Senator Schumer came up with what I think is a really good idea, although I think it could be modified a bit. His idea - rather than charging specific companies fees or equity participation for participating in the bailout program, charge a general insurance fee to all (“large”) financial institutions to provide a fund that would protect taxpayers from eventual losses. I like that idea because it socializes the losses among the financial institutions rather than the general taxpayers. It also resolves the objection Paulson has to protecting taxpayers by charging specific participants. Paulson's concern was that institutions would not participate if there is a cost involved. I think that’s a stretch for taxpayers, but Schumer’s idea isn’t a bad compromise. I would like to see a substantial required contribution into the insurance fund at the expense of dividends if necessary. After all, in the end we want capital to flow to financial institutions on a net basis but we want the ultimate protection to come from the owners of the financial institutions. If we simply charge an insurance fee over time it will ultimately be passed along to taxpayers anyway through higher costs for banking as the fee is built in to the cost structure of these institutions.
Sphere: Related ContentTuesday, September 23, 2008
Bailout Testimony
Chairman Bernanke’s testimony today was astounding to me for two reasons. First, he stated that by using public funds to purchase toxic assets from financial institutions we would gain a better understanding of the hold-to-maturity prices of these assets. In effect, he is saying that the market doesn’t work and only government intervention will provide a price discovery mechanism. I take exception to this conclusion because it is based on internally flawed logic. Creating a market with public funds does not provide price discovery, it provides a new market that is not based on “market” prices at all. Rather it is based on availability of funds from taxpayers and it is ripe for abuse.
Second, Mr. Bernanke said that punitive measures should not be used against institutions that participate in sales to the government because it would limit participation. The only reason this could be true is that the government will not allow these institutions to fail so, rather than participating in this plan financial institutions could blackmail taxpayers for another rescue plan. If the government made it clear that they either participate or fail they would participate. I, for one, am tired of being held hostage by financial institutions.
Treasury Secretary Paulson addressed the lack of oversight provisions in his bailout proposal by explaining that he did not intend there be no oversight in his proposed plan. Rather, he felt it should be up to Congress to figure out how to monitor this program. I figured that to be the case, but I have an exception to this. If the oversight was to be determined by Congress, then why put the following provision into the proposal?:
Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
Finally, I ask again, where is the presentation?!? All I am hearing is “this is my opinion as Fed Chairman” and as Treasury Secretary. Taxpayers deserve better than this. Sphere: Related Content
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.
Sunday, September 21, 2008
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. Sphere: Related Content
Friday, June 6, 2008
Sheriff John Green
I was reading this article in today’s Wall Street Journal, Online Edition and was struck by some of the conflicting messages it highlights for many. I am a student of financial markets and to some extend the Federal Reserve (the “Fed”), so I have a certain perspective on the whole subprime mortgage debacle that is no secret to anyone reading my column. I object to bailouts, whether it be for homeowners or Wall Street, and I have been writing that opinion since last October when I first started publishing my blog. But this article got me thinking about these Philadelphia residents who are being evicted from their homes because they can’t pay their mortgages. Circumstances have now changed, and they have changed because the Fed, no doubt with the blessing of Treasury, has bailed out Wall Street. (For more on this there is another article in today’s Wall Street Journal Online expressing one Federal Reserve Bank President’s concerns about the Fed’s recent actions and the market distortions that can be expected as a result.)
Admittedly bailing out Wall Street is good, in some ways, for everyone as it lessens the risk of a major economic blowup. But tell that to a resident in Philadelphia being evicted from their home who can understandably be thinking “they can bail out those Wall Street executives and their customers but they can’t help me?” Enter the Sheriff, John Green:
Sheriff John Green has spent 37 years in law enforcement. But these days he's best known around town for the law he won't enforce.
With the economy soft and thousands of Philadelphians delinquent on their mortgages, Sheriff Green this spring refused to hold a court-ordered foreclosure auction. His move raised eyebrows on the bench and dropped jaws among lenders and their attorneys, who accuse him of shirking his duty to enforce legal contracts….
