Fed Loans Losing Value

This seems like small potatoes now, but those Bear Stearns and AIG loans made by the Fed aren't doing too well. As of May 6, the Fed is under water by over $8 billion. Here are the details:



On the other hand, Commercial Paper Funding Facility outstandings are down from over $325 billion in December 2008 to $164.7 billion, and down $50 billion this past week alone.

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More Bailouts from Taxpayers

I was reading this article in The Wall Street Journal, Online Edition today titled The Next Housing Bust and had to put down an "I told you so." Here is a quote from the article:

The FHA is almost certainly going to need a taxpayer bailout in the months ahead. The only debate is how much it will cost. By law FHA must carry a 2% reserve (or a 50 to 1 leverage rate), and it is now 3% and falling. Some experts see bailout costs from $50 billion to $100 billion or more, depending on how long the recession lasts.

How did this happen? The FHA was created during the Depression to help moderate-income and first time homebuyers obtain a mortgage. However, as subprime lending took off, banks fled from the FHA and its business fell by almost 80%. Under the Bush Administration, the FHA then began a bizarre initiative to "regain its market share." And beginning in 2007, the Bush FHA, Congress, the homebuilders and Realtors teamed up to expand the agency's role.

This should come as no surprise to anyone who has been following this issue. I wrote about this in December of 2007. Keep listening because there may be more surprises, especially from the Federal Home Loan Banks.

Thanks to Val Ivanson for the link!

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GM and Washington - Finally an "Adult" Response

I just finished listening to President Obama’s speech regarding the auto industry and I found it refreshing compared to the rhetoric that has been dealt us up to this point. It sounds to me as though we are headed for a pre-packaged bankruptcy for GM with the government standing in as the DIP financier. This is what I thought should have happened in the first place, but I think the last administration kicked the can down the road. Thankfully, down the road was an adult who picked up the can to begin cleaning up the mess.

Of course this will mean some disturbing things, especially for union employees. In particular, this probably means lower wages and cuts in benefits to both employees and retirees. Even if bankruptcy is avoided the stakeholders are now under intense pressure to give up ground. It’s hard to see how we get back on track when we cut wages – this doesn’t help stimulate aggregate demand. In fact it enforces the deflationary momentum. (Hold on, I need to mute the television. That Kudlow guy is on making some noise about this. How is he still a commentator on CNBC after being dead wrong about almost everything over the past couple of years? Goldilocks economy my a$$.) Anyway, I am encouraged that the administration is taking what I consider to be the correct position on the automakers even though there is downside on the wage front. The entire mess brings the issues of trade front and center, and I expect this will be one of the most difficult dances for us to do. Is it too late to stop pushing the US down to a Global wage or can we somehow reverse this trend at a time when we need the world to finance our bailouts? Any thoughts?

Stay tuned.

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AIG - Where Your Money Went

The table above shows a summary of the payments disclosed by AIG Sunday. For the detailed list you can go here.

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Federal Home Loan Banks Leveraging Up

I haven’t read anything about the Federal Home Loan Banks since they published their preliminary third quarter results. This is just a short post to point out that Total Assets to Total Capital has been increasing while total assets (these are typically loans to banks) has been increasing dramatically. This is one of those places where taxpayers are leveraging to replace private debt contraction. To put this into perspective, I posted a couple of graphs. The first is Total Assets and the second is Total Assets/Total Capital, which hit 25 times in the third quarter. This is looking more and more like one of those investment banks, especially since almost all of the assets are mortgage related.


For additional information you can go to the FHLBank website here.

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More From The Federal Reserve

The Federal Reserve announced today that it will form a special purpose vehicle (the Commercial Paper Funding Facility or CPFF) that will purchase commercial paper in the marketplace from qualified issuers. This raises many questions, such as whether the Fed is now rationing credit to US companies without oversight.

