Paulson mistakes and chapter 11

A brief but illuminating summary of recent blunders of Henry Paulson, an expert on the Great Depression.

Treasury Secretary Henry Paulson made some disastrous decisions that had major unintended consequences.

One of those was the decision to nationalize Fannie Mae and Freddie Mac. Once the government took over Fannie Mae and Freddie Mac, supposedly preemptively, shareholders of every other financial company that perhaps needed capital were left with no choice but to sell aggressively, fearing the government might decide to preemptively wipe them out also. This made it impossible for any company to raise the capital it needed or wanted.

About a week later Lehman Brothers filed for bankruptcy, Merrill Lynch was forced to sell to Bank of America, and AIG was extended a huge government loan, all completely or nearly wiping out shareholders.

Then Paulson forced nine major banks to receive capital infusions from treasury, effectively partly nationalizing them, and creating a huge American Sovereign Wealth fund.

The above referenced nationalizations created a bizarre situation where the government contended that financial institutions needed more capital, and that it should be private capital that will solve the problem. But the government also indicated that it stands ready to provide additional assistance in the future, thus destroying the equity stakes of those prospective capital providers. Why would private capital invest, if it believes it is the policy of the government to later intervene and dilute it?

Enter the pernicious crash of October-November 2008.

The smartest CEO, John Thain of Merrill, understood the new landscape before anyone else and quickly sold at the then still available price, albeit a fraction of his company’s value at its peak. In doing that he saved Merrill from the ignominious fate it was inevitably headed towards, the same fate that awaited Lehman Brothers.

And by letting Lehman Fail, the counterparty risk was unleashed on the economy of the world, as Lehman was involved in thousands of trades all over the globe and was much bigger than Bear Stearns. That brought to the forefront the systemic risk that is now looming above us like a dark cloud. All of a sudden even money market funds were losing principal. Secured bond holders are losing money (unlike the creditors of Bear Stearns, Fannie and Freddie, who emerged whole). Nobody knew who could be trusted, and short term credit markets ceased to function, severely impairing the economy further.I believe Secretary Paulson’s policies aggravated the crisis. At the moment, Citigroup and JP Morgan are struggling; locked out of the market for private capital and their shares are in free fall. Despite major capital infusions, most financial stocks are down sharply. The nine institutions that received the first cash infusion from Washington have seen their shares fall more than 40% since then. Goldman Sachs last week was trading at a value less than just the amount of money it raised recently. So many financial institutions are failing, making the federal government their built-in savior and enervating the Fed’s resources with their insatiable demand for fresh cash.All this is making it palpably clear that the Treasury’s policy did nothing to build confidence or stabilize the markets. The sickening, precipitous drop of the equity markets in October and November are the market’s judgment on the merit of Treasury’s policies.

Here is the original article from the Huffington Post.

He accepted his errors by saying, “We’re not proud of all the mistakes that were made by many different people, different parties, failures of our regulatory system, failures of market discipline that got us here.” His solution was then and now to “buy bad assets and the administration has allocated $US100 billion for that portion of the program,” referring to the $700 billion bailout program.

His approach however looks more like a band-aid, which will postpone but by no means prevent a near certainly future problems in the financial markets. As one shrewd expert admits, “The government cannot repeal the law of gravity and stop markets from falling. Nor can it turn back the clock to reverse our financial blunders.”

The currently prevalent and rather dogmatic approach of avoiding filing for the Chapter 11 is mostly due to a misconception. It is commonly thought that a company or an organization filing for the bankruptcy (immediately) ceases its activities and (virtually) its existence. This is wrong. Usually the causes (especially in high-tech cases) to file for Chapter 11 include overwhelming debt, defensive maneuver against temporary legal liabilities and need for reducing labor problems. For the duration of being under the Chapter 11 protection, the company/organization continuous its operations. The difference mainly comes in guise of added supervision and control. The debtor usually remains in possession of the company’s assets, and operates the businesses under the supervision and control of the court and for the benefit of creditors. The debtor in possession is a fiduciary for the creditors. The objective and desired result of the Chapter 11 protection is make the company cut costs, re-orient itself and streamline in resources in efficient manner in order to return to profitability. Although admittedly the rate of successful Chapter 11 reorganizations is low (estimated at 10% or less), it is still a better solution, and is not only considered by small and medium but by large multinational corporations such as GM (which follows the same path of peering into the public money instead of doing an internal restructuring, refocusing and cost cutting as was done to save IBM in a similar case in 1993). In addition to other benefits, for the GM case, Marketing expert Seth Godin goes to the extreme of proposing, “Use the bankruptcy to wipe out the hated, legacy marketing portion of the industry: the dealers.” And then adding, “We’d end up with a rational number of “car stores” in every city that sold lots of brands. We’d have super cheap cars and super efficient cars and super weird cars. There’d be an orgy of innovation, and from that, a whole new energy and approach would evolve.” I agree.

Companies coming out of the Chapter 11 (usually few years after the initial filing) are leaner, healthier and better positioned. The most famous case in point is WorldCom.