Mortgage lenders, servicers and their attorneys thought Mr. Green was acting more Robin Hood than sheriff. "It's not his job to postpone things in favor of certain people," says Michael VanBuskirk, a Philadelphia attorney, who describes the city as a "legal free-fire zone." The city, he says, is "less attractive to business if you can't be certain that the sheriff won't invalidate a contract."
Fed policies to help rescue Wall Street firms have created distortions that have hurt many innocent bystanders in this debacle as savings rates plummet and inflation increases. In fact, the inflation in food and energy prices caused in large measure by negative real interest rates is likely a direct cause of many of the foreclosures as those consumers most at risk can no longer afford to pay all of their bills. So in keeping real interest rates negative to rescue the financial industry Fed policies are hurting many of those who would be hurt in a larger financial collapse anyway and the impact is falling disproportionately to the most vulnerable among us. To hear mortgage lenders now object to the Sheriff’s actions because they favor one group over another is, in my opinion, entertaining at best. In my view, looking to the public policy issues behind this story presents a very different picture than a simple issue of contract law.
I believe we are witnessing the spread of the bailout mentality that has been established by the Fed (and sanctioned by the Administration) in favor of Wall Street. Regardless of the ultimate consequences of allowing major Wall Street firms to fail, the general public will understandably view these actions as favoring those on Wall Street as opposed to them. Let’s do a thought experiment. The first part is to ask: “Why is it good for the Fed to bail out these Wall Street firms by providing credit at taxpayer risk?” The answer, of course, is that to do so will help avoid an economic collapse that would hurt everyone. The second part is to ask: “Why should the Sheriff refuse to sell foreclosed homes at auction?” The answer, of course, is that doing so helps avoid an economic collapse of the neighborhoods involved that would hurt everyone. So, is the Sheriff acting like Robin Hood or following the example set by the Fed? In the eyes of those on the ground I think taking the latter view is easily comprehensible.
The distortions caused by the Fed’s bailout of years of negligent lending activities by Wall Street and all of its subsidiary tentacles has set the stage for redistribution fights such as this one, and I don’t know how you put this genie back in the bottle. So at the end of this piece I have an unanswered question: Is the creativity demonstrated by Mr. Bernanke, with the certain blessings of Mr. Paulson, good for our society in the long run or just another example of how being too creative (ever heard of a CDO squared?) can really mess things up? Sphere: Related Content
Wednesday, June 4, 2008
Oil and Wall Street
I am in Seoul, South Korea on a teaching assignment. I have been here for a week and will be here for another. I haven’t had time to write anything useful, even though there is so much going on. Seoul is a great city and the people I meet here are very warm and kind. I also admire their willingness to stand up in protest as tens of thousands did last weekend in objection to the lifting of the import ban on US beef (which has now been delayed).
Although I don’t have time to write an analysis I wanted to publish a couple of links regarding the impact of speculation in the commodity markets on oil prices. There have been several hearings going on, and some hedge fund managers and others seem to be speaking out against certain trading strategies and deregulation dating back to Enron that could be causing significant upward pressure on energy prices. Here is a link to Michael Greenberger’s Congressional Testimony from this morning that I found stunning. He appeared today before the Senate Commerce Committee together with the well known hedge fund manager George Soros and others. It is not the easiest testimony to read but if you have 10 minutes I highly recommend you give it a go. You don’t need to follow all of the statutory references or read the entire document to get the drift of what he is saying so you can skip a lot of the detail and still get the message. Here is another link to some Congressional testimony by Michael Masters, a hedge fund manager, from May 20, 2008 that I think is also worth a read.
In a nutshell, some informed people believe that a large portion of the run-up in oil prices is a Wall Street phenomenon and federal regulators are simply looking the other way as US consumers are being separated from their savings. If Mr. Greenberger is correct then I believe this is an outrage of gigantic proportions and another monumental regulatory failure by our government. I hope our elected officials get to the bottom of this one quickly either way because the thought of paying $5.00 a gallon for heating oil next winter is bad enough, but to pay that much so that some investors can earn a nice return really twists my insides.
