Joseph Lee's Perspectives
My view of the world
July 23, 2008--The $25 Billion Rescue

                The Treasury today estimated that the price tag to rescue Fannie Mae and Freddie Mac will run beyond $25 billion (CNN).  That would be $25 billion of tax payer money.   And you know what?  Even if the price tag were $50 billion, we wouldn’t be able to tell the difference, we couldn’t care less, and there really isn’t much of an alternative (NY Times).

                In the early 1990’s when Japan was going through its massive real estate crash and associated financial crisis, there were four entities that were considered to be the virus of the market.  Not surprisingly, they were called AIDS, after the first initials of each of the companies (I won’t expand into the actual names).   The management philosophy in those companies was quite simple and straight forward—“When in Doubt, borrow more money.”   By doing so, the companies guaranteed that the banks would never dare call their loans, because if they did, these AIDS companies could drag the banks down with them, so large were their exposures.

                In one of the first lessons of real estate finance, I learned at a seminar of what real estate developers called the “Developer’s Creed.”    It went something like this:    a dollar borrowed is a dollar earned, a dollar refinanced is a dollar saved, and a dollar repaid to the bank is a dollar lost forever.

Such was the philosophy of the American developer.  

Today, it seems that philosophy is alive and well, but perhaps at a grander scale.   The banks keep overextending themselves.  No one really seems to know how to value their loan loss reserves.  If a CEO has the gall to admit that he doesn’t know how to measure the performance of his own company, it’s a good time not to pay him multi-million salaries.

Imagine yourself starting up a new business, and going to a bank.  They ask you for a balance sheet and an income statement.  You show it to them, and say, “wait a second, you’re not going to hold me to that are you?”  The banker looks up in shock and says, “Why of course, sir.   Your numbers have to be accurate, or at least reflective of your new business.   Now, can you tell me how your company plans to make money?”

You look at him and say, “You know, that’s the problem.  I think I’m making money, but in order to make more money, I purchase all these hedging instruments so that I don’t get caught with my pants down.”

“Your pants down?” the banker asks.

“Yes, I mean, no.  That’s not a good thing.  I have very complicated financial instruments that makes sure that if the cost of my raw materials go up unexpectedly, I have a hedge, and if it goes down, I have a reverse hedge.  It’s all very complicated and my accountants and investment bankers tell me it works 99.99% of the time.”

“Those are good odds,” the banker seems impressed.

                “Don’t you think so?” you respond.  “The only problem is that I have no idea how much I could make or lose each year.”

“So tell me, what is the main thing that you do?  I mean if you take away all that complex mumbo jumbo, what do you sell?”

“Oh, I sell lemonade at the corner of First and Main.  Great location.”

“Sir, I have no idea whether you’ll make money or not, but I like it that you have so many risk hedges set up.  You must know what you are doing.”

“Not really, but I’d still like to borrow some money.”

“Oh, and what will this be used for?” the banker asks the obligatory question.

“Oh, to repay the loan I took out last time when my risk hedges didn’t work out,” you answer, looking up at the nice marble ceiling.

“No problem sir, how much would you like?” the banker clicks his pen as he fills out the form.

“What’s my credit limit?” you inquire.

“Who’s your auditor?” he fires back.

“Big 4, of course,” you state firmly.

He smiles a big smile.

                “Sir, for you, how about $25 billion?  Would that be sufficient?”

“Sure,” you answer.  “That’ll carry me for another few months.”

2008-07-23 04:57:24 GMT
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