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.
Sphere: Related ContentTuesday, September 23, 2008
Friday, December 21, 2007
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. Sphere: Related Content
Tuesday, November 27, 2007
Schumer Gets It Right!
I have written a couple of articles that express a poor opinion of Senator Charles Schumer. In the interest of fairness, I want to also salute him for his attention to the taxpayer issues surrounding the Federal Home Loan Banks.
On November 13 I posted this article raising a red flag that the taxpayer bailout of the subprime mortgage debacle had begun through the Federal Home Loan banks. Today, Senator Schumer released this letter to the FHLBanks directly on point. I applaud Senator Schumer for his attention to this issue on behalf of all taxpayers and I hope that he continues to diligently protect taxpayer interests. Here is the letter:
November 26, 2007
Ronald A. Rosenfeld
Chairman
Federal Housing Finance Board
1625 Eye Street NW
Washington, DC 20006
Dear Chairman Rosenfeld:
I write to express my serious concern over the lending practices of the Federal Home Loan Bank of Atlanta, specifically in regard to the significant volume of advances made to Countrywide Bank. I am concerned that the loans being pledged by Countrywide to secure these advances may pose a risk to the safety and soundness of the FHLB system as a whole. I urge you to conduct a careful review of FHLB Atlanta’s collateral evaluation policies, as well as Countrywide’s pledged collateral, in an effort to determine the risk that Countrywide’s collateral poses to the FHLB system. During the current market crisis, it is important that the FHLB system perform its critical mission safely without imposing additional risks on an already strained market.
According to the most recent SEC filings, FHLB Atlanta had made $51.1 billion in advances to Countrywide Bank, representing 37 percent of the Bank’s total outstanding advances as of September 30, 2007 and far exceeding advances made to the next largest borrower. Countrywide had pledged $62.4 billion of mortgages as collateral for the FHLB advances, representing 78 percent of its total mortgage loans held for investment at the bank.
I find these numbers alarming as reports continue to emerge about how Countrywide’s reckless and predatory lending practices were a leading contributor to today’s foreclosure crisis. Moreover, it is my understanding that Countrywide’s loans held for investment at the bank have been far from immune from the credit deterioration that has resulted from unsound lending. Countrywide reportedly held $27 billion of “pay option ARMs” as of September 30, 2007, accounting for over one-third of the loans held for investment by the bank. Countrywide’s option ARMs were (and may still be) often underwritten with less than full documentation – according to UBS Warburg data prepared for the Wall Street Journal, 91 percent of Countrywide’s option ARMs underwritten in 2006 were “low doc.” It has been reported that delinquencies on Countrywide’s pay option ARMS are skyrocketing, jumping nearly 75 percent in the last quarter.
Given this rapid deterioration in the credit quality of Countrywide’s option ARMs, I urge you to conduct a review of the loans that are being held as collateral for FHLB advances in an effort to determine if FHLB Atlanta has adequate collateral to secure these advances. I would also like an explanation of how any second lien mortgages during a time of property price declines could be viewed as adequate collateral for large FHLB advances.
Furthermore, I believe that you should consider preventing any further or continuing overnight advances based on collateral that does not meet the joint financial regulators’ guidance on nontraditional and subprime mortgage products (e.g., Interagency Guidance on Nontraditional Mortgage Product Risks and joint Statement on Subprime Mortgage Lending). This quarter, Countrywide reported that 89 percent of their 2006 originations of pay option ARMs did not conform to the joint regulators’ guidance, which increases the likelihood that Countrywide is pledging loans deemed predatory by the regulators as collateral for FHLB advances. Importantly, Fannie Mae and Freddie Mac’s safety and soundness regulator has specifically prohibited any new direct or indirect investment in loans that do not meet this guidance. As the mortgage crisis threatens to get worse from here, it is critical that the FHFB do the same.
Thank you for your prompt attention to this matter, and I look forward to working with you on these issues in the coming weeks and months. If you should have any questions, please contact David Stoopler on my staff at 202-224-6542.