The Federal Reserve is already in effect purchasing asset-backed commercial paper through its Asset-Backed Commercial Paper Money Market Liquidity Facility (ABCPMMLF) where it is lending money to banks to purchase commercial paper that is then pledged to the Federal Reserve. The twist here is that the loans to the banks are non-recourse, so if the commercial paper defaults the Federal Reserve is stuck, not the bank that borrowed the funds – same risk as ownership if you ask me. This action was authorized pursuant to section 13(3) of the Federal Reserve Act (see below). The commercial paper that banks are purchasing and pledging to the Federal Reserve under the ABCPMMLF is secured by the assets backing the asset-backed commercial paper.

The Federal Reserve is now expanding its use of this authority to purchase commercial paper directly from issuers that may be non-bank companies raising the prospect that the Federal Reserve will be rationing credit to US businesses. There is also an issue of authorization, and it seems definitions are malleable in times of crisis. From today’s announcement:

The CPFF will be structured as a credit facility to a special purpose vehicle (SPV) authorized under section 13(3) of the Federal Reserve Act. The SPV will serve as a funding backstop to facilitate the issuance of term commercial paper by eligible issuers.

According to section 13(3) of the Federal Reserve Act:

3. Discounts for Individuals, Partnerships, and Corporations In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank (emphasis added): Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

According to the highlighted section of the Act the commercial paper purchased by the Fed must be SECURED. My understanding of security in lending transactions is that there is a guaranty or some form of asset available to the lender that can be sold in the event of a default, the proceeds of which would be likely to repay the debt. According to the Federal Reserve's release:

Commercial paper that is not ABCP must be secured to the satisfaction of the Federal Reserve. The commercial paper may be secured in one of the following ways: (i) The issuer pays the SPV an upfront fee based on the commercial paper initially sold to the SPV and a further fee based on subsequent commercial paper sales above that amount (emphasis added); or (ii) The issuer obtains an indorsement or guarantee of the issuer’s obligations on the commercial paper sold to the SPV that is satisfactory to the Federal Reserve; or (iii) The issuer provides collateral arrangements that are satisfactory to the Federal Reserve; or (iv) The issuer otherwise provides security satisfactory to the Federal Reserve. The Federal Reserve will consult with market participants about other methods for issuers of non-ABCP commercial paper to provide satisfactory security to the Federal Reserve.

I wonder how being paid a fee for purchasing commercial paper meets the definition of SECURED under the Federal Reserve Act quoted above. It sounds more like creation of an insurance pool to me. Shouldn't the Federal Reserve obtain Congressional approval to purchase commercial paper from issuers in this manner? The authority is not clear to me.

I do not object to the Federal Reserve taking whatever action is within its authority that could help avert a financial disaster. What I do object to is when institutions bend the meaning of laws to accomplish what they want but then speak about the rule of law and the need to police the actions of those who seek to avoid compliance. Isn't this exactly how we got into this mess in the first place? I am also troubled by the fact that the Federal Reserve can now be seen as rationing credit to US corporations and that this situation is ripe for abuse through influence. There should, in my opinion, be oversight.

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What the Plan Does (and does not)

Now that it appears Congress will pass the bailout plan the next logical question is “what’s next?” I don’t know the answer, but I have my concerns.

This plan may well deal with the current stresses in the financial markets. If so, we can all stop panicking that the world as we know it will come to an abrupt end and get back to the real economy. But, as one commentator just said on CNBC, this may put the fire out but the furniture is still burned. The problem is that the real economy isn’t doing too well. Unemployment is up, spending is down, people are concerned, so where are we headed from here? First, lets see what the current plan hopes to accomplish.

