Credit Problems Beyond Subprime

When the subprime credit crisis began to unfold in 2007 I believed it was a sign of deeper problems in the credit markets. Easy money and unchecked leverage puts pressure on banks to lend. First they make the good loans, then the not so good ones, and then they make bad loans. So far most of the media attention has been on the subprime mortgage crisis. Last week, to little fanfare, the Shared National Credits Program released the results of its review of loans to corporate borrowers that are shared by banks in the US, banks overseas, and other institutions such as pension funds, hedge funds, and insurance companies. The review is of:

loan commitments of $20 million or more and held by three or more federally supervised institutions

The review shows considerable deterioration in credit quality of these loans.

Criticized credits increased $259.3 billion and represent 13.4 percent of the SNC portfolio compared with 5.0 percent in the 2007 SNC review. Credits rated special mention (potentially weak credits) increased by $167.9 billion and represent 7.5 percent of the SNC portfolio compared with 1.9 percent in the 2007 SNC review. Classified credits (credits with well-defined weaknesses) increased $91.5 billion and represent 5.8 percent of the SNC portfolio compared with 3.1 percent in the 2007 SNC review.

Even more interesting is how the criticized loans are distributed:

Classified credits held by non-bank entities increased to $70.0 billion from $34.8 billion and represent 42.9 percent of classified credits. The volume of classified credits held by non-banks is particularly significant given their relatively small 19.9 percent share of the SNC portfolio.

The distribution could be due, in part, to purchases by non-bank entities of credits at a discount from face value but the report is silent on this point.

So what does all of this show us? It demonstrates the fact that subprime was one area of the credit binge of the past few years. Subprime is certainly a very big part of the credit crisis, but it is not the only part. Here is what the review states about underwriting standards for these $2.79 trillion of loan commitments with $1.2 trillion outstanding:

For the second consecutive year, the review included an assessment of underwriting standards. Examiners again found an inordinate volume of syndicated loans with structurally weak underwriting characteristics particularly in non-investment grade or leveraged transactions.

Add to this portfolio and mortgages all of the other loan portfolios, including credit cards, auto loans, corporate loans, small business loans, and so on, and this crisis goes well beyond subprime mortgages. Just how far is impossible to tell, but the rapid deterioration in the portfolios of major banks, such as the loss reserves announced by Bank of America, give us an indication. As reported in The Wall Street Journal Online Edition:

The nation's largest retail bank reported net income of $1.18 billion, or 15 cents per share, down from $3.70 billion, or 82 cents per share a year earlier. The results were worse than expected. Credit losses on mortgages and credit cards dragged down the results. Its provision for credit losses was $6.45 billion, up from $5.83 billion in the second quarter. Net charge offs were $4.36 billion, as compared to $3.62 billion in the second quarter.

Nonperforming assets were $13.3 billion, or 1.42 percent of total loans, leases and foreclosed properties. The dividend cut at Bank of America, the country's largest bank in terms of deposits, mirrors similar moves by smaller banks across the country as they look for ways to cut costs and raise capital amid the volatility that has driven some of the country's biggest financial institutions out of business.

For more on credit cards see this WSJ article.

I think the credit crisis and its impact on the economy have a long way to go. There are many reasons I believe this and I have been writing about them for the past year. What I found amazing and would like to point out is just how rapidly Wall Street greed exploded, bringing the financial system to its knees. In 2004, investment banks and commercial banks were recipients of deregulation relating to the amount of leverage, on and off their balance sheets, they could employ. There have been many reports on these events, including this New York Times article addressing the investment banking regulations, this blog piece by yours truly addressing both sets of regulations, and this one I penned last May pointing my finger at Bush appointed regulators. Two years after these regulatory changes, the system imploded. True, there are many other issues that are much longer term in nature. In particular, unregulated derivatives markets turn out, not unexpectedly nor without warning, to be a major structural problem in the financial system, and easy monetary policy plus global liquidity were certainly contributing factors. But notwithstanding these other factors that come in to play in this crisis, the simple fact is that if regulators had limited the amount of leverage financial institutions could employ we would not have necessarily reached the crisis stage.

In 2004 regulators gave Wall Street some rope, and it took a mere blink of the eye for Wall Street to hang itself (and, unfortunately, a lot of others).

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Goldman Profits Up on Short Sales of Goldman

OK, the headline is completely fictional, I think. I just re-read some articles about how Goldman Sachs was at the heart of creating so many toxic mortgage securities and how watching its former head (Treasury Secretary Paulson) pining for $700 billion of taxpayer money to clean up the mess is disgraceful. One of the points that came out again was the fact the Goldman came away from the whole mortgage crisis relatively unscathed from a profit point of view because it was shorting that market heavily as the crisis unfolded. Now, of course, regulators have prohibited short sales in Goldman stock to prevent Goldman's stock from collapsing and there is a witch hunt going on to find those evil short sellers. Wouldn't it be an absolute riot if it turns out Goldman was one of them?

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Credit Market Developments

Treasury has proposed a $700 billion taxpayer funded (through issuance of debt) purchase program to acquire real estate assets from the financial industry. This has been coming for a long time, and goes all the way back to the failed Super SIV that was being discussed last Fall. Of course, the numbers have grown from what was a $70 - $100 billion plan to the current $700 billion plus plan, and this plan has the taxpayers purchasing the bad assets directly. The accounting issues of valuation, however, have not changed. What has changed is that the crisis has become so bad we are probably willing to throw out the rules to save the game.

The plan is essentially a $700 billion revolving line to acquire real estate assets at whatever prices and from whatever sellers Treasury wants. There is no protection for taxpayers in Treasury’s proposal, and I can only assume Treasury has left this aspect of the plan for Congress to address. If this isn’t ringing alarm bells all over Washington and Main Street I don’t know what will.

Treasury Secretary Paulson has submitted a very broad plan that gives him extraordinary discretion and prohibits any agency or judicial review. You can see a copy of what was submitted in this CNN article and read a description of the plan at the Treasury’s website. The submission raises many questions, three of which I will point out.

1. There is no provision for protection of taxpayers. As written, it seems that Treasury will simply purchase, at whatever price Treasury determines,

Mortgage-Related Assets.--The term "mortgage-related assets" means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

The big question – at what price? If Treasury purchases securities at current market prices it doesn’t necessarily help the financial institutions that own them. Right now losses that would occur at market prices are being deferred through secured lending by the Federal Reserve, but this is obviously insufficient. If these assets are in addition to those pledged to the Fed, then this is a multi-trillion dollar problem. If Treasury pays more than current market prices, then how is the taxpayer protected? Not to get off on a rant here, but it seems to me that any financial institution that sells securities to taxpayers pursuant to this program should, at a minimum, direct all dividends to the Treasury until taxpayers have been fully repaid, at which time they can have the balance of the securities returned. It really irks me to think that financial institutions could sell the crap they profited from so handsomely over the past decade to taxpayers, letting us assume the risk, while the owners continue to collect dividends. Absolutely horrible result that I truly hope Congress will address. Some may argue that this would make it difficult for these institutions to raise capital, but that should be irrelevant now since the taxpayers are providing the capital if we pay above market prices for their securities. Another point – why are we purchasing commercial real estate assets and what are the limitations on commercial vs. residential?

2. I think there is a lack of transparency. The current proposal provides for a report to Congress three months after the program begins and then every six months. As a taxpayer whose money is being spent on these assets I want to know every week how much, who, when, and so on. I want to know which institutions are benefiting, how we are getting compensated for it, what is the asset rated, what is the mark-to-market value, and so on. Without full disclosure this plan is ripe for abuse and all purchases need to be fully disclosed. I suppose there is an argument that disclosing which institutions are selling assets to taxpayers could jeopardize the institutions, but since they would be receiving a capital infusion from the purchase this should not be an issue. Poor disclosure is one of the issues that got us here in the first place and any plan to address this crisis must include full disclosure.

3. The amount of this bailout is unclear. It specifies that:

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time

. This means we could be purchasing a lot more than $700 billion worth of this stuff, we just will not own more than $700 billion at any one time. How do we account for the value of these assets? If Treasury purchases an asset for $1 million and receives principal payments that reduce the face amount of the asset, do those payments reduce the $700 billion even though we may still take a loss on the balance of the $1 million we paid? If so, this is more likely a $1 trillion plan (or more).

In other bailout news (post AIG taxpayer bailout), the Fed established a line of credit that is reportedly $230 billion to purchase asset-backed commercial paper on a non-recourse basis (meaning the Fed will own the stuff). Asset backed commercial paper was at the heart of this crisis to begin with and is where funding dried up last week. What does this commercial paper fund? Everything, including auto loans, credit cards, and so on. If this market freezes your credit card may not work, and the resulting panic could be devastating. Think how you would react if told you could not charge your groceries on your credit card because Citibank doesn’t have the money to lend you. In addition, companies could find it impossible to fund payrolls causing more panic. This is one of the reasons Treasury acted on its plan – justified fear. (For a good explanation about how asset backed commercial paper works see this fitch report).

