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09/28/2008

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Tom Rekdal

An admirably clear explanation. So clear, in fact, that it is hard to see how we geat out of this mess. Taking a senior preferred equity stake in some banks may be the government's best option for injecting new capital, as some money managers, such as Paul Johnson have advocated in principle, and as Warren Buffett has shown by example, but the economy may be weakening so rapidly at this point that even new capital may not be sufficient to stimulate more lending when there appear to be so many weak hands reaching for it.

And, for all of the reasons Professor Becker indicates, it is hard to see how we protect innocent parties (such as money market holders) without creating serious moral hazard problems. Nevertheless, if we must role the dice with $700 billion, I am for giving Secretary Paulson as much discretion as possible to deal with the emergency. We can worry about the long-term regulatory rules when the crisis passes. I just don't see a rule-based, or policy-based solution in the short term.

Ranjit Mathoda

Warren Buffett's thoughts on Paulson's plan are worth pondering: http://mathoda.com/archives/362

Tyler Blalock

I am unclear on how your proposal would solve the problem. I was under the impression that the uncertain value of the mortgage-backed-securities was the main problem as the holders of those securities cannot sell them without driving down their value. At the same time, if they do not sell them, they keep them, and are uncertain as to their value and therefore cannot calculate their assets. You propose that instead of buying the securities from the banks, the government instead buys shares in the banks. This will provide an injection of capital, but the initial problem remains. If the banks do not sell their mortgage-backed securities, there is no way to tell what those securities are worth. And so the banks are unable to know what the value of their assets is. If they cannot measure their assets, investors will lack confidence and the banks will not know how much they can safely lend or borrow. The credit crunch will continue.

To conclude: How does your proposal address the uncertain value of those mortgage-backed securities? Unless that problem is addressed, won't the credit crunch continue?

Christian Calvo

Why dont we just pay off 2 million mortagage notes @ $350,000 each. This way we are giving the banks there infusion of $ paying off these bad loans and helping 2 millon households who will end up paying for this mess.

Dan

Great, concise summary of the issues. A few comments:

1) Related to the moral hazard problem, some commentators are arguing that the only way to truly remedy the investor confidence problem is to allow a number of banks to fail/go into receivership so that their houses will be cleaned. Obviously, this will mean a great deal of pain.

2) The deceptive practices Judge Posner alluded to have impacted home values to such an extent that, arguably, hundreds of thousands of U.S. home buyers have been defrauded. Admittedly, it will require more data/investigation to reach a responsible conclusion on this point. But this makes the phenomenon more than a simple bubble.

3) In reading discussions about the inevitable market price correction in residential housing, I have seen little out there about the likelihood that home prices will, at least for some indeterminate time, fall well below a stabilization level. No one seems to know how the witches' brew of weak dollar, recession, increased unemployment, and credit crunch will combine. But the lower prices fall, the more persons will be "underwater" in their mortgages...

4) Mortgage reformation on the consumer end is both just and essential. It is just because banks recklessly changed the traditional mortgage lending model in recent years from mortgagee ability to repay to mortgagor's ability to sell paper on the secondary market. It is unrealistic to expect the average homebuyer to have understood this business model shift and how it necessarily contributed to the bubble phenomenon.

We know that many appraisals were fraudulent and we now have reason to suspect MBS creation was heavily tainted by credit company fraud, as well. Time will tell the extent of any collusion...

Mortgage reformation is essential to mirror the correction taking place in the secondary market in valuation of MBS. Once MBS's are bought in tranches by the U.S. and reconsolidated, someone should just cut the Gordian Knot of these silly things and unwind them. The entire economy can't be held hostage by some math whiz's complex encoding. Homeowners should be allowed to deleverage in tandem with the banks, since estimates are that the actual ("stabilization") value is 30% -35% down from where we are now.

If, as Judge Posner suggests, the U.S. follows the Buffett/Goldman Sachs model and drives a hard bargain, reforming underlying mortgages can do no worse than bringing the consumer debt acquired by the Treasury more in line with the actual price paid. I would argue that the resulting paper will be far more valuable because default rates will be lower, and the taxpayer is therefore more likely to recoup. The government's extensive costs in reprocessing mortgages should be factored in when purchasing. Other reformation options are available to the government to strengthen likelihood of repayment in exchange for debt relief.

none

What I don't understand is how the u.s. government via fannie mae ended up underwriting no money down, interest only mortgages to people without income verification. After all, it is the underwriting by the government that allowed these securities to be sliced and diced into into a toxic soup.