Friday, December 21, 2007
More Subprime From Schumer
I just posted the opinion piece below that relates to how Senator Schumer continues to ignore Wall Street's role in the current mortgage crisis. Apparently, Wall Street and other banks were so hungry to originate mortgages, 23 year old kids were able to defraud them of millions of dollars. The FBI has geared up dramatically to uncover and prosecute those responsible. Here is a quote from this December 21 Wall Street Journal page 1 article:
Fraud goes a long way toward explaining why mortgage defaults and foreclosures are rocking financial institutions, Wall Street and the economy. The Federal Bureau of Investigation says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28%, up from 7% in 2003. Suspicious Activity Reports, which many lenders are required to file with the Treasury Department's Financial Crimes Enforcement Network when they suspect fraud, shot up nearly 700% between 2000 and 2006.
Here is the article I posted last night:
Charles Schumer is at it again. On December 19, 2007 he presented "A Call to Action on the Subprime Mortgage Crises: Putting Common Sense Ahead of Ideology" to The Brookings Institution. I have read those remarks and find that I must discuss them in order to keep the record, as I see it, clear. If you are new to my blog, you may not know that in October I reviewed a report sponsored by Senator Schumer that set up his current proposals. This presentation is the next logical step in the progression of deflecting attention away from the Wall Street participants and moving the burden to mortgage brokers, non-bank lenders, shareholders of Fannie Mae and Freddie Mac, and taxpayers. There is so much to be said about this that I will first provide a summary and then review the Senator’s remarks. If you are not familiar with Wall Street’s role in the subprime mortgage market, I suggest you read my October post first.
Senator Schumer’s presentation contains some things I agree with. For example, I can’t argue against a plan that says borrowers should be informed about the loans they are taking, or that borrowers should have an advocate if they are in default (two of Senator Schumer’s proposals). The problem, however, is that Senator Schumer continues to ignore the primary causes of the crisis and tailors remedies that shift the burden to other parties. According to the Senator, the crisis was caused by homeowners who were duped by unscrupulous mortgage brokers into taking out bad mortgages. To fix the problem requires regulation of those bad brokers and refinancing hundreds of thousands of loans even if it means putting taxpayers on the hook and even if these borrowers were not first-time homebuyers. I’m sure there are unscrupulous mortgage brokers and that some borrowers didn’t fully understand the terms of their mortgage. But is it the root of the problem? The Senator completely ignores the role of Wall Street and the subprime mortgage fee-fest that fed many of his campaign contributors over the past five years. He also ignores the role of the Federal Reserve and its failure to do anything to prevent this long developing crisis. Of course, his political motives for this are obvious and I believe he really does understand the origins of this problem. If not, I suggest he read some of the recent reporting to educate himself. This Businessweek article would be a good place to start learning about Wall Street’s role (the link only goes to page two – click back a page to start). He can also read this Fortune article that discusses how the Federal Reserve ignored this problem for too long.
I will give the Senator credit for at last acknowledging the issues relating to credit rating agencies and the conflicts of interest that pervade the securitization of subprime mortgages (as well as everything else). Of course, Congress was warned of these problems in connection with Enron as far back as 2002 and again in 2006 but chose to ignore these warnings. We are now paying the price for Congress’ failure to act.
Finally, Senator Schumer claims that Chairman Bernanke supports his plan to raise the caps for loans made by Fannie Mae and Freddie Mac (the GSEs) to include jumbo loans. I have two problems with this. First, Senator Schumer believes that the GSEs should use their lending capacity to refinance subprime loans on homes that cost, potentially, seven figures. He believes they should do this even though the GSEs have said refinancing these subprime loans is not profitable for them. Of course, these entities were chartered to help provide affordable housing and are owned by shareholders, but apparently that no longer matters. Let the funds be used for the well off and the shareholders pay the price.