So what happened in the commercial paper market? In general, money market investors put money into money market mutual funds that then use the money to purchase assets including asset-backed commercial paper. But when a large money market mutual fund reported that it took a loss and that investors would lose money, money market mutual funds in general received calls for redemptions from investors who feared losing their money – a run on money market mutual funds. As night follows day, the mutual funds stopped purchasing commercial paper and put their liquidity into Treasury securities, driving the interest rate on short term Treasuries to negative on at least one issue and the interest rate on commercial paper way up. This is a clear dislocation in the credit markets and the Fed jumped in to provide liquidity for commercial paper. In addition to the Fed’s new plan to purchase commercial paper, Treasury reached back to a depression era law to insure money market mutual funds. Funds can buy into the plan that will insure investors against losses. This has irked some banks that believe this places them at a competitive disadvantage to insured money market mutual funds and could cause their funding to dry up – more unintended consequences (do I hear whack-a-mole?).

One more item on the list of things being done to avoid a total meltdown – relaxation of regulations on financial firms. Since these firms cannot raise any capital because their business models are in question regulators have relaxed capital requirements – temporarily, of course. Another thing regulators did was relax the restriction on using commercial bank deposits to fund investment bank operations. After the great crash of 1929 and the ensuing depression, Congress split up the investment banks and commercial banks because investments made by investment banks in equities were too prone to value fluctuation that could wipe out depositor funds. The FDIC was established to insure deposits and banks were limited as to what they could do with those deposits (to protect the taxpayers from having to bail out excessive risk taking). The law that kept investment and commercial banks separated was repealed in 1999, but there was regulation in place that prohibited these new combined banks from transferring commercial bank deposits to investment bank affiliates. Some of this regulation is currently being relaxed so that investment banks that are affiliated with commercial banks can get access to the stable deposit based funds of the commercial banks. The result is that to some extend the FDIC and taxpayer are now behind assets of the investment banking affiliates of the large commercial banks that have such affiliates. We have gone backwards (I bet Merrill Lynch and Bank of America appreciated this change that occurred the same time they merged).

For a time I was keeping tabs on the total cost of this credit implosion and the risk to taxpayers but the numbers are getting hard to follow. Based on current media reports the Fed is now up to $700 - $800 billion in credit and commitments, Treasury is asking for a $700 billion revolving credit facility from the taxpayers that is likely to be more than $700 billion in aggregate purchases, and so far the Federal Home Loan banks have issued some $250 - $300 billion in new taxpayer guaranteed debt to lend to banks against mortgage collateral. Oh yes, FHA has approximately $100 billion in new loan guarantees from FHA Secure and has another $300 billion authorized guarantee capacity to refinance defaulted mortgages. Are we at $2 trillion yet? If not, just add the GSE loans and MBS purchases Treasury plans (there are no limits on the amounts here) and whatever funds the GSEs need to stay solvent, and we have taxpayer exposure of well over $2 trillion even before the federal guarantees of the GSEs’ debt. These numbers don’t include losses that banks have reported on write-downs of securities. The result so far - Treasury has asked for an increase in the debt ceiling twice, this time to $11.3 Trillion (approximately 80% of GDP). One more point. If the total of all residential mortgages in The United States is in the $10.6 trillion range, and taxpayers now explicitly guarantee $5.5 trillion through Fannie and Freddie and are or will be at risk for say $2.5 trillion through all of the interventions noted above, then taxpayers could ultimately be on the hook (either through guarantees or ownership) for some 75 - 80% of the entire outstanding amount of residential mortgages in The United States. I find that staggering.

A couple of nits that I have:
1. Too bad Treasury didn’t go out and raise the money last week when interest rates on Treasuries were at historic lows. Probably would have saved a lot in interest.
2. CNBC should stop praising Jim Cramer as though he is some sort of visionary for talking about a bailout plan like this one. Everyone has always known that the government could step in and get behind lots of private debt to shore up the markets. In fact, everyone has been talking about it for some time. Treasury just didn’t until it was necessary because if it did it wouldn’t get approval for it. No great vision here. When Cramer comes up with a way to protect taxpayers that Congress will pass and that will resolve the credit crisis call me.
3. If there was ever a time to fix the unfair and disproportionate tax treatment for hedge fund and private equity managers (the 15% rate on “carried interest”), now would be it. In fact, several years ago would have been better. When this was in the public discourse several months back industry pundits argued that if you taxed hedge funds you would get less of them. Right now that sounds like a good idea. Fewer hedge funds, fewer credit default swaps, less systemic risk.
4. Like many of the talking heads on television, I am angered by all of the blatently excessive amounts of compensation paid to Wall Street bankers and executives over the past six years or so that is ultimately proving to be gains from the largest Ponzi scheme in the history of the world. There should be some recourse, though I don't claim to know how that could work.
5. With absolutely no proof that trickle down Reagan/Bush-onomics has ever worked, an exploding national debt, an exploding national deficit, and the impending baby boom retirement isn’t it time to stop talking about tax cuts for the investor class?
6. And finally, when will we, as a taxpaying and voting public, stop allowing the politicians to distract us with witch hunts for evil short sellers from the real issues – the fact that the political system has been for sale to the highest bidder and the highest bidder often turns out to be Wall Street and Wall Street.

PS - there are other developments, such as the Fed now accepting equities as collateral for certain loans under the Primary Dealer Credit Facility. To find out more about what the Fed is up to you can go to its website and click around the press releases.

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What Caused The Credit Crisis?

I have been following and writing about the credit crises for some time. Watching the stock prices of the financial companies plummet over the past few months has been painful if you own any of them. As I wrote in March I have been expecting this decline, but its acceleration in recent weeks has been breathtaking.

I have been reading a lot of commentary about what caused the credit crisis. Most recently I read the first section of “The First Global Financial Crisis of the 21st Century” published by VoxEU.org. This is a collection of articles written by renowned economists addressing the credit crisis, and part one deals with the causes. Unless otherwise noted my references in this article to other writers refers to their article in this collection. There is a rather long list of suspects, but in my opinion the cause of the credit crisis was a failure of the regulators of the financial system to adequately protect it from systemic risks that they should have seen at the time. Determining why they failed under such circumstances should be the primary path of inquiry. This involves uncovering the reasons why, in the face of compelling evidence of a major financial storm in the making, financial regulators did nothing. The same can be said for Congress.

I believe there is plenty of blame to go around and there were many bad actors involved in generating loans that should never have been made. In one of my early articles I pointed the finger at many of these actors. But it is the job of regulators to monitor the financial system and prevent excessive, systemic credit problems and they failed to do so. When banks are lending people 100% of the value of a home, waiving income verification, and basing the borrowers ability to pay on a loan payment that is based on a temporary teaser rate there is abject foolishness in the market. This condition existed for at least two years while bank regulators and Congress looked on and did nothing. As if this wasn’t enough, at the same time there was obvious chicanery in the credit markets relating to housing we experienced a housing bubble of massive proportions. Regulators and Congress still did nothing, except that Congress and the President began to brag about home ownership rates.

Some commentators (see Tito Boeri and Luigi Guiso, pg 37) (see also Theodore Forstmann, “The Credit Crisis Is Going To Get Worse”, The Wall Street Journal Online Edition, July 5 2008) argue it was classic supply-push in the credit markets caused by excessive monetary easing from 2001 – 2004 that caused the stupidity that led to this crisis. I tend to agree that monetary policy has been too accommodative and is one of the root causes of the current crisis. However, we have always known that monetary policy easing increases risk taking so to blame this as the cause of the crisis misses the point.

Some argue that new innovations, such as CDOs, where not fully understood (see Guido Tabellini, pg 45). I find humor in this though I am not happy with the result. If we take a lot of crappy assets and put them together, will the resulting “diversified” pool of crappy assets have less risk? Well, when all the assets are correlated to the housing market and are the most sensitive to any price changes (subprime) then obviously all you have done is made a bigger pool of crap. Add to this the fact that history exists in the subprime lending world and it is not good. Where the assumptions came from underlying the ratings on CDOs is a mystery to anyone who has seen subprime lenders crash and burn. To say this was a failure of the statistical models is a nice way of saying the assumptions were wrong and upon further inspection this should have been obvious. Statistical complexity aside, what happened to common sense? Isn’t this where the regulators are supposed to come in? When the market is doing things that are clearly high risk and in large magnitude? Where were they?

Some argue it was the rating agency conflicts that enabled this debacle to occur. I agree this was a contributing factor, but Congress and the regulators knew this problem existed since, at the latest, 2002 when it was presented to Congress in testimony relating to the Enron bankruptcy by Frank Partnoy (see part II. D). There were very clear and explicit warnings that this type of crisis was waiting to happen yet Congress and the regulators turned a blind eye.