Sincerely,
Charles E. Schumer
United States Senator
You can view the original here. Sphere: Related Content
Friday, November 9, 2007
Stagflation and Stupidity
The two things I heard from Ben Bernanke’s testimony before the Joint Economic Committee yesterday: stagflation and stupidity.
On stagflation:
Mr. Bernanke’s testimony started out OK:
“On preliminary estimates, real gross domestic product (GDP) grew at an average pace of nearly 4 percent over the second and third quarters despite the ongoing correction in the housing market. Core inflation has improved modestly, although recent increases in energy prices will likely lead overall inflation to rise for a time.”
OK, 4% GDP growth with a little inflation pressure, not bad. Sounds like there should be a neutral policy with maybe a slight bias toward a rate hike. Not so fast. There’s a bit of trouble afoot in the credit markets. The Chairman acknowledged that investors got a lot of the risk calculation wrong on many financial instruments. He said “At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit products, rated by credit-rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of credit ratings, especially those of structured products.” (I hope Senator Schumer was listening to the part about the rating agencies as that point was absent from his report on the subprime mess – see my commentary for more on that.) The impact of this has not yet run its course.
“To be sure, the recent developments may well lead to a healthier financial system in the medium to long term: Increased investor scrutiny of structured credit products is likely to lead ultimately to greater transparency in these products and to better differentiation among assets of varying quality. Investors have also become more cautious and are demanding greater compensation for bearing risk. In the short term, however, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain.”
In other words, the credit market issues are only beginning to spill over into the broader market, and the “short term” impact will be slower economic growth. He later made some comments that would suggest his estimate of short term is the spring of 2008, but he did not have much conviction on that point.
The Chairman then went on to review FED actions over the past few months leading up to the October meeting, including the injection of excess reserves into the system and 50 basis point reduction of the discount rate in August, and the September 50 basis point cut in the federal funds rate and discount rate. Then came the reasoning behind the 25 basis point rate cut in October (which I thought was a mistake).
“Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term. Financial conditions had improved somewhat after the September FOMC action, but the market for nonconforming mortgages remained significantly impaired, and survey information suggested that banks had tightened terms and standards for a range of credit products over recent months. In part because of the reduced availability of mortgage credit, the contraction in housing-related activity seemed likely to intensify. Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing. Most businesses appeared to enjoy relatively good access to credit, but heightened uncertainty about economic prospects could lead business spending to decelerate as well. Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate. Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.”
So, in the committee’s judgment, there is downside risk to the economy and, in fact, every expectation that economic growth will be anemic for the next couple of quarters. In addition to the outlook, however, there is also downside risk that could make things worse. “One such risk was that financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected. Another risk was that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers' willingness to spend and increase investors' concerns about mortgage credit.” This is recession speak in my view. If the expectation is already for weak economic growth, worse than that likely means contraction. So we see some real concern here about the economy from the FED leading up to the October rate cut. So absent inflation concerns, the accepted strategy would be a rate cut. Lets look at what he had to say about inflation.
“The Committee projected overall and core inflation to be in a range consistent with price stability next year. Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. But the inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well.” Sounds like there is some upside risk to inflation here as well, so maybe a rate cut is a bit risky? Here is what the Chairman said about it:
“Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31 reduced its target for the federal funds rate an additional 25 basis points, to 4-1/2 percent. In the Committee's judgment, the cumulative easing of policy over the past two months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. [emphasis added] All told, it was the judgment of the FOMC that, after its action on October 31, the stance of monetary policy roughly balanced the upside risks to inflation and the downside risks to growth.”