Thomason

It's a house of (credit) cards. The fundamental criticism by his Honor is right on - the Treasury is swapping debt for debt, with no infusion of new money. Becker is spot on when counseling against gov't ownership of private companies - that's swapping moral hazards for political ones.
I tend to agree with Calvo, provide 2nd mortgages to those homeowners that can meet modest financial guidelines, then they use the 2nd to payoff the first (how about at a 75% discount)mortagage. Then, the gov't is a mortgagor rather than holder of bad mortgage-backed securities and shareholder in Wall St.

Daniel

Your argument seems to be that the government needs to inject capital because private investors can't readily determine the asset value of many of the banks, so they refrain from investing in those businesses due to that uncertainty. If the government buys the dubious assets at their "true" value, whatever that is, aren't they in effect removing that uncertainty, and price discovery can begin anew on the value of the remaining banks? In this case the government is not infusing the industry with capital, but rather trying to re-establish price discovery mechanisms to enable the investment function to work as it does in normal times.

Thomason

The math of import today is too many nays and not enought yays for the bill to pass. Stocks resume slide.

Jack

Thomas Brownback:

I like the idea you put forth for injecting a market approach to the bailout.

One would hope that those buying the portfolio would see advantages to doing work-outs rather than foreclosing... but! since I trust W-S even less than government, I'd think that pre-sale there would be a mortgagee bill of rights. There is no chance folks can make it in this environment with usurious ARMs so strip all those terms with a max of 1% above normal mtg rates.

But, truth is there is no magic to offset the tanking of home prices. See my next post:

Jack

How far WILL housing fall?

http://mysite.verizon.net/vodkajim/housingbubble/


Take a look as this chart. Note that the bubble has tanked about 25% ....... so far.

Now put your straight edge on the inflation adjusted long term trend line --- this will give you a rough idea of the support level price.

Here's why that trend line is the "support" level:

"Notice that in the 25-year period from 1975 through 1999, real house prices stayed roughly within the range of $132,000 to $171,000. Only since the year 2000 have real house prices risen above the top of this range. The United States median price was at approximately $206,500 as of the second quarter of 2008. This is 21% higher than the previous housing boom peak of an inflation-adjusted $170,900 in 1989."

........... in addition NOTE that the trend line reflects the similarly flat median household wages of $48,000. ie.. maxxed out, one can buy a house priced at about 3 times HH income thus, the fundamentals point to median home prices in the $150,000 range.

But! of course housing itself skews to a bit higher income range because those much lower than median can not buy any home and dwell in apartments, mobile homes, or rooming houses.

So, Let's say that housing might balance out at $170,000 or the upper end of the long term trend line. What that means is we've another 20% drop ahead for nearly 50% total ---- with worse, FAR worse in the hottest markets.


Now if you peek at the LV chart you'll see they began tanking earlier and faster than many others. BUT, , in addition to being WAY overbuilt, their economy built on fun, fun, fun and costly conventions is tanking much faster than is the rest of the economy......... so, one suspects that Vegas home prices are very likely to bust down thru the long term trend/support line before flattening out. One has to keep in mind those "investors" who've long been flying into LV to "take possession" for $100 and all that phantom inventory being dumped or foreclosed outright.

So... where are we? Will Paulson's "deal" plus the mandates to do "workouts" with Main Streeters be enough of a shock absorber to avoid another "crisis" mid next year as the long term trend line is approached?

Maybe. But I rather doubt it. This is just enough to A. get through the election B. provide cover for a hasty exit by all who are on or near the stage today.

A bit more to my analysis:

There are about 50 million loans outstanding with 10% said to be "in trouble".

Now consider! The average loan is held only 7 years. So.. we've two classes of home owners. Those who've held longer than the average........ and the other half who've purchased in the last seven years and taken advantage of low down, no down et al. In short they moved in with no equity or at best, little equity.

Given a 45-50% drop in prices, on average, all who bought in the last seven years will be underwater from a little under to under by 25%, 50% or more. Most will not be able to hang on and many WILL not keep paying on a home deeply underwater even if it is arithmetically possible.

Those who bought before 2000 should be OK....... they'll have experienced a fine run-up in paper equity which is now disappearing like the morning fog under the noon day sun but won't lose their homes. They WILL feel much poorer though and will delay buying new homes, new cars, taking trips etc and with not other source of wealth I'd predict a worsening recession.

In closing there is, of course the matter of FLAT wages for 20 years despite a DOUBLING of per worker productivity. I've long pointed out that this economy can NOT fly on one wing, so IF our economy is to ever recover it is going to require getting some spendable income down to the working folk of median and lower incomes. Ideally it would come from wage increases, but those are not likely in a contracting market, so next best would be extended unemployment benefits, the per person spurring of $1,000 or some such and addressing what is surely a market manipulation of oil prices that is impacting those of lower incomes so heavily.