One way or another, financial policies so far espoused by the US Treasury and Fed not only come short of calming markets and inducing confidence in money-needing banks, but also continue wasting tons of taxpayer dollars, imposing a heavy financial burden on younger generations.

Top 10 dotcom flops

Starting from year 1995, the world got an extra doze of anxiety. All approaches to millennia are debates between “the roosters and the owls.” Conspiracy theories started to flourish. Anticipation peaked. Some even predicted an inevitable doom and came up with end of the world theories. At the same time though many venture capitalists and investors started zealously investing large amounts of money in all kinds of startups and pouring dollars into pockets of geeeky college grads with barely decent business plans and fairytale ideas. This era (1995-2001) marked the rise and fall of many startups, followed by colossal losses whereby an estimated $5 trillion in paper wealth on Nasdaq were wiped out.

Below is the list of most spectacular and significant of those startups (and their brief stories), which are singled out for the accompanying hype, large sums of burnt money or for manner of their failure.

Webvan (1999-2001)

A core lesson from the dot-com boom is that even if you have a good idea, it’s best not to grow too fast too soon. But online grocer Webvan was the poster child for doing just that, making the celebrated company our number one dot-com flop. In a mere 18 months, it raised $375 million in an IPO, expanded from the San Francisco Bay Area to eight U.S. cities, and built a gigantic infrastructure from the ground up (including a $1 billion order for a group of high-tech warehouses). Webvan came to be worth $1.2 billion (or $30 per share at its peak), and it touted a 26-city expansion plan. But considering that the grocery business has razor-thin margins to begin with, it was never able to attract enough customers to justify its spending spree. The company closed in July 2001, putting 2,000 out of work and leaving San Francisco’s new ballpark with a Webvan cup holder at every seat.

Pets.com (1998-2000)

Another important dot-com lesson was that advertising, no matter how clever, cannot save you. Take online pet-supply store Pets.com. Its talking sock puppet mascot became so popular that it appeared in a multimillion-dollar Super Bowl commercial and as a balloon in the Macy’s Thanksgiving Day Parade. But as cute–or possibly annoying–as the sock puppet was, Pets.com was never able to give pet owners a compelling reason to buy supplies online. After they ordered kitty litter, a customer had to wait a few days to actually get it. And let’s face it, when you need kitty litter, you need kitty litter. Moreover, because the company had to undercharge for shipping costs to attract customers, it actually lost money on most of the items it sold. Amazon.com-backed Pets.com raised $82.5 million in an IPO in February 2000 before collapsing nine months later.

Kozmo.com (1998-2001)

The shining example of a good idea gone bad, online store and delivery service Kozmo.com made it on our list of the top 10 tech we miss. For urbanites, Kozmo.com was cool and convenient. You could order a wide variety of products, from movies to snack food, and get them delivered to your door for free within an hour. It was the perfect antidote to a rainy night, but Kozmo learned too late that its primary attraction of free delivery was also its undoing. After expanding to seven cities, it was clear that it cost too much to deliver a DVD and a pack of gum. Kozmo eventually initiated a $10 minimum charge, but that didn’t stop it from closing in March 2001 and laying off 1,100 employees. Though it never had an IPO (one was planned), Kozmo raised about $280 million and even secured a $150 million promotion deal with Starbucks.

Flooz.com (1998-2001)

For every good dot-com idea, there are a handful of really terrible ideas. Flooz.com was a perfect example of a “what the heck were they thinking?” business. Pushed by Jumping Jack Flash star and perennial Hollywood Squares center square Whoopi Goldberg, Flooz was meant to be online currency that would serve as an alternative to credit cards. After buying a certain amount of Flooz, you could then use it at a number of retail partners. While the concept is similar to a merchant’s gift card, at least gift cards are tangible items that are backed by the merchant and not a third party. It boggles the mind why anyone would rather use an “online currency” than an actual credit card, but that didn’t stop Flooz from raising a staggering $35 million from investors and signing up retail giants such as Tower Records, Barnes & Noble, and Restoration Hardware. Flooz went bankrupt in August 2001 along with its competitor Beenz.com.

eToys.com (1997-2001)

eToys is now back in business, yet its original incarnation is another classic boom-to-bust story. The company raised $166 million in a May 1999 IPO, but in the course of 16 months, its stock went from a high of $84 per share in October 1999 to a low of just 9 cents per share in February 2001. Much like Pets.com, eToys spent millions on advertising, marketing, and technology and battled a host of competitors. And like many of its failed brethren, all that spending outweighed the company’s income, and investors quickly jumped ship. eToys closed in March 2001, but after being owned for a period by KayBee Toys, it’s now back for a second run.

The rest of the five remaining flops can be found here (among which boo.com, the biggest European dotcom failure, about which there is a longer account here). Let us not forget that the huge losses of the dotcom bust must not make us loose sight of the fact that two US corporations (Enron $80+ billion and WorldCom $74+ billion in 2000/2001 alone) probably account for more direct losses than all the dotcom spending.

Let us also remember that not every startup was a looser. Indeed few companies such as Google and Amazon were also created during that period and came out of it healthier and stronger than they or the industry experts could have anticipated.

Both Google and Amazon are still going strong, notwithstanding the recent economic and financial crisis.