Some argue that it is the over reliance on statistical modeling that led to this crisis (see Jon Danielsson pg. 13). The lack of backtesting data for those once in 100 years events meant that the science was flawed. In addition, the correlations are all wrong when everyone acts the same way at the same time (the heard). I buy this argument, but what I don’t buy is the argument that the regulators were fooled by all of this. This was clearly a movement to allow financial institutions to self regulate using their own internally developed models. Whether this was politically driven or truly a belief among regulators that this was a better way I do not know, but it takes a lot of the burden off regulators to monitor and regulate! Now regulators are calling for additional powers. I ask, where were they when this crisis developed?


I actually know part of the answer to my last question. One thing the regulators were working on was providing the financial system with large amounts of leverage that would ultimately be at the root of the liquidity part of this crisis. In 2004 regulators codified banks’ use of off balance sheet entities, those SIVs and asset-backed commercial paper conduits that leapt onto the front pages last Fall, with minimal regulatory capital requirements. At the same time there were regulatory changes for the investment banks that have been referred to as the “Bear Stearns Future Insolvency Act of 2004”. With respect to the banks, the result is easily discernible from the graph above. Asset-backed commercial paper outstanding skyrocketed as banks utilized their newly codified leverage structure to take on the CDOs and other securities where the true risk of all this absurd lending was being hidden. Especially notable here is the absence of the SEC. These securities that were being rated and issued were, apparently, not understood by anyone. By extension, they were not understood by the SEC – isn’t that part of its job? Unfortunately, when investors discovered that there was excessive risk in these vehicles they stopped purchasing the commercial paper that funded them. The result was a severe liquidity crisis as the banks had to honor lines of credit they provided to these entities securing the repayment of commercial paper under just these circumstances. The Federal Reserve has received great admiration for its creative tonics when this crisis broke out, but I believe that is like honoring a firefighter for extinguishing a very dangerous fire that the firefighter ignited in the first place. I can’t finish this part of my rant without pointing out a couple of issues here. First, a crisis in the commercial paper market would certainly present a systemic risk to the financial system if all the banks had credit lines backing their $1.2 trillion in asset-backed commercial paper. Given this fact, together with the knowledge from Enron that off balance sheet treatment does not eliminate risk but increases risk taking, how did the bank regulators determine that is was 10 times safer to fund assets this way than the traditional method of holding them on a bank’s balance sheet? This seems like an extraordinary conclusion, extraordinarily wrong headed.

Of course the current crisis is well beyond a mere liquidity event. The off balance sheet leverage combined with excessive monetary easing provided much too much liquidity to the markets, and the resulting stupidity in the credit world will ultimately cost institutions their solvency. As of this writing Bear Stearns no longer exists (although the taxpayers now own $29 billion (and falling) of mortgage-backed securities that Chase didn’t want while the shareholders walked with cash) and the FDIC has seized IndyMac, a large bank with extensive mortgage operations. I don’t believe this will be the last, and taxpayers will be paying for this debacle for years to come.

So what caused this crisis? Those responsible for ensuring a sound financial system failed, plain and simple. Regulators and Congress are to blame as they were well aware of the risks of rating agency conflicts, off balance sheet financing and excessive leverage yet they turned a blind eye when it came to the financial sector. The fact that rating agency conflicts and other abuses by Wall Street and others played a role does not change the fact that those responsible for regulating these activities failed. In fact, these issues should have made the regulators even more watchful in light of the fact that they were warned of rating agency conflicts that go to the heart of the regulatory system they set up.

In hindsight all of this looks obvious, and what is obvious in hindsight is not always so clear at the time. Perhaps it was not so obvious to regulators or Congress at the time. But why didn’t they figure it out? These are the best and brightest in the field and it is their job to figure this out and monitor and protect the financial system. What forces were at play such that this set of events could be set in motion and play out without any reaction from the Fed or Congress? Perhaps there is something structurally wrong with having the Fed involved in bank regulation at the same time it is responsible for monetary policy. Perhaps there is an issue with the appointment of regulators such that a given administration’s policies become too pervasive. Perhaps too many key people in the regulatory authorities come from the very institutions they are there to regulate or get jobs at those institutions when they leave. Perhaps the financial industry has too much influence in Congress and it is the broken political system where money buys influence that caused the credit crisis. In my opinion these are the fundamental issues raised by the credit crisis and I believe they should get more attention than they are getting now. I also believe that these very same regulators should not be setting the agenda for the new regulatory regime that will follow this crisis, but as of now they are.

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California v. Countrywide

Let the fun begin! I found this link to the draft complaint filed by California against Countrywide and its executives for deceptive practices in the mortgage market. California charges that Countrywide AND some of its executives knowingly used deceptive practices to lure customers into taking on riskier mortgages than they needed or could afford in order to increase the profit Countrywide made selling these mortgages into the securitization market. The complaint makes for interesting reading (to nerds like me). I like the fact that it provides examples of some of the loan payments and how the negative amortization features work.

By the way, flying through Congress is a plan to authorize FHA to guarantee refinancing of $300 billion of mostly subprime loans. Of course, the taxpayers stand behind FHA guarantees, so get ready to dig into your pocket to pay off the banks and investors who own the kind of bad loans described in the complaint. According to this Washington Post Report portions of this plan were submitted by Bank of America. Bank of America is set to purchase Countrywide and reportedly has the largest portfolio of mortgage securities of any of the major banks (call me a conspiracy theorist). I don’t always agree with WSJ Editorials, but if you take the political finger pointing out of this one it pretty much hits the mark. Here’s more from tomorrow’s WSJ. I reviewed this legislation last month and wrote a more detailed analysis here.

So far the Federal Reserve has advanced some $400-450 billion to banks and investment banks secured by mortgage securities (we believe but can't verify), FHA is already well into refinancing many bad loans and looks to be getting authorization for an additional $300 billion, and the Federal Home Loan Banks (funded through taxpayer guaranteed bonds) have advanced over $250 billion to banks for mortgages, all since this broke out last year. That’s $1 trillion, and that’s without counting any possible exposure to the largest mortgage companies we have, the government sponsored entities Fannie Mae and Freddie Mac, or the impact of negative real interest rates from the Federal Reserve (again). To put the $1 trillion into perspective, it is about 7% of our GDP and about 11% of our entire national debt. It’s a lot of money.

I hope the summer is treating you well!

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Sheriff John Green

I was reading this article in today’s Wall Street Journal, Online Edition and was struck by some of the conflicting messages it highlights for many. I am a student of financial markets and to some extend the Federal Reserve (the “Fed”), so I have a certain perspective on the whole subprime mortgage debacle that is no secret to anyone reading my column. I object to bailouts, whether it be for homeowners or Wall Street, and I have been writing that opinion since last October when I first started publishing my blog. But this article got me thinking about these Philadelphia residents who are being evicted from their homes because they can’t pay their mortgages. Circumstances have now changed, and they have changed because the Fed, no doubt with the blessing of Treasury, has bailed out Wall Street. (For more on this there is another article in today’s Wall Street Journal Online expressing one Federal Reserve Bank President’s concerns about the Fed’s recent actions and the market distortions that can be expected as a result.)

Admittedly bailing out Wall Street is good, in some ways, for everyone as it lessens the risk of a major economic blowup. But tell that to a resident in Philadelphia being evicted from their home who can understandably be thinking “they can bail out those Wall Street executives and their customers but they can’t help me?” Enter the Sheriff, John Green:

Sheriff John Green has spent 37 years in law enforcement. But these days he's best known around town for the law he won't enforce.

With the economy soft and thousands of Philadelphians delinquent on their mortgages, Sheriff Green this spring refused to hold a court-ordered foreclosure auction. His move raised eyebrows on the bench and dropped jaws among lenders and their attorneys, who accuse him of shirking his duty to enforce legal contracts….

Mortgage lenders, servicers and their attorneys thought Mr. Green was acting more Robin Hood than sheriff. "It's not his job to postpone things in favor of certain people," says Michael VanBuskirk, a Philadelphia attorney, who describes the city as a "legal free-fire zone." The city, he says, is "less attractive to business if you can't be certain that the sheriff won't invalidate a contract."

Fed policies to help rescue Wall Street firms have created distortions that have hurt many innocent bystanders in this debacle as savings rates plummet and inflation increases. In fact, the inflation in food and energy prices caused in large measure by negative real interest rates is likely a direct cause of many of the foreclosures as those consumers most at risk can no longer afford to pay all of their bills. So in keeping real interest rates negative to rescue the financial industry Fed policies are hurting many of those who would be hurt in a larger financial collapse anyway and the impact is falling disproportionately to the most vulnerable among us. To hear mortgage lenders now object to the Sheriff’s actions because they favor one group over another is, in my opinion, entertaining at best. In my view, looking to the public policy issues behind this story presents a very different picture than a simple issue of contract law.