Here is the problem. If a bank has lots of bad assets on its balance sheet, it can’t sell them because if it does it takes a loss on the sale. That loss reduces the bank’s capital, and without adequate capital a bank cannot make loans. On the other hand, if the bank just holds on to the bad assets, it can’t raise new cash to make loans because no one wants to lend it money without knowing how bad the bank’s balance sheet actually is. So as long as these bad assets are being held by the banks lending activity slows or, in the worst case, stops all together. If this gets really out of hand and these bad assets start showing up in other places (like money market mutual funds) then investors start taking their money out of all the places they invest and all lending could stop. That would be the modern day equivalent of a run-on-the-banks. No loans, no economic activity and we fall into a very bad economic shutdown. The only difference between this kind of bank run and the classic depression era run is that the taxpayers stand behind the deposits in commercial banks today through the FDIC and Treasury so we collectively insure our deposits. This prevents a run on commercial banks. We don’t, however, insure the funding sources for all of the other financial institutions in our financial system. Money market mutual funds, insurance companies, investment banks, hedge funds, and private equity raise funds that are not insured against loss. When these bad assets start showing up in those places the sources funding them run. This is why the federal government announced an insurance plan for money market mutual funds last week, and is also why we have witnessed the demise of the independent investment banks. The investors in these banks have stopped funding them – a run on the investment banks. So, although commercial bank deposits that most Americans have in their bank are insured, there is an entire system of finance that doesn’t have this protection and is prone to a classic run. That run is in progress. The current plan hopes to remove bad assets from balance sheets of financial institutions so that lending will return to the economy and investors will stop running. It is intended to “unplug” the flow of money throughout the system by taking away the source of the clog – these bad assets. But even if it works, where do we end up?

A while back I posted an article that explained how the level of household debt to personal income has grown too high and until consumers pay down their debts to a level they can afford the economy will not do well. This is parallel to what is happening in the housing market. Until prices return to a level that makes purchasing a home affordable for the average homeowner prices will decline. As far as overall household debt is concerned, until it returns to a level supportable by personal incomes debt must be reduced. How do we reduce debt? We save rather than spend. Saving more and spending less means less economic activity, and that means a possible recession. So how does the rescue plan deal with this issue? I don’t think it does because it doesn’t deal with the bottom up issue that consumers are in too much debt. How much debt are US consumers in? Total household debt is about $14 trillion, or approximately 145% of 2007 annual disposable personal income. What was this ratio the last time we went into a banking crisis in, say, 1991? It was approximately 85%. That leads us to a thought experiment. What would it take to get us back to the levels of debt to income that we had during the last crisis? If we assume disposable personal income will grow by 2% for this year, then personal income for 2008 should be approximately $9.8 trillion dollars. At 85%, household debt would be approximately $8.4 trillion. Since actual household debt is currently in the $14 trillion range, we need to de-leverage about $5.6 trillion to get back to the 85% ratio we had in 1991. In a $14 trillion economy that represents about 40% of one year’s GDP. In fact, it’s even worse than that because if we stop borrowing in order to save then we also lose the GDP funded by debt (another $880 billion). Comparing other developed countries that have seen similar increases in household debt to disposable personal income, Japan stands out as it went over 120% in – you guessed it, 1991 (see page 47). This was the start of the “lost decade” for Japan.

I don’t expect we would make up all 40% of our adjustment back to 1991 in a short period of time, nor am I convinced that we will ever actually get there without a major new boom in real economic activity (such as discoveries relating to new energy technologies) or a major bust where debt gets written down in mass quantities. The situation does, however, point us to what we can expect next. Expect a rather protracted recession and/or more government interventions into the economy before this is over. I expect the next intervention will be of the bottom up sort, and eventually if the Federal Government owns enough mortgages I can see debt forgiveness of underlying mortgages owned by taxpayers.

Debt numbers: here
Personal Income numbers: here.

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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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Senator Schumer Insurance Plan

Senator Schumer came up with what I think is a really good idea, although I think it could be modified a bit. His idea - rather than charging specific companies fees or equity participation for participating in the bailout program, charge a general insurance fee to all (“large”) financial institutions to provide a fund that would protect taxpayers from eventual losses. I like that idea because it socializes the losses among the financial institutions rather than the general taxpayers. It also resolves the objection Paulson has to protecting taxpayers by charging specific participants. Paulson's concern was that institutions would not participate if there is a cost involved. I think that’s a stretch for taxpayers, but Schumer’s idea isn’t a bad compromise. I would like to see a substantial required contribution into the insurance fund at the expense of dividends if necessary. After all, in the end we want capital to flow to financial institutions on a net basis but we want the ultimate protection to come from the owners of the financial institutions. If we simply charge an insurance fee over time it will ultimately be passed along to taxpayers anyway through higher costs for banking as the fee is built in to the cost structure of these institutions.