Second, Senator Schumer states that this proposal has the support of FED Chairman Bernanke. I am not sure about that. In fact, I wrote about the exchange between the Senator and the Chairman regarding this issue. What the Senator does not state is that the Chairman did not give his support to this plan of simply raising the caps. Rather he was asked if the government could do something like this and he said yes. He said the GSEs could make loans up to $1 million and have the federal government guarantee them. That could be done. However, it would require a large political price because these would be taxpayer guaranteed loans in order to protect the GSEs. You can read about that exchange here – click on “stupidity”. The Senator does not mention anything about the taxpayer guarantee part of the exchange. If this is the “support” from the Chairman that he is referring to then this is a shameful act of political maneuvering and misinformation, and Senator Schumer should, in my opinion, clarify this point. It was obvious when he set the Chairman up for this. So obvious that I wrote about it.
At the end of the day, Senator Schumer apparently believes that taxpayers and shareholders of the GSEs should pick up the tab for this Wall Street mess, mortgage brokers and non-bank lenders should be regulated, but the Wall Street banks need not even be mentioned. It makes me wonder who is actually running Congress. It’s as good as money can buy.
With that introduction and summary, here is my review of Senator Schumer’s remarks.
Senator Schumer’s remarks begin by bashing the Bush Administration’s economic policies as too ideological and irresponsible. I agree with him, especially when it comes to tax policy and saving for baby boomer health care. His next focus is on what he calls the “Four Myths Surrounding The Subprime Crises.”
His first myth is that subprime lending led to millions of brand-new, first-time homeowners. He states that according to the Office of Comptroller of the Currency, only 11 percent of subprime loans went to first-time buyers last year, so the majority of subprime loans were for refinance or buyers who had already owned a home. He then goes on to conclude: “Too many of these borrowers were talked into refinancing their homes to gain additional cash for things like medical bills.” He provides no support for this claim and implicates mortgage brokers as evildoers out to rip off poor desperate homeowners. He then goes on to say that “too large a percentage [whatever that means] went to investors and speculators.” This point is also without support, but is worth remembering because when Senator Schumer speaks about why we need to help out these poor subprime borrowers he is clearly not speaking to this “too large a percent” of subprime borrowers. What is really amazing is that Mr. Schumer goes on to spend an entire page of his presentation talking about how the Paulson rate freeze plan will not help enough borrowers. Which ones? He also ignores steps that have been taken already to help some 300,000 borrowers through FHA programs such as FHASecure and the pending FHA Modernization Act. The spin is so bad it hurts.
His second myth he calls “The Myth of the Unqualified Borrower”. I love this one. He claims that a study of credit scores clearly indicates that many subprime borrowers could have qualified for prime loans. He fails to consider, however, any debt-to-income or loan-to-value criteria (or any other criteria for that matter). So in fact we really don’t know whether these people could have qualified for a prime loan or not. All we know is that their credit scores were in a range that could possibly have qualified them for some mortgage amount. The other thing about this “myth” is how it is in direct contrast to all of the hype we have been hearing from HUD and the FHA. The FHA Modernization Act, supported by the Senate, lowers the underwriting criteria for FHA guaranteed loans. If all of these borrowers could qualify for prime loans, then why do we need to lower the underwriting standards to refinance all of them into FHA loans? Sounds like BS to me. You can get more details on the FHA Modernization Act from my post on it, but it is enough to understand that the thrust is to reduce the amount down from 3% to 1.5% and raise the size of the loan that can be financed. (The FHA role in refinancing hundreds of thousands of subprime loans is also a potential problem that could lead to a taxpayer bailout.) The Senator concludes this “myth” by stating “it’s clear that many subprime borrowers have the financial foundation for sustainable homeownership, but may have been tricked into unaffordable loans by unscrupulous brokers.” There we go again – it’s all the fault of those brokers. Did the Senator ever consider that maybe these borrowers wanted more home with less down and pressured the brokers to come up with a financing arrangement to satisfy their demands?
