What should we rescue? And what can we rescue?

October 5, 2008 at 5:06 am | Posted in economics, Housing, regulations, Uncategorized | Leave a comment
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The housing and related market has several layers to it. There are a whole lot of individual mortgages. Many of these are sensible mortgages on affordable terms made to people who have been reasonably prudent. Some of them were risky, for a variety of reasons, including individuals who got greedy for more house than they could afford, or lenders / brokers who put buyers into unaffordably large mortgages or with onerous terms. Some of the risky mortgages have defaulted or are otherwise in trouble, and things will continue to worsen for some time.

Tightening credit norms are making it difficult for buyers to buy homes now, even as prices are slipping and inventory is rising, further causing prices to spiral downward.

Most of these individual mortgages were put together into pools of mortgages, and investors bought securities created out of these pools. The idea is that each mortgage-backed bond represents tiny fractions of thousands of mortgages, and so should be safe even if a few of those mortgages go bad. These securities are then broken up into tranches, with the worst tranches the first to absorb any losses from defaults, and the best tranches only taking a loss if the lower-ranked tranches were wiped out.

So far, so good. The value of these mortgage backed securities is similar to the value of the mortgages underlying these securities. But then, we add derivatives on these MBS’s. There is no real limit to the number or value or complexity of derivatives. We can bet that one security will be worth more than another, or that the defaults in one security will exceed (or be below) a certain level, or a host of other such bets. And we can then create securities that pay off based on the outcome of other bets. The size of the derivatives market has been estimated at nearly $700 trillion – A thousand times the size of the proposed bailout, and ten times the size of the global economy.

I guess thats a bit like horse racing – The amount of money that changes hands based on the outcome of a single race is many times the amount of money spent by the breeders, or the prize money they may win.

I think that if the bailout money was used to buy mortgages, the price support is more likely to buoy the prices of the derivatives, than if the attempt was to either support the derivatives directly, or to rescue the bank after the derivatives caused big losses. After all, with the money, one could buy up over 5% of mortgages, and thus support the value of derivatives that depend on the value of the underlying mortgage for their own value, or make the tiniest dent in the derivatives market. If the derivatives got support from underlying values, there wouldn’t need to be as much of a writedown.

Obviously, every trade has a counterparty. For everyone who bought a derivative, someone sold it. If the value of the derivative tanks, someone loses big, and someone makes a killing. Supporting the derivatives market via underlying mortgage action will reduce the change in the derivative value. People won’t lose as much, or make as much.

Clearly, this is distortionary – If the investors believed the government would rescue the derivatives, they would not have made the same trades. But I think that the only area where a rescue could work is at the underlying mortgage level – and if derivative investors see bets they called correctly going against them because of the rescue, I feel for them, but still think the economy is better off than if the bailout money was used to rescue the financial sector from the results of mortgage defaults.

My proposal for the rescue

October 3, 2008 at 2:23 am | Posted in credit, economics, Housing, regulations | Leave a comment
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I’ve said all this before, but I’m collecting all my thoughts in one place with the following article.

The housing crisis has caused a series of writedowns, leaving the financial sector seriously undercapitalized and averse to further lending – even if their balance sheets permitted much lending. The resulting unwillingness or inability to lend money is threatening the entire economic system, as otherwise sound businesses find themselves unable to raise or refinance debt.

While a number of ad hoc actions have already been taken, with a major bailout plan proposed, they have tended to focus on supporting financial institutions while not tackling the real housing problem or the value of the actual mortgages underlying the mortgage backed securities and various related derivatives. However, as mortgage defaults increase, the value of these securities falls, often precipitously for some MBS tranches and for some derivatives.

I would like to propose an alternative workout that could simultaneously support the institutions while also providing some relief to Main Street.

I propose creating an agency empowered to buy near-foreclosure mortgages from the banks / debt holders, at a modest 3-5% discount to the outstanding principal balance, provided the homeowner agrees to a) transfer over the title of the property to the agency without a foreclosure and, b) continues to reside in the property as a tenant for at least a two year period at a reduced rental rate.

This would serve two purposes – First, by taking distressed mortgages off banks’ balance sheets at or near par value, this recapitalizes the banks and restores equity – basically by overpaying for the mortgages at taxpayer expense. You could prop up the prices of all mortgages, and thus restore the health of all balance sheets, as opposed to current policy of letting the value of mortgages slide, and then rescuing banks piecemeal, as they fail, without supporting underlying mortgage prices. Second, by keeping the erstwhile homeowner in the property, it reduces the supply of vacant homes -and the attendant security / vandalism problems for the neighborhood and unsold / auctioned / bank-owned home inventory, which eases the downward pressure on home prices, hopefully keeping more people in their homes.