In other words, at the time of the rate cut there were risks that economic growth could slow significantly, and that inflation could become a problem. What has happened since the October 31 rate cut decision (only 8 days prior to the testimony)? According to the Chairman:
“In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted. Incoming information on the performance of mortgage-related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth. In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and may impose further restraint on economic activity. [emphasis added]”
There it is – stagflation. Slower economic growth AND inflation equals stagflation. Now, the Chairman did not say we are experiencing stagflation. If inflation does get worse, that could be because the economy continues to grow. If growth suffers, that could limit inflationary pressures. But both of those possible outcomes are now clouded by the specter of both slowing economic growth and inflation, or stagflation, because of rising oil prices plus the pressure on the dollar and its impact on prices of imported goods. The inflationary impact of the dollar decline is somewhat muted by our trade imbalance with China because the exchange rates of the currencies are manipulated, but I hate to count on that for economic security in the US. Ron Paul summed up the negative outlook by pointing out that so long as we inflate our way out of excess consumption the dollar will decline leading to inflation, and given the lose monetary policy of the recent past we are now without options to fight either inflation or slow economic growth unless we align consumption with output – i.e. recession. This is the Senators way of saying the credit binge must end somewhere, and it may just be here. That would mean that the FED is stuck between the proverbial rock and hard place. If it follows an expansionary policy of lower rates inflation could spiral up, and if it follows a contractionary policy to contain inflation it could depress an already shaky economy. What did Mr. Bernanke have to say about all of this?
“The FOMC will continue to carefully assess the implications for the outlook of the incoming economic data and financial market developments and will act as needed to foster price stability and sustainable economic growth.” Is it time to redefine “price stability” and “sustainable economic growth”? Maybe it is. For now we are “data dependent.”
On Stupidity:
Every now and again I here a stupid idea thrown about or I read a “report” to some congressional committee that makes no sense. I don’t mean an idea that just sounds different. I mean one that you hear with disbelief followed by a realization that you actually did hear what you thought you heard. You expect it once in a while, but when it comes directly from elected officials and their appointees, it takes on a whole different character.
Yesterday I witnessed an exchange between Senator Schumer and Ben Bernanke before the Joint Economic Committee of Congress. Senator Schumer pressed Mr. Bernanke on ways in which Congress could help the mortgage market, and whether increasing the caps on the size of mortgages that Fannie Mae and Freddie Mac can make (currently $417,000.00) would be helpful. Mr. Bernanke went on to say that the caps could be increased to $1 million per loan, and that to reduce the risk to Fannie Mae and Freddie Mac from this increased exposure, the federal government could guarantee those loans. That’s right, you read that correctly. The government sponsored entities set up to help expand affordable homeownership should be used as vehicles to make mortgages of up to $1,000,000.00, and your tax dollars should guarantee those mortgages. I almost broke the television set when I heard it. If you need verification, you can read about it in The WSJ Online Edition.
(I was going to forget about this whole exchange until it gained some validity through publication of this WSJ article.)
Lets start with the missions of Fannie Mae and Freddie Mac. First from Fannie: “Fannie Mae is a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.
And here is Freddie Mac:
“Our mission strives to create:
· Stability: Freddie Mac's retained portfolio plays an important role in making sure there’s a stable supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing in our communities.
· Affordability: Financing housing for low- and moderate-income families has been a key part of Freddie Mac’s business since we opened our doors. Freddie Mac’s vision is that families must be able both to afford to purchase a home and to keep that home.
· Opportunity: Freddie Mac makes sure there's a stable supply of money for lenders to make the loans new homebuyers need. This gives everyone better access to home financing, raising the roof on homeownership opportunity in America.”
In short, these entities exist to “expand affordable housing” by providing a “supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing,” and “Financing housing for low-and moderate-income families” and “new homebuyers.”
Just what is “affordable housing?” Here is what The Department of Housing and Urban Development has to say about it: “The generally accepted definition of affordability is for a household to pay no more than 30 percent of its annual income on housing. Families who pay more than 30 percent of their income for housing are considered cost burdened and may have difficulty affording necessities such as food, clothing, transportation and medical care. An estimated 12 million renter and homeowner households now pay more then 50 percent of their annual incomes for housing, and a family with one full-time worker earning the minimum wage cannot afford the local fair-market rent for a two-bedroom apartment anywhere in the United States. The lack of affordable housing is a significant hardship for low-income households preventing them from meeting their other basic needs, such as nutrition and healthcare, or saving for their future and that of their families.”