I believe we are witnessing the spread of the bailout mentality that has been established by the Fed (and sanctioned by the Administration) in favor of Wall Street. Regardless of the ultimate consequences of allowing major Wall Street firms to fail, the general public will understandably view these actions as favoring those on Wall Street as opposed to them. Let’s do a thought experiment. The first part is to ask: “Why is it good for the Fed to bail out these Wall Street firms by providing credit at taxpayer risk?” The answer, of course, is that to do so will help avoid an economic collapse that would hurt everyone. The second part is to ask: “Why should the Sheriff refuse to sell foreclosed homes at auction?” The answer, of course, is that doing so helps avoid an economic collapse of the neighborhoods involved that would hurt everyone. So, is the Sheriff acting like Robin Hood or following the example set by the Fed? In the eyes of those on the ground I think taking the latter view is easily comprehensible.

The distortions caused by the Fed’s bailout of years of negligent lending activities by Wall Street and all of its subsidiary tentacles has set the stage for redistribution fights such as this one, and I don’t know how you put this genie back in the bottle. So at the end of this piece I have an unanswered question: Is the creativity demonstrated by Mr. Bernanke, with the certain blessings of Mr. Paulson, good for our society in the long run or just another example of how being too creative (ever heard of a CDO squared?) can really mess things up?

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Hope for Homeowners Act of 2008

I have reviewed portions of the Committee Print of the proposed GSE bill (the “Bill”) that came out of The U.S. Senate Committee on Banking, Housing, and Urban Affairs (the “Senate Banking Committee”)as announced by the Senate Banking Committee on May 19, 2008. In particular, I have read Secs. 401-403 of the Bill titled “Hope For Homeowners Act of 2008.” I believe this Bill is a recipe for disaster and likely the next big target of fraud against taxpayers. First, I will attempt to summarize how this plan works, and then I will comment on it based on my interpretations and opinions.

How it works (if passed as is):
This plan authorizes FHA to provide guarantees for mortgages up to an aggregate of $300 billion. These mortgages get packaged and sold through the Government National Mortgage Association, or GNMA, and the securities sold by GNMA are backed by the full faith and credit of the United States (and that means the taxpayers).

Who can borrow under the plan:
These loans will only be made to borrowers who “provide a certification to the Secretary [of FHA] that the mortgagor has not intentionally defaulted on the eligible mortgage” and the current borrower debt to income ratio must be GREATER THAN 31 percent! So, we are talking about people who cannot pay their mortgages because they have too much mortgage debt relative to their income (I note that the Bill states “mortgage debt to income” as the ratio, but I am assuming it means to say “mortgage debt service to income” as a total mortgage debt to income ratio of 31% would make no sense in this context). Bill Sec. 402(e) The penalty for falsely stating that you did not intentionally default on your mortgage can be steep, including fines and prison time (how one proves this and what it means is beyond me – if one intentionally buys food instead of paying the mortgage is this an intentional default?)

How is this a bailout for investors?
Once a borrower is qualified, they can borrow up to 90% of the appraised value of the home to refinance their existing mortgage, assuming the mortgage holders (including the holders of the first mortgage and all subordinate loans) agree(s) to a full satisfaction of all of the borrowers obligations from the proceeds of the new loan. So if this is a better deal for the mortgage investor than foreclosing on the property and realizing larger losses, the investor should buy into the refinance. That’s where the bailout comes in – investors would be liquidating their positions at favorable recoveries based on taxpayer guarantees. In order to protect taxpayers, the Bill provides that the appraisal must not be influenced by an interested party (curiously there are no stated penalties for a breach of this requirement and no absolute limitation on using related parties). There is also an insurance fund to back these loans before taxpayers would be on the hook.

The insurance is provided through a new insurance fund, the Home Ownership Preservation Entity Fund, to be used by FHA to carry out its mission that states, in part, “to allow homeowners to avoid foreclosure by reducing the principal balance outstanding, and interest rate charged, on their mortgages…” Bill Sec. 402(b)(2) The fund is funded through an initial payment of 3% of each loan amount, paid from the proceeds of the loan, plus an annual premium of 1.5% of the remaining principal balance of each loan. Bill Sec. 402(i) Now I admit that I am not a mathematician and have not constructed a detailed quantitative model to figure out the risk that this fund will be insufficient to cover losses. I do, however, have serious doubts that this fund will support losses from these loans and I believe it is likely taxpayers will eventually be on the hook.

I wonder how the premium rate of 3% plus an annual 1.5% of non-defaulted loans plus a share of a share of future equity appreciation compares to default rates on refinanced defaulted loans? I don’t think the data exists to make this calculation, but I could be wrong about that. Even if they do, however, I wonder how any assumptions regarding default rates hold up when this plan is full of incentives for abuse by almost everyone involved:

1) FHA - FHA wants to show results and will actively try to guaranty a lot of loans. Unfortunately, as discussed in this Congressional testimony, there is already serious concern about FHA’s ability to manage its existing portfolio, let alone a huge new program like this one. That means quantity over quality – a recipe for trouble in any lending business. One other point I would like to mention is that back in December I wrote about a plan to reform the FHA. In that piece I linked to the website of the Senate Banking Committee for a copy of congressional testimony by Basil Petrou from Federal Financial Analytics that discussed many weaknesses of the plan and the FHA. That link has been taken down, and I have had to replace it with a link to the Federal Financial Analytics website. Curious. If you are interested you can now find that testimony here.

2) INVESTORS - Existing lenders want out of their bad loans and that provides incentive to push borrowers into this program thereby limiting their losses. Again we have the quantity over quality problem.

3) APPRAISERS – Appraisers are under pressure from their clients, lenders, because they appraised so many properties for too high a value. These appraisers have a strong incentive to help the lenders exit these loans at the highest possible recovery, and that means highest appraisal.

4) HOMEOWNERS - Homeowners love this even if they don’t plan to stay in the house. If you are a homeowner with two mortgages, default notices, foreclosure threats, and all of your other personal assets at risk because you are under water, would you love to get one of these loans and make all of those problems go away? The trade-off for making it all go away is being obligated for one loan that’s guaranteed by the taxpayers. Sounds like a nice value proposition for the homeowner to me. In furtherance of this perverted incentive structure, the Bill provides that any equity in the home that is realized through a later refinance or sale is shared between the homeowner and the FHA (a portion of which, if applicable, is for distribution to any subordinated mortgage holder who took a loss). If the home is sold or refinanced in the first year any appreciation goes to FHA, in the second year 90%, third year 80%, and so on to 50% after five years and forever thereafter. So, refinance with FHA at no cost or very little cost, get all of the lenders off your back, then walk away from one loan guaranteed by the taxpayers leaving them with the problem.

Lets review. What the Bill proposes is to find mortgage borrowers who cannot afford their mortgage payments and are in default. Then, an appraisal is secured through an appraiser (the same group that got values completely wrong the last time around and are likely conflicted because of their relationships with lenders). The FHA then guarantees a loan to refinance the existing mortgages up to 90% of the appraised value. All parties have incentives to do these transactions that are unrelated to the resulting credit quality. In fact, the worse the credit quality is the greater the incentive for the investor/appraiser and the homeowner to participate. Then, once the FHA is on the hook, the homeowner is given the disincentive to remain in the house because under the best of circumstances they will realize only 50% of any future equity appreciation in the home. Under these circumstances is 3% plus a share of a share of future appreciation plus 1.5% per year (on loans that do not default) enough to cover the losses on this impending portfolio? I, for one, am not convinced that it is. Of course I could be wrong and this plan could turn out to be a great idea, but I see too many conflicts and perverse incentives in the current draft to believe this plan will actually work to the benefit of taxpayers. Instead, I see too much opportunity and incentive for quick transfers of bad loans from investors to taxpayers under the inadequate supervision of FHA and, as a taxpayer, that concerns me.

[There are other issues with the Bill that, for the most part, are left to FHA to figure out. For example, does a home improvement add to the homeowner’s equity or is the value added by improvements shared as future equity? The Bill also describes future equity in a very strange way: “any equity created as a direct result of such sale or refinance”. I suppose you can consider a sale the creation of equity although that is arguable. I certainly do not see how equity is “created” through a refinance. Another issue is that the Bill provides for refinancing up to an amount not exceeding 132 percent of the old conforming loan amount – in other words jumbo loans.]

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Subprime and the Bush Administration

What did the Bush Administration have to do with the credit crisis? I keep hearing people say that a president does not have very much influence on the economy and they are given too much of the credit or blame when the economy fluctuates. I disagree for two reasons. The first is that fiscal policies can have a rather dramatic and immediate impact on economic activity as the President is making clear today by touting the fiscal stimulus plan. Tax cuts and government spending certainly impact the economy in a direct and timely way. The other reason is the general regulatory oversight that each administration is responsible for. For example, who heads the SEC and what are the priorities given it by the administration? What about the Treasury Department? I believe these policies have a direct impact on economic activity and are responsible for a lot of the fluctuation in the economy as well as income distribution from one administration to another. Here is an example.

