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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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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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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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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The Plan for GSEs

The Federal Housing Finance Agency (FHFA), the regulator of the GSEs (Fannie Mae and Freddie Mac) announced today that it is putting these two behemoths into conservatorship. I have read through the announcement from Treasury Secretary Paulson and the statement made by James Lockhart, both of which are available at the Treasury Press Room online. (Please note that any quotes in this article not otherwise noted refer to this release.) There are some interesting aspects to this plan, as well as interesting questions.

The first question is why. Why put these entities into conservatorship now? According to today’s statements, the root cause of the problem is the inherent conflict within these organizations of being run for profit but with a purpose of serving a public interest. Of course, these institutions have existed in this form for quite some time (1968 for Fannie Mae and 1970 for Freddie Mac), so this would not be why they are being put into conservatorship now. They are being put into conservatorship now because they are no longer able to accomplish their mission of helping to provide liquidity to the mortgage market and “respond appropriately to the private capital market,” (see the legislation that created Freddie Mac here) and they are at risk of failure which could have devastating ripple effects in the financial industry and the broader economy. Mismanagement, excessive lobbying success, and the rapid decline in home prices have left them inadequately capitalized to carry out their missions.

Because they are undercapitalized investors have not been snapping up GSE liabilities. The poor demand for their debt results in the GSEs paying higher interest on borrowings, and this translates into more expensive mortgages for borrowers. So, even though the Federal Reserve has the target Federal Funds rate down to 2%, a negative real rate, interest rates in the mortgage markets are going up. Some believe this situation goes well beyond the GSEs and is a reflection of the entire financial system in the United States, but don’t expect to hear any politician or regulator tell you that in public. A Heard On The Street Column in The Wall Street Journal Online Edition makes that point this morning.

In order to provide liquidity to the mortgage market (which means demand for mortgage backed securities and debt issued by the GSEs), the Federal Government has decided to step in with a four-point plan. The hope is that if this plan is successful, mortgage interest rates will decline causing increased housing demand softening the housing price declines we are seeing. In turn, this should speed a recovery in the overall economy as falling home prices represent a huge drag on consumer spending. In addition, the systemic risk from a failure of the GSEs goes away (is transferred to the United States taxpayer).

One point I want to mention before getting into the details of how the plan works is that according to the statement released by James Lockhart, “all political activities – including all lobbying – will be halted immediately.” I find this ironic, and I would like to know when this rule would be applied to Wall Street.

That’s the why, now to the how. Step one is placing the GSEs into conservatorship, meaning they will now be run by FHFA. Investors who own stock lose all of their rights although they can keep the stock in the hope that at the end of all of this there will be some value in it. There will be no dividends paid to common or preferred shareholders. There is a ripple effect to this part of the plan, as any financial institution that holds a large amount of stock in the GSEs will likely realize a sudden and dramatic loss. The agencies involved in the financial system

encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares … are likely to reduce their regulatory capital below ‘well capitalized.’ The banking agencies are prepared to work with the affected institutions….

In any event, the largest players in the mortgage markets are now in the hands of regulators.

Treasury announced an additional three steps it will take to shore up confidence in the GSEs so their debt costs will come down and to provide liquidity to the mortgage market. These are (i) taxpayer guarantees of GSE debt backed by taxpayer purchases of Senior Preferred Stock of the GSEs as required (initially up to $100 billion for each GSE), (ii) “market” purchases of GSE mortgage backed securities (MBS) in an unspecified amount, and (iii) a taxpayer credit line of an unspecified amount for loans to the GSEs and the Federal Home Loan Banks secured by GSE MBS (or, in the case of the Federal Home Loan Banks, advances). These steps are all in addition to the $400 billion of liquidity provided by the Federal Reserve, the recent $300 billion taxpayer guaranteed FHA refinance plan, and the $250 billion of taxpayer guaranteed debt issued by the Federal Home Loan Banks since this “contained” “subprime” mortgage crisis began.