Nope, doesn’t sound like a homebuyer with a $1 million mortgage to me.
What is “workforce housing”? According to Wikipidia, “Workforce housing is a relatively new term that is increasingly popular among planners, government administrators and housing activists, and is gaining cachet with home builders, developers and lenders. ‘Workforce housing’ can refer to almost any housing, but always refers to ‘affordable housing’.”
Nope, that doesn’t sound like a homebuyer with a $1 million mortgage either.
What are low- and moderate-incomes? Whatever they are, they are not applicable to the purchaser of a home with a mortgage of $1 million. I don’t even need to look that one up!
Mr. Bernanke is generally a very reasonable person in my view, although I disagree with FED action on occasion. In light of this, I decided to look up more about his position on Fannie and Freddie going outside the scope of their missions to provide mortgage financing for people purchasing homes in the $1 million range (actually with a mortgage of $1 million the purchase price could be as high as $1,250,000 at 80% loan-to-value). Here is what I found from a March 6, 2007 MSNBC report: “Federal Reserve Chairman Ben Bernanke urged Congress on Tuesday to bolster regulation of mortgage giants Fannie Mae and Freddie Mac, and suggested limiting their massive holdings to guard against any danger their debt poses to the overall economy.
“Bernanke has previously supported efforts to pare the two mortgage companies’ huge portfolios. This time, however, he was a bit more specific and recommended that their holdings might be linked to a ‘measurable public purpose, such as the promotion of affordable housing.’”
There is that phrase again – affordable housing. I wonder what caused Mr. Bernanke to do a complete about face on this issue between March and November from affordable housing only to non-conforming loans up to $1 million. I suppose if taxpayers guaranteed these $1 million loans they would not pose any additional danger to the overall economy (at least not immediately).
Now I must preface the balance of this piece with a thought about Senator Schumer. I always liked him and, it seems funny now, I have heard other people say the same thing about him. He is likeable. But since I started writing about issues of policy and economics, I have discovered that Senator Schumer shows up on the wrong side of many issues (that would be the side opposite mine). (I have written about such issues twice before here and here.) This is another good example because it appears Senator Schumer and Chairman Bernanke are concerned about the mortgage crises fall out on people with mortgages and homes valued at $1 million and more. This seems to be a little out of place given the current housing market crises impact on lower- and middle-income families. In addition to this incongruous line of thinking is the plainly stupid idea that the federal government should be guaranteeing mortgages in the $1 million range. Of course this leads me to the inevitable question – where do I apply!
I am against any taxpayer bailout of mortgagors who bit off more than they could chew. If you would like to read my opinion on this topic and my reasons for it you can see my post from October on that subject here. I am absolutely against any taxpayer guarantee of mortgages on non-conforming loans anywhere near the $1 million mark. In fact, I am dumbfounded by that entire exchange unless it was meant to soften us up for some other bailout proposal. At this moment in time, with two wars, a $9 trillion national debt, a falling dollar, inflation concerns, and tightening credit I believe there are much more important things to do with the credit of the American taxpayer than to put it behind purchases of $1 million homes. Focusing help on the wealthiest among us at a time when income distribution is coalescing at the top and raising taxes on high income is met with staunch criticism is indicative of a government that is completely out of touch. I am also concerned about the future unintended consequences that could result from this type of market manipulation and the distortions that it would create.
I am left hoping that Chairman Bernanke was not serious in his comments and/or Senator Schumer dismissed the concept out of hand. Unfortunately I have become a bit cynical in these times of mortgage meltdown and wealth transfers, and I fear there is a legislative proposal being prepared right now by one of Senator Schumer’s aids. I hope my fears prove unfounded.