As hedge fund investor David Einhorn laid out in his recent remarks, ”Private Profits and Socialized Risk” the SEC, under the Bush Administration, altered the capital requirements for broker-dealers. Einhorn concludes that the result was a lower capital requirement leading to higher leverage. The higher leverage, as we know, leads to higher risk and that higher risk culminated with the failure of Bear Stearns. So, is this why we have the credit crisis? Wait, there’s more.

The SEC regulations applied to the broker-dealer world. What about the commercial banks? What have they got to do with all of this? Well, as I wrote about last October, the rules regarding commercial bank capital requirements were also altered back in 2004 through rules promulgated by the Federal Reserve and Treasury as regulators of the commercial banking system. In effect, these rules said to banks they could move loans and other assets from their balance sheets to off-balance sheet conduits and reduce their capital requirements. Banks love this because it allows them to – guess what – leverage! They set up something called a conduit that purchases assets from the bank and/or a bank customer. The conduit gets the money for the purchase by issuing securities, like commercial paper. The rating agencies rate the commercial paper based, in part, on the fact that the bank typically provides a line of credit to the conduit so that if the commercial paper market dries up the conduit can borrow to repay maturing commercial paper. This is a very general description and these structures can get very complex, but this is the basic idea. So how does this increase leverage? The rules promulgated in 2004 established that under this structure banks could provide these credit lines to back these conduits but hold only 10% of the risk based capital they would hold against the same assets if they were on the bank’s balance sheet. You can find the announcement of the rules here. So, using this structure, banks can leverage their capital in multiples. Eureka – a way to get around the sound banking principals established by the regulatory framework over the past 90 years! The regulators behind these rules included the Office of the Comptroller of the Currency (Treasury), The Federal Reserve System, The Office of Thrift Supervision (Treasury), and The Federal Deposit Insurance Corporation.

Lets review. According to Mr. Einhorn, in 2004 the SEC relaxed capital rules for broker dealers, placing more of the regulatory requirements in the hands of the banks and allowing them to use more leverage than before. In the very same year the Federal Reserve and Treasury codified the rules that permitted commercial banks to leverage through off-balance sheet entities. (In case you were wondering, Congress had hearings on many of these issues as well.) All of this turned out to be extremely profitable for the banks, brokers, and rating agencies.

Suddenly, there is an incredible credit bubble that begins with loans and ends up as securities in the portfolios of, among others, the investment banks, banks, and off-balance sheet bank sponsored conduits. I wonder if there is a link between these events? Now, to be fair, the credit bubble began a little before these regulatory changes. But these changes must have accommodated a huge demand that was unsustainable. The graph accompanying this post illustrates the credit bubble I am referring to.

What really caps all of this off is the cries from many of these agency heads now about what should be done to fix this mess. For example, Sheila Bair, head of The Federal Deposit Insurance Corporation, has been calling for months for a bailout of subprime borrowers. First, back in October, she called for a freeze on interest rates for those who had adjustable rate subprime mortgages. She is now lobbying for loan modifications to reduce principal for those subprime borrowers whose mortgages exceed their property values. From her recent comments before Congress

Permanently forgiving part of the principal amount can provide a better financial result for investors than foreclosure by creating long-term, sustainable solutions that will allow borrowers to stay in their homes. This approach also has the added benefit of limiting the overall adverse affect of declining property values on communities.

In closing, Ms. Bair states

Congress, the SEC, the Treasury Department, as well as federal bank regulators have expended considerable time and effort to assure that the industry has authority under tax and accounting rules to modify loans proactively. The industry needs to demonstrate greater commitment to using those authorities.

They should be expending all the time they possibly can and they should never mention it because these agencies are collectively, in my opinion, among the most culpable groups in this entire debacle.

To be fair to Ms. Bair, she was appointed to head the FDIC in 2006, after these regulatory changes. She was, however, on the FDIC’s Advisory Committee on Banking Policy. Donald Powell was FDIC Chairman in 2004, John Snow was Secretary of the Treasury, William Donaldson was Chairman of the SEC, and our old friend Alan Greenspan was Chairman of the Board of Governors of the Federal Reserve System. Who appointed these people?

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Some Hidden Costs of the Credit Crisis

The Federal Reserve (the Fed) is likely causing dramatic distortions in the markets by lowering interest rates below the level of inflation and the impact may only be evident in retrospect. One side effect of the Fed's actions is a massive shift of the costs associated with the credit crisis from borrowers to savers. While negative real interest rates are helping some homeowners keep their payments down they are also fueling inflation resulting in a tremendous loss in value to those who have saved for retirement. Artificially low interest rates are also causing pain for those living on a fixed income through both inflation and loss of investment earnings. Here are a couple of hypothetical situations based on real stories I am hearing from friends and relatives to illustrate these distortions I am referring to.

The first story is about a hard working middle-class family headed by Dick and Jane. Dick and Jane grew up in the 1950s and 1960s. They have worked full time for almost 40 years, raised a family, a dog and several cats, and have been preparing to retire. They have contributed to Social Security from every paycheck they have ever received, and have been frugal and lucky enough to put aside some money for retirement. They purchased their home 30 years ago and have paid off the mortgage through 360 consecutive monthly payments of principal plus interest. Everything was going along according to plan until, suddenly and without warning, the earnings on their investments began to plummet.

They couldn’t understand what was happening at first. Because they were getting close to retirement they had allocated much of their portfolio to fixed income investments, and some of those were falling in value at the same time they could not get more than a 3% return on CDs and Treasury securities. They went to their bank to get advise and were told that because the Federal Reserve had lowered interest rates safe investments were yielding very low returns. They took out their calculator and figured that if inflation is around 4% and the real interest rate is 2.5%, they should be earning 6.5% on a risk free investment. Instead they are being offered 2.5% on a CD, so the cost to them is 4%. Based on their retirement portfolio of $750,000 they are losing $30,000 per year! Even if they can get a 3.5% return the cost is still $22,500 per year. But that’s not all. If we believe that these low interest rates are also causing inflation in basic goods such as energy and food, the value of their retirement savings is declining. Where $750,000 may have been enough based on all reasonable forecasts just a year or so ago, now it is not enough because of the cost of living increases.

Confused and angry, Dick and Jane reconcile to the fact that they will likely not be retiring as planned unless they cut back dramatically and save as much as possible. They will delay any major expenditure until absolutely necessary, and because of inflation they have less to save. The $1,100 fuel oil bill drove this point home last week. A portion of their retirement has disappeared through no fault of theirs, and they wonder why. Why is it that with inflation getting worse interest rates are going down? Shouldn’t it be the other way around?

The second story is about Cathleen, a neighbor of Dick and Jane. She retired from her clerical position ten years ago. Her husband passed away several years back and she now lives on Social Security and the income from the $250,000 portfolio of treasury securities, money market accounts, and CDs left from their lifetime savings and her husband’s live insurance. She can’t understand what is happening, but for the first time since retirement she must liquidate some of her retirement portfolio to pay all of her bills. Her Social Security income of $1,500 per month doesn’t come close to covering all of her expenses so she has relied on the interest from her portfolio for the rest. Last year her interest income was $13,750, giving her total income with social security of $31,750. This year her interest income was $8,750 giving her total income of only $26,750. Adding the rising costs of her medications, property taxes, food and energy she is for the first time concerned that she could run out of money. She wonders why, and she has decided she must cut back to only the necessary expenditures.

While lower interest rates are helping some homeowners with adjustable rate mortgages they are hurting savers and those living on a fixed income. Inflation also harms savers but benefits borrowers. At the same time, as between the average savers and the average adjustable rate mortgage borrowers it is the latter who have more culpability for the crisis in the first place. It is clear that the American people are paying the price of this credit crisis one way or another, and the question at hand is whether the distortions resulting from the remedy are making things better or worse as the burden is shifted from borrowers to savers?

There are at least three reasons for the Fed to be lowering rates right now. Let’s take a look at each of the primary reasons for the Fed to be lowering interest rates.

The first reason to lower interest rates when the economy is soft is referred to as the wealth effect. When interest rates are lower asset values tend to be higher. If mortgage payments are lower house prices can be higher because it is more affordable based on the payments. This applies to financial assets as well. As interest rates fall, in general, the value of financial assets rise. In practice, this effect makes people feel better off because their assets are worth more and this is good for the economy because when people feel wealthier they tend to spend more. This sounds great, but there is dark side.