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Bailout Testimony

Chairman Bernanke’s testimony today was astounding to me for two reasons. First, he stated that by using public funds to purchase toxic assets from financial institutions we would gain a better understanding of the hold-to-maturity prices of these assets. In effect, he is saying that the market doesn’t work and only government intervention will provide a price discovery mechanism. I take exception to this conclusion because it is based on internally flawed logic. Creating a market with public funds does not provide price discovery, it provides a new market that is not based on “market” prices at all. Rather it is based on availability of funds from taxpayers and it is ripe for abuse.

Second, Mr. Bernanke said that punitive measures should not be used against institutions that participate in sales to the government because it would limit participation. The only reason this could be true is that the government will not allow these institutions to fail so, rather than participating in this plan financial institutions could blackmail taxpayers for another rescue plan. If the government made it clear that they either participate or fail they would participate. I, for one, am tired of being held hostage by financial institutions.

Treasury Secretary Paulson addressed the lack of oversight provisions in his bailout proposal by explaining that he did not intend there be no oversight in his proposed plan. Rather, he felt it should be up to Congress to figure out how to monitor this program. I figured that to be the case, but I have an exception to this. If the oversight was to be determined by Congress, then why put the following provision into the proposal?:

Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Finally, I ask again, where is the presentation?!? All I am hearing is “this is my opinion as Fed Chairman” and as Treasury Secretary. Taxpayers deserve better than this.

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Shock And Awe

I feel like I did just before we attacked Iraq. I feel as though we are being frightened into doing things that in the long run are very bad ideas, but only those in power know all of the details. It's Paulson's way or else. I think we need debate on how to approach this crisis, and I would love to hear plans that focus on supporting market function while allowing bankrupt entities to fail. One problem is that those working on fixing the problems are the same people who created it and their view is strongly biased toward Wall Street. I have a bad feeling about this.

So far, the steps being taken don’t seem to be working while at the same time are creating the dangers of the next financial crisis. For example, I think there is real subterfuge going on with the IBanks. First, the Fed relaxed rules on using FDIC insured deposits to fund IBank operations (that happened the day Merrill & BOA merged). In effect, this is a taxpayer guaranty for Merrill without any congressional review and could be the seeds of the next disaster. This rule is only effective until the end of January 2009, but if the Ibanks are relying on depositor funds at that time what will happen – they will magically find an alternative source of funds? With Goldman and Morgan converting into national bank holding companies they will benefit from the same rule relaxation as Merrill and perhaps use more favorable accounting treatment to value their assets. If I get some time I want to look into that and I welcome all comments on it. Also, today the Fed relaxed rules on private ownership of financial institutions - another move that could contribute to the next disaster as private equity groups that control all types of businesses purchase controlling interests in taxpayer backstopped institutions. All of these moves have, in my opinion, negative implications for the future of our financial system.

What is missing from this entire debate is a clear description of what exactly we are afraid of. Now, I understand the implications of a complete meltdown of the financial system and I think we should be doing something to address the issues. But I have not heard from Paulson or anyone else a clear description of what happens if we do nothing and what the alternative actions may be. Where is the slide show? Where is the full and complete analysis? How does this flow of funds from the US Taxpayer to privately owned financial institutions that continue to pay dividends to their investors fix the problem? Why are these institutions still paying dividends? Shouldn’t there be a prohibition on dividends until taxpayers are made whole through recourse guarantees or some fund created through dividends that would have been paid to investors? Is there a way to fix this problem from the bottom up rather than the top down? Shouldn’t there be some executive compensation limitations? Etc., etc., etc. Rather than all of these issues being addressed we are getting shock and awe. Congressional hearings are beginning – let’s hope our representatives in government step up to the plate. They have certainly heard from me, and you can express your views by going here and contacting your Senator.