Myth three is “The Myth that Borrowers Can Easily Obtain Perfect Knowledge of The Terms of Their Mortgage Loans.” Well, if he is referring to the fact that the rate varies and the payments are likely to go up, borrowers can easily obtain and understand that information. The other thing borrowers generally understand is that if they cannot make their payment they will lose the home. According to Senator Schumer, however, most people are too stupid to understand this and so we must step in to protect them. Now, I wonder which people these are. Are these the ones who had to refinance to pay medical bills or the “too large a percentage” of investors and speculators? No, these must be the ones who were duped by the unscrupulous brokers. Yah, that’s it. How many of those are there again?
Myth four is that the free market will fix everything. I agree with his supposition that free markets do not fix everything, but stupid policy doesn’t fix everything either. If the Senate had listened to all of the warning signals it got about the housing bubble and leaned on the FED a little more, or about rating agencies and acted on that, then much of this mess probably could have been avoided. Instead, the politicians (pretty much all of them) stuck their heads in the sand because they didn’t want to throw cold water on a very popular housing boom (especially when their contributors were making a fortune from it). Glass houses and all of that.
The four myths are followed by warnings of impending doom. In fact, according to Senator Schumer “we are facing an economic downturn that we haven’t seen in this country since the Great Depression.” Yikes! If this is true I’m really glad I took most of my money out of long positions in equities! He goes on to point out that “a 10 percent decline in housing prices could lead to an overall $2.3 trillion economic loss…” That would be bad, but less than half of the approximately $5 trillion in losses from the dotcom bubble bursting. I agree this is not good for the economy, but the Great Depression? I hope not.
The presentation ends with seven policy options proposed by Senator Schumer to address the subprime mortgage crisis. Here they are, in a nutshell:
1) Provide more mortgage counselors to serve as borrowers’ advocates. OK, not bad.
2) Raise the portfolio limits for Fannie Mae and Freddie Mac so they can refinance subprime loans, even though these entities have said this would not be profitable for them. Also raise the cap on the loans they can make to include jumbo mortgages (no mention of the government guarantee part). I don’t like these, especially when the GSEs are saying they want no part of it.
3) Allow states to issue tax-exempt bonds to refinance subprime loans. As long as it’s not my state tax dollars guarantying the loans, fine.
4) Modify the bankruptcy code to change the protection mortgage lenders currently enjoy – mortgage loans are exempt from restructuring in bankruptcy without the consent of the lender. OK, but this could make mortgage loans more expensive in the future. Senator Schumer understands this, and acknowledges that this could be limited to only existing loans. This one gets a maybe and a ho-hum from me. If the lenders will be better off cutting a new deal they will.
5) Enact new regulations covering practices by mortgage brokers and non-bank lenders, including limitations on the types of loans they can make. Remember these brokers and non-bank lenders? They are the bad guys in all of this, according to Senator Schumer. Notice how these are mortgage brokers and non-bank lenders, and not banks or investment banks. If you didn’t click on that link to Senator Schumer’s top contributors you may not get this point as clearly. Here it is again. The Senator simply ignores the role of Wall Street and the investment banks in this crisis and makes no mention of any remedy targeted to them.
6) Create an easy to read summary of mortgage terms for borrowers so the big bad mortgage brokers can no longer dupe them into bad loans. OK.
7) Finally, Senator Schumer proposes to closely examine the role of rating agencies in all of this. Hooray! He is finally getting warm. Sphere: Related Content
Sunday, October 28, 2007
Dirty Little Secrets of Subprime
I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: http://jec.senate.gov/Documents/Reports/10.25.07OctoberSubprimeReport.pdf. Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:
1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?
2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.
3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.
“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”
At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:
“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.
4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.
5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:
“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”
Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257. You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here: http://polecolaw.blogspot.com/2007/10/public-and-private-bank-regulation-or.html
6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: http://polecolaw.blogspot.com/2007/10/maybe-stalling-is-viable-master-siv_19.html and here: http://polecolaw.blogspot.com/2007/10/i-did-not-have-sex-with-that-siv.html. It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.