When inflation becomes a problem rising asset values tend to be offset by rising costs. While keeping interest rates depressed may help support the value of certain assets it is also fueling inflation, and the inflation is countering the wealth effect. Low interest rates don’t always spark inflation, but in the current global economic situation commodity prices are rising dramatically and inflation is becoming a real issue. Lower interest rates in the US hurts the value of the dollar and sparks price increases in dollar denominated commodity prices. Anyone who goes to the grocery store or drives a car or heats a home knows that inflation is a rising problem today. So assuming low interest rates are in fact supporting asset prices the resulting inflation could be countering the impact because real values (adjusted for inflation) are not changing or are, perhaps, even falling. Is the wealth effect of lower interest rates working this time? I question its efficacy under current conditions when real interest rates are negative AND we have supply shocks in energy, food, and metals all at the same time.

The second intended effect of lowering interest rates is to spur business investment by making it less expensive for businesses to borrow and invest. This should also lead to increased employment as businesses hire more workers. Before businesses invest, however, they must believe that consumers will consume. Helping to keep mortgage payments down for a portion of the population will certainly help consumer sentiment, as will the resulting benefit of slower price depreciation in housing. But there is also a downside to consumers of low interest rates and the inflation we are now seeing. The retirement savings of the baby boom population are losing value to inflation, while at the same time low interest rates are cutting into the income of those living on their savings. The loss of real savings and real income (from both depressed interest rates and the impact of inflation) to the population of savers and spenders is likely to have a negative impact on consumption, especially as those close to retirement increase savings and those in retirement are forced to cut back on spending. This, in turn, could offset the positive impact of low interest rates on consumer sentiment. Consumers also have more debt as a percent of their personal income now than at any time in the past several decades and probably need time to pay it down rather than consume more. So will lower interest rates spur investment under these circumstances or simply prolong the reckoning while causing a very troubling inflationary spiral? There is certainly room to question the efficacy of further rate cuts on business investment in the current economic climate.

The third reason for lowering interest rates right now is to help rescue the financial industry in the US and prevent a collapse of the financial system. A major meltdown of the financial industry would certainly be a problem that would have a negative impact on all of us because it could result in a severe recession or even a depression. If the banking system becomes insolvent (meaning the banks do not have capital and cannot make loans) then anything people purchase on credit could suddenly experience dramatic reductions in demand, while at the same time businesses would find it very difficult to obtain funds for investment. When things get really bad you get deflation because there is simply not enough demand for anything to keep prices from falling. This may sound OK at first but in fact it is worse than inflation in many ways. Who will lend you money to buy a house if the value of the house is expected to decline next year? The same logic holds for a car or any other major purchase. Imagine your mortgage payment staying the same while your home value and wages drop – that’s deflation and it can spiral down the same way inflation can spiral up. At the same time unemployment would rise dramatically because businesses facing falling demand and lack of funds for investment would be laying off workers. This is certainly a situation to be avoided. So how does lowering interest rates help us lower the risk of this happening? Aside from the wealth effect and business investment helping the economy stay afloat, the lower interest rates help to support the value of assets on banks’ balance sheets (remember these are interest bearing financial assets). That means fewer write downs and, in turn, lower losses and more capital. The low interest rates also reflect banks’ cost of obtaining funds to lend, and when their costs go way down their profits can go up. More profit means more capital and more incentive to lend. So lowering interest rates helps the banks to preserve and add to their capital helping to lower the risk of financial system insolvency. Of course, if this is truly the reason for lowering interest rates right now one must wonder why banks continue to pay dividends to investors. If they are under-capitalized that should be the first place they go for capital preservation, not to the policies of the Fed. This is especially true when the Fed policies are creating distortions in the market and may not be helping to support the economy for reasons discussed above. If the financial system is in fact under-capitalized perhaps the Fed should be reaching back into its bag of tricks and figuring out another way to add capital to the banking system.

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A History of The Great Economic Collapse of 2008

Looking back several decades at the economic downturn in the United States that began in the third quarter of 2007 and lasted for the better part of a decade, the causes seem predictable and inevitable. The United States had been consuming more than it produced for many years, running massive trade deficits. At the same time consumers were borrowing from international sources of capital to finance consumption, the United States Government was also running budget deficits, financing its expenditures largely from foreign investors and the retirement funds of the baby boom population – some 75 million Americans. Some of this over-consumption was funded through asset sales, especially after the initial decline in the dollar, as foreign investors thought they were getting bargains purchasing US assets.

The cracks in the system began showing up in earnest in 2007 with the great Subprime Mortgage Meltdown. This crisis in the subprime real estate market ultimately spread to the rest of the market and triggered an exodus of capital from the financial system as investors realized they had been taking on too much risk for the promised returns. Notwithstanding valiant attempts by the Federal Reserve to provide liquidity to the banking system, the risk re-pricing forced historic write-downs of assets on the books of the major banks, both commercial and investment, resulting in capital shortfalls at the major institutions. The first bank to experience a run was the 83-year old investment bank Bear Stearns, which was temporarily kept afloat through emergency loans from the Federal Reserve. This marked the first time such a loan was made since the Great Depression of the prior century. The resulting lack of financing into the economy drove investment to levels not seen in decades and unemployment soared. At the same time as the employment picture soured, many in the baby boom generation were retiring. Unfortunately the insolvency of the Federal Government resulting from tax cuts for the wealthiest Americans and deficit spending required massive cuts in health care and social security as well as large tax increases, further depressing the economy. A massive portion of the population retired into poverty.

In an attempt to fight both the re-pricing of assets and the lack of financing in the economy the Federal Reserve lowered interest rates dramatically, from 5.25% to 1%, at the same time inflation was running up. The interest rate targeted by the Federal Reserve at the time, the Federal Funds Rate, was negative in real terms for the second time in a decade. Unfortunately, these lower rates did not pass through to borrowers because the banks’ lack of capital prevented them from making loans regardless of how low their cost of funds was, and the fear of insolvency prevented banks from lending to one another which was how the system worked at the time. In fact, the monetary easing resulted in a further flight of capital as investors sold dollars to invest elsewhere where returns were better. The resulting fall of the dollar was also historic in nature as it hit all time lows against a basket of currencies week after week. This would have been a bright spot due to its impact on net exports, except that the decline in the US economy spread to the rest of the developed and developing nations reducing demand for exports.

Ultimately the Federal Government had to step in and bail out the financial system that had profited so handsomely for many years prior to the meltdown. The size of the bailout dwarfed the S&L bailout that was still visible in the rear view mirror, enraging much of the population. At the same time, those who had amassed fortunes during the boom years were able to acquire vast holdings of productive assets thereby widening the already large gap between the wealthy and the poor. Despite passing law after law and amending regulation after regulation in favor of the banking lobby for two decades, Congress professed shock at the actions taken by some of the major financial institutions during the ensuing hearings. The conflicts of interest of the rating agencies, the off-balance sheet accounting, the lax capital requirements, and several other issues resurfaced in the public view. Once the population at large learned that all of these issues had been brought to the attention of Congress years before, but ignored at the behest of the finance industry, there was a near revolt in the streets. This resulted in what we now refer to as the Great Political Restructuring.

Between the devaluation of the dollar and the massive infusion of funds to rescue the financial system inflation raged out of control for some time until the collapse progressed, after which deflation took hold as the world economy followed suit and demand for everything fell off globally. The lessons of this era remained strong and bank regulation was revised and strengthened. However, due to advances in technology and other systemic changes, the banking industry is now lobbying Parliament for additional powers such as combining their commercial and investment banking operations and allowing them to export interest rates from their home state to other states. They are also seeking reform to the bankruptcy laws and a declaration of Federal Preemption for protection from state regulators. Some argue that we should honor the lessons of the past and deny these powers to the banks, especially since the banks are ultimately backed by the taxpayers as lender of last resort. The neo-neo-conservatives, however, argue that the free markets will provide better competitive results for all consumers and the bankers, notwithstanding their incentives to take excessive risk, will adequately manage any potential risks to a systemic crisis. Paul Krugman, the sage economist now in his 98th year, declared such proposals outrageous and claimed they will lead the economy on a path to great divergence of wealth and the rebirth of the poverty population. Larry Kudlow, the underground talk show pundit whose age none can ascertain, pronounced this to be a great day for America, the likes of which he has not seen since the Great Political Restructuring. Time will tell which of these elder statesmen is still connected to the political economy and which is simply disconnected.

[Of course, I hope none of this is true and we see a rebound in the second half of 2008 as many predict. I just could not help having a bit of fun with this. I may do a serious analysis if time permits.]