First, the Treasury (that would be the taxpayers) has guaranteed the solvency of the GSEs. So, if these entities lose money and become insolvent, the United States taxpayer will purchase up to $100 billion of Senior Preferred Stock in each entity that will be senior to existing preferred stock and common stock outstanding. This amount is not necessarily a limit on what taxpayers will invest – rather it is an amount chosen by Treasury as an initial facility size. Just to put this amount into perspective, the current common equity of Freddie Mac is approximately $12 billion. This taxpayer investment program is aimed at shoring up demand for GSE debt in the hope it will reduce the cost of debt and, in turn, bring down mortgage interest rates. In order to protect taxpayers, Treasury also gets warrants to purchase, at a “nominal” cost, up to 79.9% of each GSE. Senior and subordinated debt issued by the GSEs and the MBS they issue and guarantee remain senior to taxpayers and are, in fact, guaranteed by taxpayers because if the GSE can’t pay them taxpayers purchase more Senior Preferred Stock to provide the funds. The total amount of this debt is massive, but these are backed by mortgages and so losses are what we should be focused on. Even so, we are talking about a total principal exposure of over $5 trillion dollars.

As part of the agreement between Treasury and the GSEs, each GSE must shrink its on-balance sheet mortgage assets by 10% per year from $850 billion (a little more than what they are today) on December 31, 2009 to $250 billion. The impact of such a reduction in size on the GSEs’ ability to act as a conduit between lenders and the secondary market is likely to be substantial. According to FHFA this should address the systemic risk posed by the size of these institutions. It seems a shame, however, that publicly assisted housing finance that had worked so well until a few years ago is being forced to all but disappear. The ultimate losers would be the general public and the ultimate winners – well – whoever will satisfy all the mortgage demand when the GSEs are too small. Hopefully Congress will figure out a way to preserve the public benefit (Representative Frank?).

The second step Treasury is taking is initiating a program of purchasing GSE MBS that are credit guaranteed by the GSEs. Now remember that pursuant to the step just discussed these guarantees are now guarantees of the Treasury. Yes, the taxpayers will be purchasing taxpayer guaranteed debt with taxpayer funds. This part of the plan hopes to provide additional liquidity to the market for mortgage backed securities – something that the $400 billion or so that the Federal Reserve has provided, plus the $250 billion or so the Federal Home Loan Banks have provided, plus the $300 billion FHA plan, have not accomplished. Treasury will designate “independent asset managers as financial agents” to make purchases of mortgage backed securities on behalf of Treasury. Of course, none of these people know one another so we can rest assured that there will be no favoritism regarding who Treasury purchases the GSE MBS from (hummm). Two glaring mysteries in this part of the plan – how much will taxpayers purchase and from who?

Finally, Treasury is providing a collateralized loan facility to the GSEs AND the Federal Home Loan Banks. So, if the market for GSE debt is unfavorable even after all of the other steps, taxpayers will lend the money to the GSEs taking MBS as collateral, and if the Federal Home Loan Banks run into problems issuing their taxpayer guaranteed debt they too can borrow from the taxpayers directly (this type of borrowing would fund advances at these banks that are collateralized by mortgage assets of financial institutions). These lines of credit are available until December 31, 2009, as authorized by the recent legislation passed by Congress. There is no stated limit on the overall size of this facility.

If you are interested in following your money Treasury will be releasing information on borrowing by the GSEs and Federal Home Loan Banks in the Daily Treasury Statement. Purchases of MBS will be reported monthly in the Monthly Treasury Statement.

All of this raises some very interesting questions about our overall economic system. If time permits I will publish a perspective on possible root causes of all of these deviations from our “free market” system.

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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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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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Another Win for the Top

In another victory for the top 1% of income earners, The New York Times reported today that Representative Charles Rangel, Chairman of The House Ways and Means Committee, agreed to drop the carried interest proposal from the legislation that was passed by the House to adjust the AMT threshold.

The AMT was originally enacted to make sure high-income earners paid their share of taxes by limiting the amount of deductions that can be taken over certain income thresholds. The problem is that the thresholds were not inflation adjusted, so every year people with less real income get caught up in having to pay this tax unless Congress passes a law to provide relief. Now, instead of just fixing the problem by changing the law to index the income thresholds to inflation, every year Congress passes a law for the following year only, wasting many of the tax dollars the Treasury does collect in the process. The end result of increasing the income threshold is fewer taxes are collected and millions of taxpayers who don't quite make the top 10% are spared a very unpleasant surprise at tax time. In order to pay for this reduction of anticipated tax revenues, Representative Rangel had proposed a change in the carried interest rules that apply to hedge fund and private equity managers.