Sunday, October 28, 2007
Dirty Little Secrets of Subprime
I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: http://jec.senate.gov/Documents/Reports/10.25.07OctoberSubprimeReport.pdf. Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:
1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?
2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.
3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.
“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”
At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:
“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.
4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.
5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:
“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”
Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257. You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here: http://polecolaw.blogspot.com/2007/10/public-and-private-bank-regulation-or.html
6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: http://polecolaw.blogspot.com/2007/10/maybe-stalling-is-viable-master-siv_19.html and here: http://polecolaw.blogspot.com/2007/10/i-did-not-have-sex-with-that-siv.html. It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.
I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.
Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.
All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html . Shell games at the highest levels of government.
Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here: http://polecolaw.blogspot.com/2007/10/subprime-socialization.html
Looks like all the lose ends are getting tied up nicely.
Thursday, October 4, 2007
A Tale of Two Cities: New York and Detroit (Wall Street Competitiveness)
A Tale of Two Cities: New York and Detroit (revised)
The other day I wrote about the recent UAW/GM contract negotiations, and some commentary about the outcome. The bottom line of my piece is that US autoworkers are being forced down the standard of living scale by a shift in power from labor to business, and the main argument used to support this shift is competition from the global economy. Whether this is actually the case remains unclear, but it is certainly the reason given by business and the media in general for the decline in US manufacturing job compensation in Detroit. (For more on that see my post.)
I was reading an article in The WSJ Online edition today regarding Sen. Jeff Sessions promotion of a bill favoring financial institutions over accepted intellectual property rights, and I was struck by the way the rules are changed when the “victim” is an industry with very strong ties to the rule makers. (Of course, we all know there was gambling at Rick’s, but at least it was in the back room.)
Being interested in this example of the imbalance of power, I began to poke around a little, and came upon a recent report published by The Senate Republican Policy Committee which can be found at http://rpc.senate.gov/_files/061907competitivenessDK.pdf . The report (the “Senate Report”) is entitled Excesses Threaten U.S. Competitiveness, When Excess Damages Success: Have Litigation, Taxation, and Regulation Gone Too Far? This report, dated June 19, 2007 explains that US banks (Wall Street) are losing competitiveness to foreign markets. The conclusion of this report is:
"The declining competitiveness of the United States’ capital markets may be a canary in the coal mine of a much deeper problem. The trends of excessive regulation, litigation, and taxation in our capital markets are being replicated in other parts of our economy. Unless Congress, the Administration, and the business community create a clear and unified blueprint for maintaining our nation’s competitiveness, capital and jobs will continue to move overseas."
One of the major resources relied on for this finding is a report (the “McKinsey Report”) generated by McKinsey & Company for Mayor Blumburg of New York and United States Senator Charles Schumer entitled Sustaining New York’s and the US’ Global Financial Services Leadership which can be found at http://www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf . Citing this report, the Senate Report states that
“Regulatory and litigation burdens are two major drivers of declining
competitiveness for capital markets.
In a large survey of industry leaders, McKinsey & Company, a premier management consulting firm, found that about two-fifths of CEOs surveyed expected that New York City—and by extension the United States—would become less attractive as a place to do business. McKinsey found that what clearly dominated these views were fears that two factors would not be present: 1) a fair and predictable legal environment and 2) a strong but responsive regulatory environment.”
In other words, the problems causing New York banks to lose market share are taxes, the lawyers bringing too many frivolous lawsuits against companies in the US, and over-regulation of US companies. This is causing companies to go overseas and sell their stock in foreign markets. Now, to be fair, there is some merit to these claims, and I am all for rationalizing our regulatory systems. There is a price to be paid, however, for transparency and safety and I do not believe we should go too far. (This is the stuff of a future blog piece.) All of this got me thinking about the competitiveness issue for investment banks. Being a former analyst and having just written a piece regarding global competition, the first question that came to mind was how much of this competitive loss is being caused by these factors as compared to good old competition from lower cost global competitors?