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The F-LEF, or the Federal Reserve Liquidity Enhancing Facility

The Federal Government is in full swing on the current crisis in the financial markets. We have the FHA refinancing subprime loans and financing purchases with no money down (they claim 3% is required but this can be satisfied with a Seller’s Concession for closing costs, and we all know that’s code for raise the price to cover the concession); we have the Federal Home Loan Banks lending hundreds of billions of dollars to the banks on mortgage collateral; we have pressure on the GSEs Freddie and Fannie to step up their participation in the mortgage markets at a time when they are experiencing large losses themselves; we have the fiscal stimulus package (that, in part, increases the amount FHA and the GSEs can lend against homes from the high 300ks/low 400ks to $729k in many markets); and we have the Federal Reserve not only lowering interest rates but also providing $100 billion in liquidity for the banks through the new Term Auction Facility, or TAF. Wow! I have written on all of the foregoing steps taken to blunt the impact of the financial crisis that started with subprime mortgages except the TAF. You can find these articles by clicking on the “bailout” keyword on the list of keywords below. Today I want to look at this TAF.

Several months ago many commentators, including me, where writing about the Treasury plan to create a master liquidity enhancement conduit, or M-LEC. The purpose of this conduit was to be a buyer for assets that struggling SIVs, or structured investment vehicles, needed to liquidate. SIVs, at their core, take advantage of short-term financing at low rates to invest in longer-term assets that pay higher rates making a profit on the spread. When the short term funding dried up because of concern over the value of the assets held by SIVs they were forced to look elsewhere for funding or sell their assets. The problem was that the SIVs could not sell many of their assets into an unfavorable market without suffering losses on those assets. If they were sold at losses investors would suffer and the market could be permanently harmed. Enter the M-LEC that could purchase and hold these assets until the markets returned to “normal” and then sell them or simply hold them until maturity, thereby eliminating the need to sell them at a loss. Of course this raised accounting issues, among others, because if the market value of these assets was below the amount they were sold for the accounting really didn’t work. In the end the M-LEC was never formed. Instead, some banks that sponsored these SIVs ended up taking the SIV assets onto their balance sheets in order to avoid very embarrassing and reputation devastating results of SIV failures. Others were restructured into longer-term debt or liquidated at a hair cut to investors. (There were also liquidity lines from banks to these SIVs at stake, although the reporting on these was and is very confusing.) So in the end, the assets that caused the trouble ended up sold or on the balance sheet of the sponsoring banks.

Now enter TAF, or the Federal Reserve’s Term Auction Facility. This was introduced in December, around the time the M-LEC was originally to be finalized. The TAF is a loan facility from the Federal Reserve to banks. The Federal Reserve has been increasing the amount of the TAF facility in the aggregate from an original $30 billion to $60 billion, and last week to $100 billion. Here is what it does. Bank A needs liquidity to meet deposit withdrawals and/or loan commitments. It can try to get more deposits if it can, but apparently the banks can’t. It can borrow from other banks, but apparently the banks don’t want to lend enough to each other right now either. It can sell an asset on its books to raise liquidity, although this would reduce its profits by shrinking its balance sheet. Or, perhaps it can’t sell an asset on its books to raise the needed liquidity because the market value of the assets is below the carrying value and Bank A would take a loss. Hum, food for thought.

Enter the TAF, where Bank A can pledge assets to the Federal Reserve in exchange for a loan as long as 28 days in duration. Problem solved, Bank A has the liquidity it needs and the markets are not flooded with assets no one wants to purchase. All of this has me wondering – has the Federal Reserve become the Master Liquidity Enhancing Conduit that the banks and Treasury could not work out? The amount, about $100 billion, seems about right. The timing seems about right. It walks and talks like a duck, so maybe it is. I call it the F-LEF, or the Federal Liquidity Enhancing Facility.

The next question that follows is what assets is the Federal Reserve taking against these $100 billion in loans to the banks? Are they those same assets that moved from SIVs and perhaps other asset backed commercial paper conduits sponsored by the banks to the balance sheets of the banks? Seems like a very logical sequence of events viewed this way, so I decided to try to verify whether this was in fact the case. (The banks can pledge collateral that includes mortgage-backed securities, even ones that may contain subprime mortgages). Unfortunately, the Federal Reserve has not, to my knowledge, published a schedule of the collateral it has taken for these loans. So, the usually transparent Federal Reserve has hit a wall of opacity. It is not publicizing which banks are borrowing and it is not disclosing what assets are being pledged against those loans.

I, for one, would like to know what collateral the Federal Reserve is accepting and how it is being valued. Until these facts are made public, I will assume that the Federal Reserve has done what the M-LEC failed to do by creating the F-LEF through which the banks are delaying sales of assets that have been negatively impacted by the changing markets in order to preserve liquidity (or is it the appearance of solvency?). At the same time the banks are being openly encouraged to raise additional capital. So just how solvent are the banks?

Some very interesting questions and issues have been raised by this TAF. On the one hand, some commentators believe it could be the first step to nationalizing the banks (see this article by Steve Randy Waldman). If there are margin calls on the collateral that the banks cannot meet, what is the Federal Reserve to do? Convert the loan to equity? Interesting point. One colleague of mine suggested the Federal Reserve could simply forgive a portion of the debt, or “write it down”, just like the Federal Reserve Chairman Ben Bernanke is suggesting lenders should do with mortgage loans that are more than the property values securing them. That would raise a lot of very interesting issues. Others have said this is just a more effective way to provide needed liquidity to the banking system and should be well down the list of current concerns (see this article by Caroline Baum in Bloomberg).

Stay tuned – I have a feeling this isn’t over yet.

(Ordinarily banks that are solvent can borrow from the Federal Reserve using the Discount Window. The TAF is different in several ways. First, the Federal Reserve will not publish the names of the banks that win the auctions so we just don’t know which ones they are. These loans are also much longer in duration at 28 days and the Federal Reserve has assured the markets that it will provide these lines of credit for at least six months unless market conditions clearly show they are no longer needed and will increase the size if necessary. In the Federal Reserve’s words:

First, the amounts outstanding in the Term Auction Facility (TAF) will be increased to $100 billion. The auctions on March 10 and March 24 each will be increased to $50 billion--an increase of $20 billion from the amounts that were announced for these auctions on February 29. The Federal Reserve will increase these auction sizes further if conditions warrant. To provide increased certainty to market participants, the Federal Reserve will continue to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary.)

For more details about the TAF visit the Federal Reserve's website.

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Proposals for Taxpayer Bailout of Banks

I was reading this article in The Wall Street Journal Online Edition titled Worried Bankers Seek to Shift Risk to Uncle Sam about proposals being shopped around DC to move defaulted subprime loans to FHA. According to the article:

The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers.

This will almost certainly lead to a taxpayer bailout in my opinion. I have been writing about this for months and the fact that it is being considered in DC is truly troubling. Congress has been warned about the consequences of this in 2006 testimony before the Committee on Banking, Housing and Urban Affairs. You can read that testimony here. If you would like my article on this issue you can find it here. The ideas discussed in the WSJ article referenced above go beyond what I wrote about back in December.

If you object to taxpayers bailing out the banking industry, again, I urge you to write to your congressional representatives.

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More Subprime From Schumer

I just posted the opinion piece below that relates to how Senator Schumer continues to ignore Wall Street's role in the current mortgage crisis. Apparently, Wall Street and other banks were so hungry to originate mortgages, 23 year old kids were able to defraud them of millions of dollars. The FBI has geared up dramatically to uncover and prosecute those responsible. Here is a quote from this December 21 Wall Street Journal page 1 article:

Fraud goes a long way toward explaining why mortgage defaults and foreclosures are rocking financial institutions, Wall Street and the economy. The Federal Bureau of Investigation says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28%, up from 7% in 2003. Suspicious Activity Reports, which many lenders are required to file with the Treasury Department's Financial Crimes Enforcement Network when they suspect fraud, shot up nearly 700% between 2000 and 2006.

Here is the article I posted last night:
Charles Schumer is at it again. On December 19, 2007 he presented "A Call to Action on the Subprime Mortgage Crises: Putting Common Sense Ahead of Ideology" to The Brookings Institution. I have read those remarks and find that I must discuss them in order to keep the record, as I see it, clear. If you are new to my blog, you may not know that in October I reviewed a report sponsored by Senator Schumer that set up his current proposals. This presentation is the next logical step in the progression of deflecting attention away from the Wall Street participants and moving the burden to mortgage brokers, non-bank lenders, shareholders of Fannie Mae and Freddie Mac, and taxpayers. There is so much to be said about this that I will first provide a summary and then review the Senator’s remarks. If you are not familiar with Wall Street’s role in the subprime mortgage market, I suggest you read my October post first.