The carried interest proposal would have raised taxes on hedge fund and private equity fund managers who benefit from a tax gift, paying only 15% on much of their (often seven figure) income. Basically, these money managers have structured their businesses so they can claim that the income they receive from managing other peoples' money should flow through to them in the same way it flows to those investors. If the investors are getting capital gains, then the managers also get capital gains treatment on their income because their income is based on a share of the investors' income, even though it is not their own money that is at risk (the typical justification for capital gains treatment in the first place). So, hedge fund managers and private equity managers, many of who are in that top 1% of income earners, pay a 15% tax rate on much of their income. Now, if you work for a mutual fund you don't get this benefit. If you sell real estate and the owner receives a capital gain the broker doesn't get this treatment. But somehow, hedge fund and private equity managers do.

Well, there are all kinds of cerebral arguments and debates over this topic. One such argument made by the private equity and hedge fund group is the claim that because they provide such a necessary service to the economy by reallocating resources to their most efficient use they somehow deserve this special tax treatment. Teachers, firemen, and police apparently don’t contribute in ways that benefit society as much as hedge fund and private equity managers because they don’t get special tax treatment. I have written about this rule in the past and how I believe it is a sham on all other taxpayers. You can read that comment if you would like more detail.

All of these very complex and sophisticated sounding debates aside, my cynical brain boils it down to a very simple situation. These very wealthy people who do things that most of us don’t understand hide behind this complexity to gain a tax advantage over the rest of us. They take a portion of this tax savings and they donate it to their elected representatives to ensure that these representatives will not change their tax benefit. See how simple that is? Now, I don’t want to simply dismiss the plight of taxpayers, so lets take a look at the various groups of income tax payers and see how they have fared over the past few years since the Bush tax policies have been in effect.

The latest release to shed light on this issue is the Congressional Budget Office report Historical Effective Federal Tax Rates, 1979 – 2005 (the “Report”). The Report contains interesting data on the distribution of incomes since the Bush tax cuts, especially when combined with the same report from two years ago.

Here is a table of the percentage of all after tax income that went to households in the five quintiles by income (approximately 20% of households fall into each of these quintile categories):

Quintile	2002	2003	2004	2005
Lowest	5.2	5.0	4.9	4.8
Second	10.4	10.3	10.0	9.6
Third	15.7	15.5	14.9	14.4
Fourth	21.6	21.4	21.2	20.6
Highest	48.2	48.8	50.1	51.3

The data make it clear that low-income households have been getting less of the total national after tax income than those in the highest quintile. In fact, the highest quintile is the only one that expanded its share of total after tax income over the period, from 48.2% in 2002 to 51.3% in 2005. Since these are expressed as a percentage of the total income, the gains come from losses to others. In this case the losers are those in the lower quintiles.

About 82.5% of the households in the highest quintile are also in the top 10% of households by income. Here is the trend in income share among those in the top 10%, 5%, and 1%:

Rank	2002	2003	2004	2005
Top 10%	33.3	33.9	35.5	37.4
Top 5%	23.5	24.2	25.9	27.8
Top 1%	11.5	12.2	14.0	15.6

The top 10% did exceptionally well as compared to all others, gaining a minimum of 4% of the total national after tax income while all other groups lost share. But that’s not the whole story. Lets look at what has happened to the actual average after tax income in each group as opposed to group shares of the total. The data for 2002 are in 2003 dollars while the data for 2005 is in 2005 dollars. To compare apples to apples, I adjusted the 2003 dollars to 2005 dollars using the US Department of Labor Bureau of Labor Statistics Inflation Calculator to get inflation adjusted numbers for 2002:

Quintile	2002	2005	% Change
Lowest	15,178	15,300	0.8
Second	32,585	33,700	3.4
Third	47,233	50,200	6.3
Fourth	66,444	70,300	5.8
Highest	141,486	172,200	21.7

It looks like things have been pretty good for those in the highest quintile, with the average after tax income increase (21.7%) of 3.5 times the next best quintile. In the lower two quintiles things have been relatively stagnant with less than single digit gains in the lowest quintile. What about the top 10%?