Where does the money come from? Like all wealth it comes from productivity. Our productivity per capita has doubled in 20 years while median and lower wages remained flat; working folk much participate in the "rising tide" or we'll continue to have a sick economy that is lacking in demand.

Jack

Brian Davis

Not to toot my own horn but I've been pitching BONDS for weeks if not months. I'm talking about, in effect, force-fed coupon bonds issued "on behalf of" (like an indenture) the sick enterprises. The U.S. becomes & remains a super-secured creditor until the bonds are retired. Come on American, Japanese, Chinese, Arab, European, South American, et al., savers and investors. Nobody cashes in on bond proceeds without the FDIC's go-ahead. The taxpayer fronts initial working capital + interest but the sickos have to establish sinking funds and pay off the bonds out of future earnings? Careers in banking, any of you young 'uns? Maybe the taxpayer could help you with grad school or law school. I'm neither the President nor do I have a vote in the Congress. But I like that lady, Sheila Bair, who runs the FDIC. She's cut from Seidman's cloth, and she'd be hell on wheels if she had some money to work with. Get good people committed and keep it simple, Congress can pass a strong bill that only the culpable will fear.

Constantin

One major loophole in the bailout proposal is that it does not mention anything about the treatment of assets from banks that have already filed for bankruptcy. The marks that the Treasury will use to purchase mortgage-backed assets from still operating banks have to be in line with the prices realized for similar assets during the liquidation of institutions like Lehman or Washington Mutual. Otherwise we would allow the creation of two separate markets for mortgage backed securities with inconsistent valuations. This would offer arbitrage opportunities at the expense of the tax payer.
A bank that holds eligible assets on its balance sheet could agree to sell these to the Treasury at 70% face value arguing that this is the "hold-to-maturity" value. At the same time it could turn around and buy the same (or similar) assets for 30% face value (which would be the current market value) from a bankrupt institution and realize a 40 Cents arbitrage profit for each Dollar of face value.
As long as the Treasury does not communicate exactly how it will protect the tax payer from overpaying for these illiquid assets, people will reject the bailout bill...

Steve Eugster

The dilemma we are in is one of the role of money lending in a capitalist free market economy. The money lenders are saying they can no longer make money on the money they have lent. They cannot roll it into cash, into new borrowing. Therefore the money lending gravy train is coming to an end. They want the borrowers to buy them out so that they can lend more money to a few, a very few, of the borrowers. The moral hazard question is whether the borrowers are going to yield to this, this graduated fraud, by the money lenders. They were fought off today, but they will be back. Even our presidential election candidates are on their side.

PHP Developer

We had Enron then Arthur Anderson cooking the books... Now this. Let the market work. It will adjust. Lets get past this in a natural way.

I see way too much debt in America. Where is my social Security?

I've been restrained and do not want to pay for those who have not. We need to feel the pain and learn from it. This is good!!

Diego Valiante

Christian, it is not working in the way that you repay all the mortgages and then everything is gonna be fine. There are two reasons. First of all, if mostly the value of the subprime (but also part of the prime is involved) is 10, there is a level of CDOs in circulation 100 (or probably 1000)times that value, because they issued CDOs on CDOs. So the suffering securities are much more than that value. Secondly, there is no liquidity for that market (no demand) but few liquidity in the market in general (mainly for lack of confidence). Therefore, financial institutions are holding a huge and undefined amount of securities for which nobody is going to pay a penny, also if you decide tomorrow to repay all the mortgages. The reasons of this is that the bankruptcy in the last months of all the banks or companies directly involved on subprime and the increasing number of foreclosures have already emptied the box on which these securities (issued till the end of the 2007)were issued. In fact, the bankruptcy of those companies has been determined also for the impossibility to resell the foreclosed houses on the market (price down because offer was much more than demand; who was supposed to control the growth of the construction market and the inefficiency of the rent market??? it's not only a problem of the credit market!). Hence, when progressively those securities go to maturity those institutions do not get anything from them. There is only "toilet paper" on the market right now!
So, the bailout plan, rebuying those securities, want to give back confidence and trust on the market restarting the exchanges and increasing the liquidity on it, fuelling new exchanges and reducing the negative impact (also on the confidence) of those troubled assets.
What is not clear in this plan is, firstly, how do you define the price of this "toilet paper", because the real value is very low and on which basis they are going to help some institutions instead of others. My opinion is that there are also reasons linked to the difficulties for big firms like GM and Ford to find resources for their new restructuring programs (the alternative is another disaster on the real economy). These doubts, i think, pushed the Congress to correctly say NO. The solution should be to help only some big institutions (Citigroup, Goldman and Bank of America) giving strong incentives to the entry of new private capitals (like Buffett in Goldman, but in general hedge funds (the richest part of the market at the moment)) and taking stocks till the control if nobody is going to show up. The way of the "funds" proposed by Bebchuk could be one of the ways to do it. However, the profits those managers should generate (performance fees) from those securities are inconsistent, so they just would buy healthy securities not solving the problem of the "toilet paper".
This would already be a "public intrusion" in market mechanisms! I do not want consider at all the last plan proposed to the Congress, just because it gave money to banks and other institutions, as the problem was to make a lifting of their balance sheet, not considering the instability of the entire financial system and of the real economy on the background. And $100bln to the discretion of the Treasury's secretary looks so "Italian Job"!!!

