Defense Contractors and General Motors

I work in DC and live in Alexandria. Consequently, when I take the Metro into work, I pass by the Crystal City, Pentagon City and the Pentagon Metro stations. For those not familiar, at each of these stops are a plethora of signs from defense contractors - each saying how they save soldiers lives in the field, or how the particular item they are hawking is essential to the fight against terrorism, Iraqi insurgents, the next enemy, etc.

As I ride past them, I never fail to get angry. Really angry. Because I see them in the same light I have come to see General Motors - a company I fully expect to fail or be bought within the next 10 years, bailout or not. Because both groups are building products the customers don't really want. GM is moving its 8 mpg only because GMAC has received bailout money and can offer these gas hogs at 0 percent interest. The defense sector is the same. The argument is the companies are too crucial to national security to fail... or their products are the latest segment of the revolution in military affairs... or vital to the "next war."

GM will fail because it builds substandard products with poor maintenance records at too high a cost. Our defense industry is in trouble for exactly the same reasons. Exactly when the US should be leading the world in the supply of defense equipment (to reputable allies...), we are on the cusp of losing the entire market. The reason is we have priced ourselves out of the market. When we accept that a single warship (or single airplane like the B2) can or should cost over $1 Billion, we have lost the battle for pocketbooks. If that is the cost of their products, we are all doomed.

And yet, there is also the side that pisses me off. Because the words I see used I have heard before, when I was in Iraq. There, more than anywhere else, I gained my disparagement of defense contractors. As a measure of disclaimer, there are many good contractors - good people trying to do their best for their country. Then there is KBR (Kellog, Brown and Root - formerly "owned" by Halliburton, the company with which VPres Cheney was associated) and L3 Communications. KBR has allowed soldiers to die because they have held fast to the letter - not the spirit - of their contract, which does not require them to be certain Iraqi-built structures are electically safe. They may argue it is a matter of money - they can't afford to fix everything. And yet, while being paid to hire Americans, they hire Ugandans, Romanians, Hungarians, Ukrainians, Philippinos, Malays, Indonesians, etc. I do not say there is anything necessarily wrong with foreign nationals are hired - my concern is they are being exploited. And then there is L3... they are requested to supply trained, experienced analysts, and they provide untrained, inexperienced junior personnel whose only qualification is their security clearance. Many have never written a report before, and most lack the ability to write coherently.

Then I see advertisements about how bad guys aren't waiting for some integrated network to be built, or how some project is crucial to US security. And yet, I have been at the tip of the spear - indeed, I have spent most of my career there - and what these companies are offering, is usually not what the actual "warfighter" really wants. One more piece of software, one more piece of unecessary (expensive) gear... I have come to believe many of these companies are only in the game for the profit. I see no difference between them and GM - the Chevy Corvette I once had was a beautiful machine, but cheaply built and succombed by problems from the day I took possession of my custom-built vehicle.

We have come to expect our defense equipment to be expensive, but the day is soon coming where neither us - nor our many allies - will be able to afford US manufactured equipment. Not even GM would refuse to fix the tire of a car being driven off a lot. Yet frequently, that is the case with US built equipment. For example, with the LPD program, the ships were built, but any required repairs identified during acceptance trials had to be paid for by the Navy.''

Unless we are careful, our defense industries will go the way of GM. But if an equivalent product can be bought for a fraction of the price, maybe that isn't such a bad thing.

How We Got Here

Considering the fact that the government is debating throwing almost a trillion dollars at a bailout plan, I thought it would be a good idea to sort of review how we find ourselves backed against the wall.

How did we get into this financial mess? It is actually pretty easy to explain and track. As population increased over the last couple of decades, wealth increased, and desirable property grew scarcer throughout most of our major cities. Real estate prices heaved upwards. Sensing opportunity, speculators began to buy properties solely with the intention of “flipping” them; that is, re-selling them at a substantial profit to someone else. At the same time, appreciating real estate created wealth, allowing selling home-owners to buy bigger and more expensive houses. The combination of these two factors led to increased price pressure in the real estate market and a real estate “bubble.” The market prices were artificially inflated above where supply actually met demand.

Why am I talking about the real estate bubble? Because the money to feed the bubble had to come from somewhere, and it could not come from cash, because the savings of your average American simply could not support it. So, it came from financial institutions—banks. Increasingly ambitious and innovative financial tools were pushed by specialty lenders and mortgage brokers. As long as prices kept going up, this was a self-feeding cycle. Of course, eventually, someone needs to make actual payments towards principal and interest rather than selling and borrowing money. When it came time to pay, many people couldn’t. Many residential developers, piggy-backing on this housing frenzy, also had over-extended—built out property that no one could buy. Once the bottom fell out, prices collapsed.