I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.
Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.
All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html . Shell games at the highest levels of government.
Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here: http://polecolaw.blogspot.com/2007/10/subprime-socialization.html
Looks like all the lose ends are getting tied up nicely.
Friday, October 12, 2007
The Rich Get Richer - for now
News out today about growth in income inequality tells us that through 2005, the wealthiest among us got even wealthier. The rich got richer, the poor poorer, the middle closer to the bottom. Actually, that’s not really what the data show. The true message is that a higher percentage of the total of all incomes went to the top 1% of the earners. Whether they kept any of that income is not in the data, so they may or may not be “wealthy.” If you want the details, you can find them all over the wires, including on this blog: http://commonsenseforecaster.blogspot.com/2007/10/rich-keep-getting-richer-this-short.html?referer=sphere_related_content .
The income data explain why the middle class is uneasy about the economic outlook while others feel everything is just fine. The share of the national profits that went to high earners grew (for them, everything is fine), which means the share that went to everyone else fell (things are not so good). Some argue this is because those with high-level skills can gain scale economies from these skills through the globalization of the economy (the argument from the right). Maybe. Or maybe the political machine has been used to benefit high earners more than low earners (the argument from the left). I think some of both, plus some other factors that someone should research (and I am sure someone will).
As I began analyzing this news, my mind went off in so many different directions that I have a scratchpad of notes that could provide blog fodder for a week. Issues include tax policy, executive compensation, national competitiveness, social fairness, immigration, and so on. I decided that I should focus on one discrete issue at a time, and picked the economies of scale argument as a starting point. (Maybe I’ll come back to some of the others in another post.) Here goes.
Truth be told, I kind of like the economies of scale argument. It makes some intuitive sense to me and relates to other issues I have written about lately. If your skills are suddenly in demand from many more customers (the world is flat!) and nobody else has learned to do what you do (or has the required resources at their command), according to the laws of supply and demand your skills should be worth more. If this is the reason for the higher share of income going to the wealthy, then the top earners better watch out! You know what happens in a global free market? Price (the high price of your skills) signals profitable demand and, as a result, people allocate resources to learning to do what you do. Supply goes up, price (the value of your skills) goes down. Right now you may be very valuable, but as those millions of students in China and India learn to do what you do, you may become less valuable.
It seems to me that this trend is already evident. Skills that take less time to learn, such as manufacturing and programming, have already moved to other markets. Just ask the UAW about this. I believe the same trend is happening in some areas of the high-earner industries, although many are in denial. It may just be that it has taken longer for global competition in high earner industries to develop due to lags in education or financial infrastructure.
Lets take Wall Street as an example, where high earners abound. There is concern on Wall Street that the United States is becoming less competitive in the business of underwriting. Our market share is in decline. What could be wrong? Well, Wall Street rallied the politicians who commissioned studies to determine why we are losing market share. They concluded that there are lots of reasons why, but THE FACT THAT WALL STREET CHARGES ABOUT TWICE THE FEES AS CHARGED IN OTHER MARKETS has nothing to do with it (they are in denial). I have written on this before, and if you would like the full commentary you can find it here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html. I suspect someone who writes full time will fully research this issue at some point, and I look forward to the result.
Wall Street is used to charging high fees because for decades they have had the only game in Globaltown. The global market for financial resources has, however, begun to mature and Wall Street is no longer the bouncer at the only club in town. If you don’t like the cover charge you can go down the street (or across the pond). As capital accumulates in other markets, financial talent follows it. These markets will naturally compete with our markets, and more competition leads to lower prices. Supply and demand - remember that’s why Wall Street salaries are high to begin with. So why is Wall Street losing market share? Because Wall Street charges too much given its loss of the monopoly it has had for so long. Does this sound like Xerox? Yup.
