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November 21st, 2008

Prisoners’ Dilemma: Atlas vs. Atlas Shrugged

In the classic form of this logic puzzle each prisoner’s rational choice is to defect, yet their optimal reward is reached if they all play cooperatively. In today’s version of the game Atlas is portrayed by the Federal Government as it attempts to support the economy on its shoulders and Atlas Shrugged is played by a rich assortment of parties: corporate management, security holders, labor unions, congress, bankers and taxpayers who judge the TARP program solely against its ability to return them to their August 30, 2008 status quo. Neither of the two will be as successful “defecting” for their own self interest as they would be collaborating by surrendering some self interest for the greater good. Irrespective of the cooperation levels, voluntary or not, the patina that recklessness is being rewarded over rectitude may survive as this era’s message. Jackson Browne’s “happy idiot who struggled for the legal tender”, now stuck with the bill, will be the poster boy for the period. The interdependence of the many systemic elements has been starkly demonstrated.

The list of villains who had contributing roles in creating the continuing credit contraction is ample. It ranges from greedy generators of fee income on the lending side to greedy borrowers entering into compacts no three digit IQ could reasonably expect to fulfill. Leadership in risk management was absent at most substantial institutions. Thoughtful discourse at banks’ board of directors level was absent. Congress and the Administration waived their responsibility to regulate, dissolved Glass-Steagall, eliminated the uptick rule for shorting stocks, whiffed at monitoring credit default swaps and effectively removed the leverage limits on large investment banks, while pushing “apple pie” notions of home ownership regardless of the foreseeable scams that would result under the banner of increasing home ownership. Pursuit of colossal fee levels in leveraged lending led to a complete disintegration of the lender’s defenses as loans no longer required payment of current interest nor current maintenance of capital ratios. Bull markets and leverage were accepted as a superior substitute for brains by investors allocating capital to hedge funds on shylockian terms. Private Equity Analyst published compensation data for 2007 that noted PE firms paid bonuses 77% of the time for deals closing, (at time of closing neither the firm nor its investors have earned a dime), but only 47% of the time upon exit. Chasing Alpha became the national sport.

Despite the grim results and the greedy midwives who birthed this quagmire, the seedlings to grow the economy again are being planted, amidst the vestiges of the financial conflagration that marked this Autumn; some by government and private actions. Most economic downturns follow a rough “survival of the fittest” pattern which weeds out the less able competitors. That pattern has generally held in this recession. However, due to the critical role of the banking system the “oil” that lubricates the entire system, intervention had to occur to prevent system failure and the complete collapse of confidence in it. Full credit to Congress, the Administration and the Fed shall be given for acting. Lesser credit is owed for the thoughtfulness of the details of the plan. Demerits are due for the total inability of most parties to subordinate their egos or greed in a process that really mattered for the entire country. (Most remarkable were the earmarks attached to TARP with benefits for groups ranging from wooden arrow manufacturers to Rum distillers: our national priorities.). Failing to attach lending requirements to the capital infusions into US Banks was Marxist, (Groucho, not Karl), in style, but it began the necessary steps to recreate market confidence.

As insurance companies and auto companies attempt to become banks to share some of the federal lucre we have reached a dangerous intersection as Big Brother rather than the customer selects the industrial winners. Consider the queer results so far in the cases of Washington Mutual and National City Corp. Each was insolvent. Each had recent multibillion dollar infusions of private equity. The Treasury declined to give TARP Funds to National City due to its fragile condition. The government turned out the lights on Washington Mutual which officially wiped out the “worthless” private equity investment in Washington Mutual. Yet they infused billions into PNC to finance its purchase of National City, at a price 60% below the conversion price of the “worthless” private equity preferred stock investment in National City, miraculously making the private equity investment in National City, which was worthless a day earlier, worth par! Picture for a moment if you will: Two deals, two parallel universes, same circumstances, same economic result, two opposite results for investors. Do we need the winners being selected with such caprice?

Rick Wagoner, the GM CEO, was on the verge of becoming the 21st Century’s Sewell Avery, who was carried out of his Montgomery Ward Office in his desk chair by federal marshals, as he refused to consider leaving his job as part of the changes needed to attract government money. The Pandito, running Citicorp, continues to announce legions of layoffs, announces very little about managing risk, but did manage to remove $80 billion in assets from mark to market accounting. CEO’s being sold out of massive equity positions to satisfy margin calls must make shareholders skeptical of their ability to manage corporate balance sheets. Lehman Brothers, Washington Mutual and others have shown that the system can survive the loss of large companies. Continental Airlines and others have shown us that Chapter 11 can be used to revive a large industrial firm. A freshman economics student can perform the analysis to demonstrate federal aid to the auto companies, in the absence of altering the labor contracts and closing plants, will be lost money. Each of the constituents, management, labor, and politicians who expects the aid is not prepared to sacrifice any of their hallowed ground in the process. Moments like these call for actual leadership making hard choices to benefit everyone. Wagoner actually planning a pre-packed bankruptcy requiring the government to guarantee the debtor in possession financing would be a much more thoughtful move than a mere extension of the open palm for donations.

We are faced with a microcosm of these choices every day in our portfolio without the expectation that someone else is required to rescue us if our companies are in financial trouble. There is leverage to make large changes via a cooperative solution either in or out of bankruptcy for all leveraged companies if the participants collaborate. If we do not collaborate, the defect choice in the prisoner’s dilemma leads to a suboptimal results for all parties.

I’m Rob Morris and I approved this blog.

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