Rank	2002	2005	% Change
Top 10%	192,328	246,300	28.1
Top 5%	269,811	369,800	37.1
Top 1%	688,008	1,071,500	55.7

Now those are income gains!

The next time you hear any Republican talking about how Democrats engage in class warfare against the rich, remember these numbers. Looks as though it is the other way around, and the rich have been winning all the battles.

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More On Taxpayer Bailout of Subprime

UPDATE: Congress is likely to pass the FHA Modernization Act. This will reduce downpayments from 3% to 1.5%, provide for wider use of risk-based premiums by FHA, and raise the maximum loan amount to the "conforming loan" amount for Freddie and Fannie of $417,000.00. The Senate passed this legislation last week and the House passed similar legislation in September. You can get details of the proposed legislation at this summary of the proposed legislation.

On November 13 I wrote an article about the beginnings of a taxpayer bailout of the subprime mortgage mess. I want to add to that article some new information I have found since then. This has nothing to do with the “Paulson” plan, except that his plan seems to be more of a diversion from what is really happening than anything else.

What is really happening? As I wrote in the article referenced above, the Federal Home Loan Banks have increased their exposure to banks by some $183 billion from December 31, 2006 to September 30, 2007. The FHLBanks obtain funds by issuing federally guaranteed securities, so ultimately this is a taxpayer guaranty. Freddie and Fannie have also substantially increased their portfolios over this time period. But there is more.

The FHA is now into the act in a big way. According to this press release yesterday FHA has now refinanced 33,000 subprime loans and plans to refinance another 20,000 by year end. Plans for 2008 are to refinance 240,000 subprime loans. This is all pursuant to the Bush FHASecure Plan. Of course, as with many Bush plans, the name is deceiving. If anything, I believe this plan makes the FHA less secure and more likely to ultimately require a taxpayer bailout.

Granted the FHA program is backed by an insurance fund – the Mutual Mortgage Insurance Fund (the MMI Fund), that is supposed to stand behind these mortgages. The fund is financed with insurance premiums paid by borrowers. The problem is that the health of the fund (which has a capital ratio around 6.4% of outstanding guaranteed loans based on May 31 2007 data that you can find here) depends upon underwriting standards. With all of the buzz around helping subprime borrowers, and based on some observations, I am very concerned that the fund will ultimately be in jeopardy and have to be bailed out by taxpayers. This is based on my reading of the threats to the MMI Fund.

According to this testimony by Basil N. Petrou, Managing Partner, Federal Financial Analytics, Inc. to the Housing and Transportation Subcommittee of the Committee on Banking, Housing and Urban Affairs, United States Senate, June 20, 2006. prepared and presented in consideration of FHA reform proposals in Congress, the primary sources of financial risk are identified as low or no downpayment loans and risk-based premiums.

Regarding risk-based premiums, the report warns that FHA is likely to get it wrong. FHA does not have the ability to accurately determine which borrowers are higher and lower risk thereby justifying a higher or lower premium. The current system of cross subsidization is a key part of why the MMI Fund has been successful (cross subsidization refers to the fact that all borrowers pay the same fee, resulting in higher quality borrowers subsidizing the lower quality borrowers).

Regarding low or no downpayment loans, it warns that such loans could result in high default rates and serious harm to neighborhoods where these loans would be prevalent. Adding to the risk, according to the testimony, would be a declining real estate market. Does this sound familiar? It sounds like the justification now being given by politicians for helping to stem subprime defaults. This testimony lays out the subprime problem quite clearly, and warns that FHA should stay away from these loans.