To stay competitive Wall Street will likely need to lower its price and this means less money for the high earners on Wall Street. So it appears to me that Wall Street may just be a few years behind Main Street. For other professionals such as corporate executives who reap huge benefits from running concentrations of shareholder investment, it will probably take longer to suffer any competitive impact. They are, to some extent, insulated from competition for their positions because they have some control over the process (that argument from the other side). Likewise, attorneys (another high earner group) still have barriers to entry as against global competitors because attorneys must be admitted to practice in the United States. But if Wall Street lowers prices, they may put pressure on their lawyers to follow suit. I am beginning to feel some pain.
Since Wall Street makes up a large portion of those top earners, the latest trend in earnings may soon reverse course. The reported data is from 2005, and I wonder what it will look like for 2008.
Back to the scratchpad. Maybe I’ll wait and try to decipher some of the (other) inevitable babble that will follow this news.
(c) Mark Palermo, 2007
Thursday, October 4, 2007
A Tale of Two Cities: New York and Detroit (Wall Street Competitiveness)
A Tale of Two Cities: New York and Detroit (revised)
The other day I wrote about the recent UAW/GM contract negotiations, and some commentary about the outcome. The bottom line of my piece is that US autoworkers are being forced down the standard of living scale by a shift in power from labor to business, and the main argument used to support this shift is competition from the global economy. Whether this is actually the case remains unclear, but it is certainly the reason given by business and the media in general for the decline in US manufacturing job compensation in Detroit. (For more on that see my post.)
I was reading an article in The WSJ Online edition today regarding Sen. Jeff Sessions promotion of a bill favoring financial institutions over accepted intellectual property rights, and I was struck by the way the rules are changed when the “victim” is an industry with very strong ties to the rule makers. (Of course, we all know there was gambling at Rick’s, but at least it was in the back room.)
Being interested in this example of the imbalance of power, I began to poke around a little, and came upon a recent report published by The Senate Republican Policy Committee which can be found at http://rpc.senate.gov/_files/061907competitivenessDK.pdf . The report (the “Senate Report”) is entitled Excesses Threaten U.S. Competitiveness, When Excess Damages Success: Have Litigation, Taxation, and Regulation Gone Too Far? This report, dated June 19, 2007 explains that US banks (Wall Street) are losing competitiveness to foreign markets. The conclusion of this report is:
"The declining competitiveness of the United States’ capital markets may be a canary in the coal mine of a much deeper problem. The trends of excessive regulation, litigation, and taxation in our capital markets are being replicated in other parts of our economy. Unless Congress, the Administration, and the business community create a clear and unified blueprint for maintaining our nation’s competitiveness, capital and jobs will continue to move overseas."
One of the major resources relied on for this finding is a report (the “McKinsey Report”) generated by McKinsey & Company for Mayor Blumburg of New York and United States Senator Charles Schumer entitled Sustaining New York’s and the US’ Global Financial Services Leadership which can be found at http://www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf . Citing this report, the Senate Report states that
“Regulatory and litigation burdens are two major drivers of declining
competitiveness for capital markets.
In a large survey of industry leaders, McKinsey & Company, a premier management consulting firm, found that about two-fifths of CEOs surveyed expected that New York City—and by extension the United States—would become less attractive as a place to do business. McKinsey found that what clearly dominated these views were fears that two factors would not be present: 1) a fair and predictable legal environment and 2) a strong but responsive regulatory environment.”
In other words, the problems causing New York banks to lose market share are taxes, the lawyers bringing too many frivolous lawsuits against companies in the US, and over-regulation of US companies. This is causing companies to go overseas and sell their stock in foreign markets. Now, to be fair, there is some merit to these claims, and I am all for rationalizing our regulatory systems. There is a price to be paid, however, for transparency and safety and I do not believe we should go too far. (This is the stuff of a future blog piece.) All of this got me thinking about the competitiveness issue for investment banks. Being a former analyst and having just written a piece regarding global competition, the first question that came to mind was how much of this competitive loss is being caused by these factors as compared to good old competition from lower cost global competitors?
