Source: Techniques In Automotive Careers ® [See References]

You can  purchase the above book by clicking on the graphic.

When the Big 3 flew East in their private wings, they didn’t have a prayer.  The 3 CEO’s might try to reclaim business success (either together or separately) by scrounging up $200 and reading the book above.  But the path to industrial automotive success and salvation might not be found in any book.

It’s particularly tough to run a business if you try to guess the actions of the big elephant in the room, the US Government -  and get it wrong.  Once you’ve blown the big one, it almost doesn’t matter what you do next.  Your company will fail, the only thing left to  determine is  – when.

GUESSING WRONG ON HEALTH CARE

The automakers “blew it” when they guessed wrong on health care reform.   If the old health care system had been replaced by a compulsory Federal plan in the early 1990’s,  it  would have pre-empted or assumed the automakers’ expensive promises.  But it didn’t work out that way, and the Big 3’s viable business model as automobile [as opposed to light truck or SUV] manufacturers died with health care reform.  Things are so  bad that they are trying to survive by turning  themselves … into banks. 

There have been recent suggestions that new “Health Care Reform” could follow the model of the current Federal Reserve System [See References], but the  federal government’s recent and past economic under-performance suggest caution.

GUESSING WRONG ON HEDGING

I’d like to share with you my personal account of a Federally-inspired failure that occurred during the “Savings and Loan Crisis“, some twenty-five years ago.

About 750 S&L’s failed at a cost of $160 billion. The Federal government “picked up” about $125 billion.  Hard to believe, particularly with today’s news, but at one time $125 billion seemed like a lot of money.

S&L’s failed because, as balance sheet lenders, the rates on their long term assets (mortgages) did not rise as quickly as the rates on their relatively short-term deposits.  Rates rose because inflation (”CPI-U”) skyrocketed (see chart below).

 
Source: Federal Reserve Bank Of Cleveland [See References].

The late Nobel-prize-winning monetarist, Milton Friedman, taught the now no-longer-controversial maxim that “inflation is everywhere and always a monetary phenomenon.“.  It was as true then as it will be in the future. 

The surge in  inflation and rates gutted the balance-sheet-based business-models of the S&Ls.  This eventually led to a mortgage lending “solution” that relied upon securitization and off-balance sheet funding vehicles.

But before embracing securitization, regulators rolled out another plan – S&L’s should hedge their assets so that the interest rate sensitivity of their “long term” assets effectively became “short term”.  S&L’s would “lock in” and live off of the (assumed) positive spread between their assets and liabilities.

One day, I was talking with the CFO of a large S&L that had adopted this hedging strategy.  He was distraught and said:

• We screwed up.  We never should have hedged our assets as the regulators “encouraged.” 
• Once rates had risen, it was a one-way bet.  If rates had stayed the same, or risen, then the S&L would fail.  The S&L’s  hedging program didn’t matter, it was too late.
• The S&L had no choice but to fail if rates remained at the early 1980’s levels.  So there was one only other rate alternative.  Rates could fall. And if they did, the S&L would make money, but only if there were NO hedges.
• So what purpose did the hedges serve?
• The hedges simply preserved the breakup value of the institution for the FDIC.  But the FDIC was not a stockholder of the S&L.  Since the hedging strategy was of no value to the stockholders, the S&L should never have hedged.
• Under hedge accounting, the hedge losses that had occurred as rates had fallen since the start of the hedging program could be deferred  and spread out over many years.  But if the hedges were closed out, then all of the losses would have to be recognized in the current period, and no one had any stomach for that.

Several years later, the S&L was gone.

Automakers’  bet on health care reform certainly looks foolish now, but may have seemed reasonable then.  S&L’s did not cause the inflation that doomed their industry. 

I’ve worked in the banking business most of my life,  but  am bothered by the following.  At the “First Thanksgiving” in 1621, it was illegal to mortgage property in the Plymouth Colony.  In 2008, the Federal devotion and path to salvation begins, and ends, with banks. Have we guessed correctly this time? Happy Thanksgiving.

- – - – - – - – - – - 

I used to work with numbers for a living, but now I’m trying to achieve a sliver of success as I look for a job or at least my next idea.  Till next time.

REFERENCES [Accessed 24 Nov 2008]

 
Federal Reserve Bank of Cleveland, US Inflation – Charts & Data.

 
A. Greenspan, Federal Reserve Board – Risk and Uncertainty In Monetary Policy,  3 Jan 2004.

 
A.Smith, April Smith & Associates, Inc. – Be Afraid (Open Letter), 22 Nov 2008. [April Smith’s ‘Open Letter’ also refers to incidents that occurred during the S&L Crisis.]

 
Techniques In Automotive Careers® – How To Succeed In The Automotive Industry ©.

 
D. Warsh, Economic Principals – Toward A Health Care Fed, 23 Nov 2008.