This reform that was in front of Congress was not passed. The Bush Administration has, however, authorized modifications to the HUD program that allow HUD to utilize risk based premiums. According to a HUD press release:

President George W. Bush today announced that HUD's Federal Housing Administration (FHA) will help an estimated 240,000 families avoid foreclosure by enhancing its refinancing program effective immediately. Under the new FHASecure plan, FHA will allow families with strong credit histories who had been making timely mortgage payments before their loans reset-but are now in default-to qualify for refinancing. In addition, FHA will implement risk-based premiums that match the borrower's credit profile with the insurance premium they pay-i.e., riskier borrowers pay more. This common-sense, risk-based pricing structure will begin on January 1, 2008.

“Common sense” – hummmm. Not according to congressional testimony. I also point out the spin. If riskier borrowers pay more, doesn't that mean "less risky" borrowers pay less?

Does HUD plan to implement these changes? Well, according to the Annual Management Report of The FHA:

This past year has seen an increase in interest rates and a decrease in house price appreciation, leading to the current mortgage credit crunch. Accordingly, FHA will expand its refinance program, FHASecure, to include those individuals and families who are in default as a result of an interest rate reset. With the inclusion of delinquent borrowers under the FHASecure umbrella, the government’s largest mortgage insurance provider will now be able to assist even more troubled homeowners. In addition, FHA will implement risk-based premiums that match the borrower's credit profile with the insurance premium they pay. This administrative risk-based pricing structure will begin in early 2008.

(Again the spin - "a decrease in home price appreciation" isn't really an accurate description of the current housing market.)
What about the downpayment issue? Well, according to the same press release announcing the FHASecure plan:

To qualify for FHASecure, eligible homeowners must meet the following five criteria:
1. A history of on-time mortgage payments before the borrower's teaser rates expired and loans reset;
2. Interest rates must have or will reset between June 2005 and December 2008;
3. Three percent cash or equity in the home;
4. A sustained history of employment; and
5. Sufficient income to make the mortgage payment.

Note the 3% cash or equity in the home. This is not much. If it is cash, it is most likely not equity given the decline in home prices (as opposed to a decrease in appreciation) so you are left with 100% (or higher) loan-to-value. The implementation of these requirements also concerns me. For example, here is what the FHA website says:

WHO IS ELIGIBLE
To qualify for FHASecure, and include the delinquent loan payments, homeowners wishing to refinance must meet the following requirements:
1. Have a non-FHA insured ARM that has reset;
2. Sufficient income to make the mortgage payment; and
3. A history of on-time mortgage payments before the loan reset.
Homeowners who are current on their conventional mortgages must have sufficient income to make the mortgage payment.

What happened to the “cash or equity” requirement? It isn’t there. Is this an oversight or a reflection of the implementation of this subprime refinance plan? What is this about refinancing delinquent payments? Doesn't this reduce the loan-to-value ratio (making it negative in many cases)? I am cynical, so you know what I think. Here comes the taxpayer bailout. Don't be surprised if sometime in the not too distant future you hear about a MMI Fund taxpayer subsidization plan. Want more? Here is a clip from the Congressional Testimony referred to above:

Key points to consider for FHA reform include:
• As a government program, FHA should serve its targeted borrowers if they are not already being adequately served by the private sector. It is not appropriate for FHA, as a government program, to launch initiatives to expand its “market share.”
• Recent General Accountability Office (GAO) and Department of Housing and Urban Development (HUD) Inspector-General reports, as well as the President’s FY 2007 budget raise serious questions about the Mutual Mortgage Insurance (MMI) Fund’s financial soundness. The most recent available MMI Fund data are for only mid-FY 2005, and these show a serious reduction in the economic value of the fund that undermines its capital adequacy. Mortgage-market trends since then have shown significant weakening, as evident by recent guidance from the federal bank regulatory agencies designed to protect insured depository institutions.
• The FHA should not seek to grow its way out of its current financial problems. Doing so is reminiscent of the actions taken by distressed savings-and-loans during the 1980s.
• The MMI Fund is already taking financial risks. For example, 50% of all FHA loans insured in 2004 had downpayment assistance, with nonprofit organizations that received seller funding accounting for 30 percent of these loans. GAO analysis indicates that these sellers raised the price of their properties to recover their contribution to the seller-funded nonprofit—placing FHA buyers in mortgages that were above the true market value of the house. The Internal Revenue Service (IRS) is curtailing these programs, but the significantly higher claim rates FHA has experienced from these loans will continue for those remaining on its books. Indicative of FHA’s problems is that its delinquency rates are higher than those associated with private subprime loans. Adding yet more risk means potentially profound FHA losses that will heighten the risk of calls upon the taxpayer.
• From a budgetary perspective, the MMI Fund now is only breaking even, but even this is based only on out-dated information. Any shift in the MMI Fund’s financial condition will convert the program into a net cost to taxpayers, increasing the federal budget deficit.