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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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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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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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Subprime Conspiracy Theory

By now you have certainly heard that the Federal Government is taking steps to help those poor borrowers of subprime mortgages who were duped by banks and mortgage brokers. I’ll refer to this plan as the “Subprime Bailout Plan”. They plan to help as many as they can refinance into more “secure” fixed rate mortgages, and to freeze the adjustable rate for those who cannot refinance. This plan required many varied interests coming together, and they did so under the guidance of Treasury Secretary Henry Paulson.

At the same time and also with the help of Secretary Paulson, the major money center banks in the US are putting together a plan to finance the purchase of certain assets from Structured Investment Vehicles (SIVs). I’ll call this the “SIV Bailout Plan”. Word is that these vehicles were the repositories for pieces of mortgage securitizations, although finding any actual data on these has been an exercise in futility. The basic idea of this plan is to find a financing source for these assets other than the current structure because the current structure no longer works since these assets have been or may be downgraded by the rating agencies. Once they are downgraded, the SIVs liquidate selling the assets in the marketplace. Because the market for these assets is terrible and sales at current prices would produce large losses, the plan provides a purchaser (the MLEC or Super SIV) for these assets. With time, hopefully, the actual cash flows from these assets will be sufficient to repay the financing used to purchase them at above current market prices. The accounting for all of this raises serious questions in my mind, and if you are interested in that part of it you can read my previous post on that topic here.

To the conspiracy part:
Now, I am not making any direct accusations here, but I would like to point out an issue that I believe should be scrutinized carefully. If the assets in these SIVs are indeed mortgage backed securities or in any way tied to subprime mortgages, then the Subprime Bailout Plan is related to the SIV Bailout Plan because refinancing the subprime mortgages and/or fixing rates for a period of time provides both cash in the form of full repayment of these subprime loans to the owners of those loans, and time to work out the other loans that would default if the interest rates adjust. So, the Subprime Bailout Plan and the SIV Bailout Plan are related, and are both being structured with the assistance of the Treasury Secretary. This raises a potential conflict of interest regarding which subprime borrowers actually receive the assistance that the Subprime Bailout Plan is to provide because those whose mortgages are owned by SIVs or impact repayment on SIV assets could gain preference to aid the SIV Bailout Plan. I believe there should be a call for oversight and full transparency of this entire mess because there is the appearance of a potential conflict of interest here.

Unfortunately, that’s just the beginning of the “conspiracy”. Lets follow the mortgage refinancings to see where the risk of all of these defaults is going. Unfortunately, that road leads indirectly to the federal government and, ultimately, the taxpayer. HUD currently plans to refinance approximately 300,000 subprime mortgages raising serious questions about the ability of the Mutual Mortgage Insurance Fund to adequately cover potential future exposure. Any shortfall in the fund would result in a taxpayer liability. If you would like details about this, you can read my post on it here.

The other place many loans appear to be going is The Federal Home Loan Banks. These banks issue bonds backed by the full faith and credit of The United States (that would be us, the taxpayers) and use the proceeds to purchase mortgages from banks. How much do they purchase, you ask? Well, from December 31, 2005 to June 30, 2007, outstanding advances went from $619.8 billion to $640.0 billion. From June 30, 2007 to September 30, 2007, advances went from $640 billion to $824 billion, an increase of $184 billion. Humm. That would be an annualized rate of increase of ($184 x 4) $736 billion! Senator Schumer has recently questioned the quality of the loans being purchased in an open letter to Ronald A. Rosenfeld, Chairman, Federal Housing Finance Board. You can find that letter here.

Lets review. The Treasury Secretary has developed a plan with major financial institutions to move beaten down assets relating to subprime mortgages (we think) to a Super SIV to buy time to try to liquidate and recoup the value of these assets. At the same time, the Treasury Secretary has developed a plan to refinance and/or freeze the interest rate on some 1.2 million subprime mortgages. The refinance portion of this plan relies on FHA guarantees, and we don’t really know how many subprime mortgages are being refinanced through ultimate sales to The Federal Home Loan Banks. The United States taxpayers ultimately back both of these sources. So, is this really a plan to help those poor victims of the big bad banks that made these subprime mortgages or is this really a bank bailout disguised as a plan to help homeowners? I don’t know the answer, but I know I have serious doubts and there should be some oversight of this entire mess.

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