Senator Schumer’s presentation contains some things I agree with. For example, I can’t argue against a plan that says borrowers should be informed about the loans they are taking, or that borrowers should have an advocate if they are in default (two of Senator Schumer’s proposals). The problem, however, is that Senator Schumer continues to ignore the primary causes of the crisis and tailors remedies that shift the burden to other parties. According to the Senator, the crisis was caused by homeowners who were duped by unscrupulous mortgage brokers into taking out bad mortgages. To fix the problem requires regulation of those bad brokers and refinancing hundreds of thousands of loans even if it means putting taxpayers on the hook and even if these borrowers were not first-time homebuyers. I’m sure there are unscrupulous mortgage brokers and that some borrowers didn’t fully understand the terms of their mortgage. But is it the root of the problem? The Senator completely ignores the role of Wall Street and the subprime mortgage fee-fest that fed many of his campaign contributors over the past five years. He also ignores the role of the Federal Reserve and its failure to do anything to prevent this long developing crisis. Of course, his political motives for this are obvious and I believe he really does understand the origins of this problem. If not, I suggest he read some of the recent reporting to educate himself. This Businessweek article would be a good place to start learning about Wall Street’s role (the link only goes to page two – click back a page to start). He can also read this Fortune article that discusses how the Federal Reserve ignored this problem for too long.

I will give the Senator credit for at last acknowledging the issues relating to credit rating agencies and the conflicts of interest that pervade the securitization of subprime mortgages (as well as everything else). Of course, Congress was warned of these problems in connection with Enron as far back as 2002 and again in 2006 but chose to ignore these warnings. We are now paying the price for Congress’ failure to act.

Finally, Senator Schumer claims that Chairman Bernanke supports his plan to raise the caps for loans made by Fannie Mae and Freddie Mac (the GSEs) to include jumbo loans. I have two problems with this. First, Senator Schumer believes that the GSEs should use their lending capacity to refinance subprime loans on homes that cost, potentially, seven figures. He believes they should do this even though the GSEs have said refinancing these subprime loans is not profitable for them. Of course, these entities were chartered to help provide affordable housing and are owned by shareholders, but apparently that no longer matters. Let the funds be used for the well off and the shareholders pay the price.

Second, Senator Schumer states that this proposal has the support of FED Chairman Bernanke. I am not sure about that. In fact, I wrote about the exchange between the Senator and the Chairman regarding this issue. What the Senator does not state is that the Chairman did not give his support to this plan of simply raising the caps. Rather he was asked if the government could do something like this and he said yes. He said the GSEs could make loans up to $1 million and have the federal government guarantee them. That could be done. However, it would require a large political price because these would be taxpayer guaranteed loans in order to protect the GSEs. You can read about that exchange here – click on “stupidity”. The Senator does not mention anything about the taxpayer guarantee part of the exchange. If this is the “support” from the Chairman that he is referring to then this is a shameful act of political maneuvering and misinformation, and Senator Schumer should, in my opinion, clarify this point. It was obvious when he set the Chairman up for this. So obvious that I wrote about it.

At the end of the day, Senator Schumer apparently believes that taxpayers and shareholders of the GSEs should pick up the tab for this Wall Street mess, mortgage brokers and non-bank lenders should be regulated, but the Wall Street banks need not even be mentioned. It makes me wonder who is actually running Congress. It’s as good as money can buy.

With that introduction and summary, here is my review of Senator Schumer’s remarks.

Senator Schumer’s remarks begin by bashing the Bush Administration’s economic policies as too ideological and irresponsible. I agree with him, especially when it comes to tax policy and saving for baby boomer health care. His next focus is on what he calls the “Four Myths Surrounding The Subprime Crises.”

His first myth is that subprime lending led to millions of brand-new, first-time homeowners. He states that according to the Office of Comptroller of the Currency, only 11 percent of subprime loans went to first-time buyers last year, so the majority of subprime loans were for refinance or buyers who had already owned a home. He then goes on to conclude: “Too many of these borrowers were talked into refinancing their homes to gain additional cash for things like medical bills.” He provides no support for this claim and implicates mortgage brokers as evildoers out to rip off poor desperate homeowners. He then goes on to say that “too large a percentage [whatever that means] went to investors and speculators.” This point is also without support, but is worth remembering because when Senator Schumer speaks about why we need to help out these poor subprime borrowers he is clearly not speaking to this “too large a percent” of subprime borrowers. What is really amazing is that Mr. Schumer goes on to spend an entire page of his presentation talking about how the Paulson rate freeze plan will not help enough borrowers. Which ones? He also ignores steps that have been taken already to help some 300,000 borrowers through FHA programs such as FHASecure and the pending FHA Modernization Act. The spin is so bad it hurts.

His second myth he calls “The Myth of the Unqualified Borrower”. I love this one. He claims that a study of credit scores clearly indicates that many subprime borrowers could have qualified for prime loans. He fails to consider, however, any debt-to-income or loan-to-value criteria (or any other criteria for that matter). So in fact we really don’t know whether these people could have qualified for a prime loan or not. All we know is that their credit scores were in a range that could possibly have qualified them for some mortgage amount. The other thing about this “myth” is how it is in direct contrast to all of the hype we have been hearing from HUD and the FHA. The FHA Modernization Act, supported by the Senate, lowers the underwriting criteria for FHA guaranteed loans. If all of these borrowers could qualify for prime loans, then why do we need to lower the underwriting standards to refinance all of them into FHA loans? Sounds like BS to me. You can get more details on the FHA Modernization Act from my post on it, but it is enough to understand that the thrust is to reduce the amount down from 3% to 1.5% and raise the size of the loan that can be financed. (The FHA role in refinancing hundreds of thousands of subprime loans is also a potential problem that could lead to a taxpayer bailout.) The Senator concludes this “myth” by stating “it’s clear that many subprime borrowers have the financial foundation for sustainable homeownership, but may have been tricked into unaffordable loans by unscrupulous brokers.” There we go again – it’s all the fault of those brokers. Did the Senator ever consider that maybe these borrowers wanted more home with less down and pressured the brokers to come up with a financing arrangement to satisfy their demands?

Myth three is “The Myth that Borrowers Can Easily Obtain Perfect Knowledge of The Terms of Their Mortgage Loans.” Well, if he is referring to the fact that the rate varies and the payments are likely to go up, borrowers can easily obtain and understand that information. The other thing borrowers generally understand is that if they cannot make their payment they will lose the home. According to Senator Schumer, however, most people are too stupid to understand this and so we must step in to protect them. Now, I wonder which people these are. Are these the ones who had to refinance to pay medical bills or the “too large a percentage” of investors and speculators? No, these must be the ones who were duped by the unscrupulous brokers. Yah, that’s it. How many of those are there again?

Myth four is that the free market will fix everything. I agree with his supposition that free markets do not fix everything, but stupid policy doesn’t fix everything either. If the Senate had listened to all of the warning signals it got about the housing bubble and leaned on the FED a little more, or about rating agencies and acted on that, then much of this mess probably could have been avoided. Instead, the politicians (pretty much all of them) stuck their heads in the sand because they didn’t want to throw cold water on a very popular housing boom (especially when their contributors were making a fortune from it). Glass houses and all of that.

The four myths are followed by warnings of impending doom. In fact, according to Senator Schumer “we are facing an economic downturn that we haven’t seen in this country since the Great Depression.” Yikes! If this is true I’m really glad I took most of my money out of long positions in equities! He goes on to point out that “a 10 percent decline in housing prices could lead to an overall $2.3 trillion economic loss…” That would be bad, but less than half of the approximately $5 trillion in losses from the dotcom bubble bursting. I agree this is not good for the economy, but the Great Depression? I hope not.

The presentation ends with seven policy options proposed by Senator Schumer to address the subprime mortgage crisis. Here they are, in a nutshell:

1) Provide more mortgage counselors to serve as borrowers’ advocates. OK, not bad.
2) Raise the portfolio limits for Fannie Mae and Freddie Mac so they can refinance subprime loans, even though these entities have said this would not be profitable for them. Also raise the cap on the loans they can make to include jumbo mortgages (no mention of the government guarantee part). I don’t like these, especially when the GSEs are saying they want no part of it.
3) Allow states to issue tax-exempt bonds to refinance subprime loans. As long as it’s not my state tax dollars guarantying the loans, fine.
4) Modify the bankruptcy code to change the protection mortgage lenders currently enjoy – mortgage loans are exempt from restructuring in bankruptcy without the consent of the lender. OK, but this could make mortgage loans more expensive in the future. Senator Schumer understands this, and acknowledges that this could be limited to only existing loans. This one gets a maybe and a ho-hum from me. If the lenders will be better off cutting a new deal they will.
5) Enact new regulations covering practices by mortgage brokers and non-bank lenders, including limitations on the types of loans they can make. Remember these brokers and non-bank lenders? They are the bad guys in all of this, according to Senator Schumer. Notice how these are mortgage brokers and non-bank lenders, and not banks or investment banks. If you didn’t click on that link to Senator Schumer’s top contributors you may not get this point as clearly. Here it is again. The Senator simply ignores the role of Wall Street and the investment banks in this crisis and makes no mention of any remedy targeted to them.
6) Create an easy to read summary of mortgage terms for borrowers so the big bad mortgage brokers can no longer dupe them into bad loans. OK.
7) Finally, Senator Schumer proposes to closely examine the role of rating agencies in all of this. Hooray! He is finally getting warm.

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