Well, I reviewed the McKinsey Report (though I will admit I did not read all 142 pages of it in its entirety), and was startled at what I did not find. What I did not find in all of the 142 pages of the McKinsey Report was a material discussion of the impact of lower fees charged by banks in other countries having an impact on the competitiveness of New York banks. Not to digress, but how can one of the premier consulting firms on the face of the Earth, engaged by The City of New York and the United States Congress, produce a report that purports to study why US Banks are losing competitiveness to banks overseas not consider the prices being charged by overseas competitors? Either the researchers were instructed to report only on select issues, or the research is completely flawed. You be the judge. Here is what they had to say about the fees:
“Another explanation put forward by some commentators as to why international issuers are staying away from US equity markets is the fact that the underwriting fees charged by investment banks are significantly higher for US listings than in competing markets. One study reveals that underwriting fees for non-domestic listings were 5.6 percent and 7.0 percent on the NYSE and NASDAQ, respectively, compared with just 3.5 percent on London’s man market. But while such figures may seem significant when looked at in isolation, their importance relative to the overall value of an IPO s fairly low, and easily outweighed by the benefits of a more liquid market and superior execution. Surveys conducted for this report corroborate this thesis: when asked to rate the importance of underwriting fees in the overall process of listing a company on the public equity markets, survey respondents ranked underwriting fees last among seven factors, with just 4 percent judging the issue ‘very important.’” (See pg 49 of the McKinsey Report.) (Note that they did not site the LSE Report discussed below here, as that would show a larger fee discrepancy.) Who are these respondents who deem it not important that the fees charged are almost double? “… a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 75 additional global financial services senior executives through a separate on-line survey.” (See McKinsey Report pg 8.) So the people who say the vast differential in the fee is not important are the very people running these businesses and charging these fees. Sounds conclusive to me.
As it turns out there has been a study that identifies the fee differentials between international markets for investment banking services. I found it in a footnote to the McKinsey Report (so they looked at this report). You can find the report (the “LSE Report”), published by The London Stock Exchange, here http://www.londonstockexchange.com/NR/rdonlyres/B032122B-B1DA-4E4A-B1C8-42D2FAE8EB01/0/Costofcapital_full.pdf .
The LSE Report finds "Gross spreads of IPOs on the US exchanges are found to be highest, averaging 6.5% for the NYSE sample and 7% for Nasdaq IPOs. In comparison, median spreads of IPOs on the LSE’s Main Market are 3.25% and those on AIM somewhat higher at 4%. Thus, there is a cost saving of three percentage points for a UK transaction compared with a US transaction." (See pg 18 of the LSE Report.) How much is 3%? Well, for the over $4 billion Blackstone initial public offering, that would be at least (.03X4,000,000,000) $120 million! That's just the excess of US over other markets. How does this compare to the first year’s cost of compliance with Sarbanes-Oxley? That cost is estimated at $4.4 million according to a 2005 survey cited in the LSE Report (LSE Report pg. 33).
So let’s review. The fee charged is by far the largest component of the cost of issuance in the US, and fees in the US are by far the largest among international competitors. This fee differential is not, however, why US banks are losing competitiveness. The reason is the cost of these darn law suits and regulations that companies in the US must put up with. That’s the New York tale. The Detroit tale? US workers at GM, Ford, and Chrysler must reduce their standard of living because we cannot compete with lower cost labor from foreign competitors. My conclusion? Perhaps Wall Street should lower the standard of living of its employees so that it can better compete with the foreign competition just like those on main street in Detroit are doing. Otherwise, stop spending my tax dollars on stupid reports that ignore the most obvious issues. Now don’t get me wrong. I am all for US competitiveness. We need to continue to study our competitiveness and actions we should take to ensure our future. I, however, would prefer to do so with full information applied across all of the US constituents rather than targeted reports used to influence the rule making process for the benefit of those in power (which is my interpretation of the McKinsey Report).
PS – if you think the higher fees charged by the New York banks has to do with the cost of living in New York, forget it. The studies show that is not the case.