St. Darwin Assisi's Cat

Gentlemen, thank you. Alice and the rabbit are in the hole.

patrick

I have a question, maybe a dumb one. From the description, I gather that "banks" sold the mortgages and took the mortgage backed security in return. Those securities are now tied to the value of the mortgage, which they no longer control the value of.
Why don't the banks just buy back those mortgages that their securities are tied to. If they overpay, their securities value goes up, No? Wouldn't this help the balance sheet and its real value too?

A stockholder

Please link to this site‚ô™

neilehat

It looks like the House found the "bailout pill" a bit to hard too swallow and rejected it. The question now becomes "Where do we go from here"?

The reality is, everything depends on free flowing monies/credit, and nowadays, at high velocity across numerous frontiers. So what happens when it dries up? Everthing else dries up with it and much like the Dust Bowl blows away.

We've got a problem and it is a real dusie! Unlike the ostrich, we can't stick our heads in the sand and hope it goes away. Much like Congress and the rest of the Country seems to think.

James T. Struck

Is it intentional that Posner smiles with his and Becker's own commentary and is not smiling with the replies? My own response to the discussion of bailout was that it, some media was describing it as bailing out the banks that just foreclosed on your house. My feeling, in response to some media perception was that not bailing those banks out
might promote the banks selling back the homes to those foreclosed upon for some lesser amount. I thought Posner's discussion of investment in these
companies rather than takeover made some
sense. It still seems to me that floating
bonds all the time to pay for everything
has economic consequences that Posner
is not discussing. I apologize as I did not
read the other replies to the Posner's post. For the
first time today, I saw what seemed like
a gorilla praying on the ground. I will try
to sell the photo to trib etc. Just using that
as an example of how normal projects like selling
a picture of a gorilla seeming to pray often
do not have any benefit. Similarly, normal concerns
such as buying or investing in banks have
unintended consequences. I have still not bothered
to study the list of what is being bailed out so
my perception is limited and faulty.

St. Darwin Assisi's Cat

On a lighter, brighter, more hopeful note...here is a web site for Dina Cat Posner:

http://videos.komando.com/2008/09/24/the-boxing-cat/

Diego Valiante

Patrick, the structure is not that easy. Basically, State-chartered companies or little banks made those subprime mortgages (and some very risky prime) to people with low credit score. Those mortgages had been packaged mainly by banks that mainly bought those mortgages from those companies. These packages are structured by investment banks that underwrote some of those MBS (mortgage backed securities; a lot in this case). Many of those MBS had been packaged in other CDOs, increasingexponentially the leverage. It is oftenly used the metaphor of a box in other boxes. Those securities were strongly appreciated by financial markets because they gave a good yield and the risk was theoretically low because the assets behind them (mortgages) were supported by the increasing price of the houses (increasing home value; always increasing in the history of the US). It's important to precise that rating agencies classified those securities as triple-A (like Treasuries Bonds), giving to them a better appeal.
Therefore, the money freed from the packaging banks were mostly used to create other mortgages through the little companies or merely to bump the profits of the big banks that bought those mortgages from the little State-chartered companies to package them on the financial markets. How do you justify the impressive and enormous amount of profits in the banking sector in the last years???

patrick

Thanks Diego for the comments,
I apologize for the simplex question. The optimist in me kind of hopes that the Banks will help clean up their mess. But I remember reading that some of these securities may be duplicates tied to the same mortgage and are held by different institutions, and therefore nobody knows which, if either has any value.
I know that some sort of government intervention is needed, but hope that the banks will at least do the due diligence to determine what they hold, and where they think there is value - do the work to clarify what it is, and when possible clean up some of their own mess (and hopefully mitigate their losses at the same time.) I guess the root of my question (rhetorical) is if there is some way, with market incentives, to get the banks to do the research in determining value. My guess is that whoever was snatching up all this paper at these banks a couple years ago has a little free time now to do some due diligence and figure out exactly what they hold. I don't think we can put the genie back in the bottle, just want to identify the bottle and the genie.

Dan

Here is Thomas Cooley on Forbes.com with an interesting proposal for mortgage reformation:

http://www.forbes.com/home/2008/09/30/mortgages-haircut-paulson-oped-cx_tc_1001cooley.html

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