BOOM. It crashed.

Now, many banks who jumped on the bandwagon and offered these heretofore highly profitable (and complicated) adjustable loans have foreclosed or are foreclosing on a bunch of real estate that is worth far less than the loan secured on it. What happens on the balance sheet? Well, after reviewing the market and realizing that property that the bank loaned someone $400,000 to buy is actually worth about $150,000, the bank’s books suddenly look not so good. The high-performing commercial paper with a principal value of X is converted into non-performing real estate with a principal value of .2X. What do you tell your investors and shareholders? Whoops? (As an aside, you could make the argument that the banks deserve even more blame than I am about to heap upon them below by seemingly introducing a credit card technique into mortgage loans—get your debtor to run up debt and get in over his head with 0% interest over a period of time and when they miss a payment, jack up the rate to prime plus 10% or whatever. Problem is, when you’re talking about hundreds of thousands of dollars, these folks just can’t service the payments).

Okay, so who is to blame for all of this? Here is your list, which I will call the Usual Suspects because... well, because they always are in some form or another—the consumer (home-buyer), deal-maker (mortgage broker), and bank (bank). (The list is also named in honor of one of the best movies of all time). In increasing order of culpability:

THE USUAL SUSPECTS

1) Home-buyers. Specifically, those persons who just could not hold back from getting that extra bedroom or dedicated wine-tasting cellar in that house that they could not afford by any reasonable financial calculation without absolutely relying on (a) massive appreciation of the property, (b) a gimmicky loan allowing lower payments initially, and/or (c) increased prospects for income in the future. Dumb and irresponsible decision-making.

2) Mortgage brokers. That guy who set up your loan who exuded trust and confidence? Who probably told you that you could do it, you could trust him, etc.? That guy was plain fibbing, ya’ll. Truth is, he doesn’t care. A mortgage broker has no fiduciary duty to the borrower—he has obligations to the lender to make loans within various programs, but really no duty to protect the lender, either. His goal is singular: to make lots of money. That is not really bad in and of itself except for the fact that sometimes the mortgage broker is the only one who is really consulting with the borrower. Remember, the mortgage broker gets paid at the loan closing—it is not in his interest to consider the long-term health of the loan, only that a borrower is able to get a loan of some kind, because then he gets paid. If banks were asleep at the wheel, mortgage brokers were stripping everything they could from the car.

3) Banks. Look, if you have the pot of money, and you do not do your research and due diligence and lend it out to a bunch of bad debtors... do I have to finish stating the obvious? A fool and his money are soon parted, okay? Having myself been involved on the legal side of lending more than a few times, I have been shocked at how some of these guys just hand cash out like candy with little investigation and little attention paid to agreements the lender and borrower are actually signing. Some banks do a really good, responsible job, but others—it’s just like there is no one there in that position—like no one wanted to take the job or something. And unfortunately, in my experience, the fraction of “asleep at the wheel” banks is something like 1/3 of the total. That’s a lot.

I’ll have a post later (if someone else does not beat me to it) about what I think about the proposed bail-out plan(s). Setting aside the whole collapse of our financial system as we know it issue for now; specifically, how do we fix the (primarily residential) real estate lending system that led to this disaster? Here are a couple of quick suggestions:

* Ban certain kinds of loans from banks. No more BS loans (how about the zero interest for six months adjustable rate mortgage with 3 rate-leveling points? Got that?), particularly zero interest loans or extremely short-term fixed rate period loans, which simply encourage speculation. They get too confusing and are quasi-predatory. Proviso: if you can clearly afford it, allow it. We do not want to put the kabosh on simple financial maneuvering and handy retirement tools like reverse mortgages.

* Make sure the mortgage broker has skin in the game over the life of the loan (or a period of years, say, 5 or 10). That way, the mortgage broker is also concerned about the borrower defaulting, because if the borrower does default, he doesn’t get paid in full.

* How about some required financial planning classes prior to someone qualifying for a lender’s program? A one-day 3-hour class should do it.

This is really not rocket science. We can fix it and should act to prevent this kind of disaster from occurring again. And to those who say the above ideas (or other proposed regulatory fixes) would constitute undue regulation of free enterprise: I think taking $5,000 from every taxpayer to bail out a bunch of banks is a bit more intrusive to our way of life than more regulation of the banking industry.