our companies had good economic performance in 2008, but saw a decline in December and further (severe) contraction in January, 2009. If not corrected, this financially-induced tailspin becomes a real world death spiral.


Unprecedented situation? No easy answers? I don't agree. In the early 1990's we had very similar conditions. Credit markets were in turmoil, Citicorp (again) was technically insolvent, no one was lending, bank balance sheets were in disarray. Maybe the problem wasn't as big, but it was very similiar. How was this problem solved? Citicorp turned undervalued assets into cash and raised money from a Saudi prince. The institution I was soon to join, Mellon Financial Corporation, took another tack, setting up the nation's first "Good bank, bad bank".


How did it work? Actually, very simple. First the "troubled" assets were put in a new "bad bank", they were valued and a well known investment bank (Drexel Burnham) underwrote a bond which was sold to the public. Ultimately, the assets were sold, the bond was paid, and the investors made money. Which left an undercapitalized "good bank". Private equity investors (Warburg Pincus) recapitalized this bank, which allowed it, free of bad loans and with adequate capital, to begin lending again. The stock price went from around $3 to about $90, so everyone was happy.


If it's this easy, why not try it again? Well, that was actually the stated purpose of TARP, the $700 billion "Troubled Asset Relief Plan" that we hurried through Congress 4 months ago. Results to date: haven't spent the money and what we did spend didn't go for "troubled asset relief". Instead, the big banks sucked up the equity and, at the urging of the Treasury Department and the Federal Reserve, constrained their lending even further. Should we be surprised that it didn't work and the real economy is now getting crushed?


So what do we do? How about "working the plan"? Get the troubled assets off the banks' balance sheets and recapitalize the "good" banks. Can it be done? Sure, the problem is bigger than the 1990's, but the Federal government is bigger than Drexel Burnham who, incidentally, put up no money and suffered no losses in the process. Billions of private equity (compared to Warburg Pincus's $250 million) is sitting on the sidelines waiting for the government to take the first step.


If this is the plan, then let's focus on executing it. This is the hard part, but at least we can test our actions and measure our progess. For example, does a trillion dollar stimulus package make sense? Maybe it helps in other ways, but stimulating consumer demand doesn't solve our core problem. How about nationalizing a bank or two? Avoids the Lehman phenomenon but just moves bad assets on to the government's books indefinitely. Treats the short term pain but not the underlying disease. Mortgage relief? Focuses on a small part of the problem that, even if solved completely, does nothing to ameliorate the bigger issue.


So where does that leave us? I'm optimistic for several reasons. First, I think we have a lot of bright guys in charge and focusing on the real problem. I'm a little disappointed that there has been no articulation of the long term plan and no holding Congress accountable for its enthusiastic spending, but I think that's coming. Americans need to know there is a plan and that it will work. Second, if you believe in the business cycle, there are mechanisms inbedded in it that causes things to improve when excesses are wrung out. Govenment can encourage this and ease some of the pain along the way, but even if it does nothing the system self-corrects. Finally, and most importantly, this problem exists within a support system (the credit markets) which facilitate commerce, but does not have it roots in our productive core, which until recently has continued to perform well. If we can solve this secondary problem, our primary activity of manufacturing an unparalled quality and quantity of goods and services for worldwide consumption will be well positioned to lead an economic recovery.