So why didn’t Congress pass this plan? Looks pretty obvious to me. Of course I hope I am wrong and there is no need for a taxpayer bailout of the MMI Fund. Time will tell.

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Taxpayer Bailout Act 1?

I was reading the WSJ today and came across an article here about how the Federal Government is putting up more of the cash for home mortgages. Now, if you have been reading my column up to this point you know that I have been warning of this for a while and that I am concerned that the taxpayers will ultimately pay for the mortgage meltdown (see my October 7 article and here and here).

I decided to do a little homework and I looked up the portfolio and guarantee growth of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank portfolios from December 2006 to September 2007 (I can’t wait for the October numbers). What I found is that on a combined basis, these three entities (the Federal Home Loan Banks are considered one for this) increased their portfolios (for Federal Home Loan Bank this includes portfolio mortgages and investments) by over $640 billion in that nine-month period. Is this a lot? Well, it is an annualized compound growth rate (compounding monthly) of approximately 16%. In 2006 the growth rate was 7.7% for Fannie Mae, 8.4% for Freddie Mac, and 1.8% for the Federal Home Loan Bank. In September Freddie Mac's portfolio grew at a 23.3% rate, Fannie Mae's portfolio grew at approximately 14%, and the Home Loan Banks grew almost 30% from June 30 to September 30. Add to that the fact that total mortgage originations are expected to be down this year by 15%, and we see the massive shift to government program mortgages.

Of particular note is the Federal Home Loan Bank. Federal Home Loan Bank advances have grown from $619.8 billion at December 31, 2005 to $640.7 billion at December 31, 2006 to $824 billion at September 30, 2007. WOW! Just what are “advances” from the Federal Home Loan Banks? "FHLBank Advances. Advance lending is the FHLBanks' main business line. It currently represents about two-thirds of all the FHLBanks assets. These loans, known as advances, are well-collateralized loans used by members [that would be the banks as we know them] to support mortgage lending, community investment and other credit needs of their customers.” That quote is from here. In other words, secured loans to the banks backed by mortgage related collateral (I think). Now, I know critics will say that these are not subprime mortgages. This is just the government utilizing its tools to get the mortgage market liquidity machine running again. Unfortunately, I could not find any detail describing exactly what collateral is backing those additional $183.3 billion “advances” from the Federal Home Loan Banks or the FICO scores of the recently added GSE (Fannie and Freddie) loans, so for now that is open for uninformed debate. What is clear, however, is that the federal government has funded and/or guaranteed, either implicitly or explicitly, approximately $640 billion of mortgage loans since the 2006 year-end.

(Note: None of this includes Ginnie Mae which as of year-end 2006 had total outstanding government guaranteed mortgage backed securities of $410.5 billion. I have been unable to find any quarterly data on Ginnie Mae exposure. And according to HUD, the total dollar amount of single-family home mortgages guaranteed by the FHA was $342.6 billion at the end of September, up from $336.6 billion at the end of December 2006. Not a substantial increase but lets keep an eye out for the October report. You will find it here when it is published.)

The taxpayers are propping up the mortgage and real estate markets and could well be the ultimate big loser in the subprime mortgage meltdown. The data is not available yet to figure this out (at least not to someone with a computer and internet connection). The really scary thing is that most of the problem loans have yet to refinance. Even worse still (if you can believe it) is the idea floating around the halls of the Senate to back jumbo mortgages of up to $1 million with taxpayer guarantees. This is an outrage in my book, and a complete waste of taxpayer dollars even to be considering such a proposal (not to mention the distortions that such a program would create in the market). If you would like more information on this, go here and click on “stupidity”.

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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.

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