Well, I reviewed the McKinsey Report (though I will admit I did not read all 142 pages of it in its entirety), and was startled at what I did not find. What I did not find in all of the 142 pages of the McKinsey Report was a material discussion of the impact of lower fees charged by banks in other countries having an impact on the competitiveness of New York banks. Not to digress, but how can one of the premier consulting firms on the face of the Earth, engaged by The City of New York and the United States Congress, produce a report that purports to study why US Banks are losing competitiveness to banks overseas not consider the prices being charged by overseas competitors? Either the researchers were instructed to report only on select issues, or the research is completely flawed. You be the judge. Here is what they had to say about the fees:
“Another explanation put forward by some commentators as to why international issuers are staying away from US equity markets is the fact that the underwriting fees charged by investment banks are significantly higher for US listings than in competing markets. One study reveals that underwriting fees for non-domestic listings were 5.6 percent and 7.0 percent on the NYSE and NASDAQ, respectively, compared with just 3.5 percent on London’s man market. But while such figures may seem significant when looked at in isolation, their importance relative to the overall value of an IPO s fairly low, and easily outweighed by the benefits of a more liquid market and superior execution. Surveys conducted for this report corroborate this thesis: when asked to rate the importance of underwriting fees in the overall process of listing a company on the public equity markets, survey respondents ranked underwriting fees last among seven factors, with just 4 percent judging the issue ‘very important.’” (See pg 49 of the McKinsey Report.) (Note that they did not site the LSE Report discussed below here, as that would show a larger fee discrepancy.) Who are these respondents who deem it not important that the fees charged are almost double? “… a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 75 additional global financial services senior executives through a separate on-line survey.” (See McKinsey Report pg 8.) So the people who say the vast differential in the fee is not important are the very people running these businesses and charging these fees. Sounds conclusive to me.
As it turns out there has been a study that identifies the fee differentials between international markets for investment banking services. I found it in a footnote to the McKinsey Report (so they looked at this report). You can find the report (the “LSE Report”), published by The London Stock Exchange, here http://www.londonstockexchange.com/NR/rdonlyres/B032122B-B1DA-4E4A-B1C8-42D2FAE8EB01/0/Costofcapital_full.pdf .
The LSE Report finds "Gross spreads of IPOs on the US exchanges are found to be highest, averaging 6.5% for the NYSE sample and 7% for Nasdaq IPOs. In comparison, median spreads of IPOs on the LSE’s Main Market are 3.25% and those on AIM somewhat higher at 4%. Thus, there is a cost saving of three percentage points for a UK transaction compared with a US transaction." (See pg 18 of the LSE Report.) How much is 3%? Well, for the over $4 billion Blackstone initial public offering, that would be at least (.03X4,000,000,000) $120 million! That's just the excess of US over other markets. How does this compare to the first year’s cost of compliance with Sarbanes-Oxley? That cost is estimated at $4.4 million according to a 2005 survey cited in the LSE Report (LSE Report pg. 33).
So let’s review. The fee charged is by far the largest component of the cost of issuance in the US, and fees in the US are by far the largest among international competitors. This fee differential is not, however, why US banks are losing competitiveness. The reason is the cost of these darn law suits and regulations that companies in the US must put up with. That’s the New York tale. The Detroit tale? US workers at GM, Ford, and Chrysler must reduce their standard of living because we cannot compete with lower cost labor from foreign competitors. My conclusion? Perhaps Wall Street should lower the standard of living of its employees so that it can better compete with the foreign competition just like those on main street in Detroit are doing. Otherwise, stop spending my tax dollars on stupid reports that ignore the most obvious issues. Now don’t get me wrong. I am all for US competitiveness. We need to continue to study our competitiveness and actions we should take to ensure our future. I, however, would prefer to do so with full information applied across all of the US constituents rather than targeted reports used to influence the rule making process for the benefit of those in power (which is my interpretation of the McKinsey Report).
PS – if you think the higher fees charged by the New York banks has to do with the cost of living in New York, forget it. The studies show that is not the case.
