GM

Earth Track Blog Post

A number of recent articles on subsidies going wrong provide a useful set of examples on how and how not to structure these programs.  Examples include Evergreen Solar, GM and Chrysler, tax credits for film production, and Goldman Sachs. 

1)  What happens with hopes or hype crash with market reality?  Massachusetts firm Evergreen Solar announced that it was shutting down its in-state production facility due to high costs.  The firm received approximately $58 million in state incentives only a couple of years ago. 

I like this company, and take no pleasure in its struggles.  (I own a small number of shares, so its low stock price is not a point of glee either).  But there are some useful lessons for the subsidy grantees.  First, if subsidies are for job creation, there needs to be a formal contract demonstrating what will be provided and when.  Since state governments love these things, they ought to pool together to generate a standard agreement for this type of arrangement, and work with performance bonding companies so that states get compensated if the terms aren't met even if the firm is bought out or goes bankrupt.  Massachusetts did have some guarantees, which is better than many states.  But all should do better.

Second, state programs may seem big in the State House, but are piddly in terms of broader investments by national governments and private capital providers.  These programs can't overcome big forces in the economy -- whether it is missing infrastructure to connect power generation to the grid, or the Chinese government surreptisiously subsidizing the very energy technologies you are trying to anchor in your state (as they do for solar and a variety of other energy technologies as well).  Dreams are nice.  Really understanding why a particular industry hasn't succeeded in the past in your state, region, or country is much better before you plunk taxpayer cash on the table.

2)  Knowing when to hold them or when to fold them isn't something governments have normally been good at.  Here are examples of the government's sale of GM stock in the restructured firm's recent IPO and a second sale of Chrysler's finance arm.  The Congressional oversight panel argued that the sales left a great deal of money on the table.  In the Chrysler example, the asset was resold within only 7 months for 30 percent more, a loss to taxpayers of about $1.5 billion. With GM, the IPO price was less than the government's break-even on the loans, locking in a loss on the investment.

To me, the question about break-even seems irrelevant for a number of reasons.  The feds main interest in these subsidies has been to boost the general economy, not to meet certain targets for return on a specific investment.  Furthermore, if we entered into a double-dip recession, perhaps the prices received would look good right now, rather than bad:  nobody knows the future.  But there are challenges to governments being smart on the exit strategies from these deals that stem from less expertise and from political pressures from interested parties.  These are hard to overcome.

The flip side to undershooting break-even is that given the timing and amounts of capital poured into the firms, a reasonable return -- even under government management -- should be well above break even.  It would be quite interesting to compare the fed's deal terms and realized returns with those of other distressed situation lenders (Warren Buffett to Goldman Sachs, for example).  Buffett wanted a huge risk premium on his money.  Maybe the government doesn't need one quite so large given its other goals.  But it ought to do better than break even for sure; and its returns should be presented not only in gross numbers, but in comparison to what happened to private capital during that same period.

3)  Subsidy arbitrage, and subsidy power rules

This one is simple.  If government subsidies create disparities in the pricing of risk or capital in the marketplace and the government program, many parties will try to exploit that differential for their own gain.  The bigger the gap, the bigger the arbitrage opportunity, and the longer the line will be to get in.  Because subsidy policy arises from a complex set of political drivers, it is not surprising that powerful, well-connected groups are the ones best able to exploit these subsidy opportunities.  Indeed, these are the groups that so often actually create the subsidies from wholecloth, a process that I refer to as policy-enhanced investing.  The government may try to direct how those subsidies are distributed within eligible recipients, but generally it is a losing game.  The subsidies will flow to the powerful.

Two examples:

-Massachusetts, again -- though this time with subsidies to film production.  My own views on the efficicacy of a bunch of states and provinces bidding against each other to provide the largest subsidies for film production are fairly negative.  This example illustrates one reason why.  As noted in a Boston Herald report, one quarter of the tax credits the state provided went to out-of-state actors earning $1 million or more.  Total claims for tax credits in 2009 were $82.4 million, a hefty chunk of change for a small state.  Distasteful perhaps.  But it shouldn't really be a surprise given that these actors are also the more powerful players in the film's value chain.

-Goldman Sachs.  The bailouts gave them access to cheap money.  They are smart, and figure out ways to exploit this access for the benefits of themselves and their clients -- such as kicking in a bunch of money to Facebook.  Good for the country?  Likely not.  Facebook would find investors regardless.  No regular person would care if Facebook's IPO price increased 4x rather than 5x due to the absence of cheap money from Treasury.  Goldman employees would remain better paid than a teacher or public health worker.  But it is a logical outcome of the way this process was structured, and likely but one of a long list of similar examples. 

Deal structure matters quite a bit in the subsidy area, but is too often glossed over.  Tying payments to outcomes rather than investments; forcing potential recipients to bid against each other for the minimum subsidy required to achieve that outcome; and establishing clawback provisions guaranteed by third parties if private entities take the subsidies but don't live up to their side of the bargain would all be good starting points.

 

 

Earth Track Blog Post

A central thrust in many of the energy-related legislative initiatives over the past few years has been a growing role for the federal government in funding and financing infrastructure for favored fuels.  Some lessons from both energy and non-energy sectors highlight the problems with this approach:

1)  Inconsistent application of even rational government constraints (AIG executive pay).

2)  Congressional meddling in core business decisions (GM dealer closures).

3)  Mixed objectives weakening original goals of legislation (prevailing wage laws covering even small energy ventures, reducing total jobs created and likely skewing program applicants toward larger firms and projects).

4)  Political pressure to mis-state financial risks in order to help favored industries (DOE lobbying of OMB to reduce default premiums on multi-billion dollar loan guarantees).

5)  Hard-wiring solutions that favor one fuel (ethanol pipeline loan guarantees, though other liquid biofuels can go through conventional pipelines). 

6)  Poor risk measurement and management, resulting in adverse selection of projects supported and ultimate taxpayer ownership of far more what was planned at program inception (federal mortgage programs).

Got some others you want to share?  Let me know.