Economic and Financial Bad News

If you’re one of those people who needs a negative GDP number to convince yourself that we’re in a recession, here you go. But the headline -0.3% figure isn’t the worst bit: that would be the 8.7% fall in disposable personal income. If there was any doubt about the outcome of this election, that number alone should put it to rest: there’s no way that the incumbent party can win in that kind of economic environment.

And while the macro picture is bad, the financial picture is just as gnarly. The NYT has had a great pair of back-to-back pieces on important financial stories which people aren’t paying enough attention to: Diana Henriques looked at the The Reserve Fund yesterday, while Mary Williams Walsh, today, turns her attention to AIG.

While both of these entities look like studies in incompetence, The Reserve is clearly the worse of the two. The shock of breaking the buck seems to have been so great that it suffered some kind of institutional cardiac arrest, to the point at which it has become utterly unresponsive:

Initially, the company simply announced that it would delay redemptions from the Primary Fund for up to seven days, as allowed by law. Customers were somewhat reassured, but anyone trying to get additional information was met with busy phone lines and unanswered e-mail.

The news occasionally posted on the fund’s Web site got steadily worse. On Sept. 18, investors in a host of other Reserve money funds learned that their money would be tied up for as long as a week; that delay later became open-ended. On Sept. 19, the fund delayed redemptions from both the Primary Fund and the US Government Fund indefinitely.

Since then, investors have been on a roller coaster of broken promises, with the company repeatedly blaming its record-keeping systems for delays.

Several requests for comment from management of the Reserve Fund have been declined. “I have no confidence at all in what it says,” said Mrs. Dews.

This is incompetence of the highest order, in the context of a world where institutional investors are actually putting money in to money-market funds. A couple of days’ delay in communication is one thing; a month and a half is so far beyond unacceptable as to mean that The Reserve is going to be tied up in litigation for years. Certainly while The Reserve has shut down like this, it won’t be the beneficiary of any inflows. Quite the opposite: all its investors are likely to leave as soon as they can — including, I suspect, the Chinese government, which has as much as $100 billion at least $5.4 billion invested with The Reserve.

As for AIG, the problems there stem from the fact that the financial-products people kept on insisting that their assets were just fine, thank you very much, that marking to market was a silly thing to do, and that their CDS portfolio was worth much more than the market said it was worth.

Of course, they were spectacularly wrong.

I’m reminded of Alea’s "why you should cut your losses quickly" chart from last Friday. You thought it was a bad idea for SocGen to liquidate Jerome Kerviel’s massive stock-futures position on a US holiday? Well, maybe. But in hindsight, if they’d decided to wait for the markets to rebound, they would have lost much more. AIG, in contrast, decided to hold on to its positions for dear life, and pray they’d go up:

After the insurer’s credit rating was downgraded in September, its G.I.C. customers had the right to pull out their proceeds immediately. Regulators say that A.I.G. had to come up with $13 billion, more than half of its total G.I.C. business. Rather than liquidate some investments at losses, it used that much of the Fed loan.

Clearly, liquidating in September would have been a much better idea than holding on through October: I’m sure the losses AIG was worried about have gotten substantially larger over the past month.

And then of course there’s the CDS portfolio, which AIG has been overly optimistic about every step of the way. It could have hedged in 2007 or earlier this year, but passed up all opportunities to do so, and as a result it is now facing hundreds of billions of dollars in unnecessary losses. This is why marking to market is a good thing: it forces companies to realize losses and liquidate early at a survivable loss, rather than adopting the hope-and-pray strategy and seeing losses become so large as to be systemically dangerous.

Finally, in the intersection of the economy and finance, James Hagerty of the WSJ looks at Frannie spreads, which have been widening out steadily for the best part of two months now, despite nationalization. The first thing the new Treasury secretary should do is implement an explicit government guarantee on the senior debt of both companies. It won’t cost anything, since the guarantee is there already, just not explicit. But it might help mortgage rates come down rather than up during a time when the Fed’s rate cuts clearly aren’t doing the job.

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