How would this be structured, and how much would it cost? Here’s a back of the envelope calculation with some simplifications: Let’s say home ownership declines from near two-thirds of all households down to a 64% historical average level, which would translate into 3 million fewer home owners, with an average of $300,000 in outstanding debt (above the $203,100 median home price, to be conservative, as defaults are more likely in urban and suburban areas). At about a 5% discount, these mortgages could be purchased for $850 billion in capital ($900 billion face value). This money could support home prices and help keep other homeowners in their homes.

The homeowner must commit to a two-year rental on the property to be eligible for this scheme, with the rent set at a level that can recover the cost of capital for the agency. I assume a 4% cost of capital, the average tenant with a $300,000 loan would pay $12,000 a year towards capital cost. Assuming a $4000 annual property tax, the monthly rent could be set at just over $1300 for this average property – almost certainly more affordable than their current payment. If the tenant can make payments for two years, they avoid a foreclosure on their credit record. This brings the agency $36 billion in annual cash inflow, after paying $12 billion in property taxes (thus bolstering the local communities as well).

Some tenants will still be unable to make these rent payments on time, and will fall behind – Let us assume 20% of them fall behind, on average halfway through the two-year rental period. This would create a $10 billion shortfall in rental cash inflows over the two years. While these places can be rented to another tenant, let us assume they are sold at 25% below the debt value. Since the properties were bought at a 5% discount, the actual loss to the agency would average $60,000 per home, or $36 billion in capital.

Finally, if the remaining properties were sold after twoyears at a 15% loss to the debt value (10% loss to purchase price), the agency would lose a further $72 billion. In addition, the agency would incur various legal, administrative and property management expenses. Let us assume the annual cost to manage the entire process is 15% of the annual rent, above conventional propoerty management fees, considering the complicated transactions and higher default risk. This totals to about $10 billion. The total cost comes to $128 billion, or ~$56,000 per acquired house. Private sectors investors could be attracted to this scheme either in place of a federal agency, or in competition with it, by offering a $43,000 (14%) taxpayer-paid subsidy per average house, and acquiring it a 5% discount to outstanding principal. In fact, the government could auction the subsidy, granting the contracts to bidders who require the lowest percentage subsidy.

The government would need to create the legal framework, structure and guidelines to ease acquiring mortgages as well as to create a new “tenancy” alternative to foreclosure.

With a capital outlay of $850 billion, and a conservatively estimated cost of $128 billion to the taxpayer, this scheme can help homeowners in trouble, support housing prices and ease excess inventory, and support the mortgage backed securities’ and derivatives’ prices, restoring bank balance sheets. Hopefully, this could restore liquidity and some return to normalcy for the credit markets and the broader economy as well.

Uh-oh! The bailout failed to pass…

September 30, 2008 at 4:40 am | Posted in credit, economics, Housing, regulations, Stock market | Leave a comment
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While I am not a fan of the bailout proposal, and have blogged about an alternative plan that incorporates support for homeowners – both those in trouble and those who might benefit from a price / inventory stabilization – here, something certainly needs to be done.

The NY Times cover story says it all –

Defying President Bush and the leaders of both parties, rank-and-file lawmakers in the House on Monday rejected a $700 billion economic rescue plan in a revolt that rocked the Capitol, sent markets plunging and left top lawmakers groping for a resolution.

It seems clear to me that the US economy, and the financial sector is clearly undercapitalized and does not have the wherewithal to absorb the kind of massive losses we have seen and are likely to continue to see. Wall Street needs help, and it needs help soon.

Analyzing the cost of a tenancy workout for the credit crisis.

September 25, 2008 at 5:35 am | Posted in credit, Housing, regulations | 3 Comments
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Maybe we can have an agency or a fund that buys off foreclosed properties from banks, and allows the erstwhile owner to continue to occupy the place as a tenant (I’ve written about this here) . This would take the toxic mortgage off the bank’s balance sheet, and, by buying the mortgage at face value, or at a slight discount to face value, it would basically rescue the bank’s capital by overpaying for the debt. This, in turn, may support the mortgage market and the derivatives on these mortgages.

Knowing that the bad mortgages – those approaching foreclosure- can be sold at near-par (I suggest a 3-5% discount) would support prices of all mortgages.

In the meantime, the agency could convert the foreclosure process into a tenancy process – Ownership transfers to the agency, the previous owner now pays rent (at a rate somewhat lower than the mortgage payment, but one which covers the capital cost of the money the agency used to acquire the place), and, if s/he makes the rent payment regularly for a certain period of time (say two years – after all, plenty of renters lock themselves into a two year lease), they can then exit without a foreclosure on their credit record.

How much will this cost?

Lets try some round numbers to estimate this.

Two-thirds of about 110 million households own their homes, while the historical rate has been about 64%. The difference is about 3 million households, or about 4% of current homeowners. While the cycle could take homeownership even lower, I think rescuing homeowners would support the market to the point that perhaps prices and, more importantly, home ownership does not dip too far below this level.

The median home price in August 2008 was $203100, down from $224,400 in August 2007. However, we can assume that the median foreclosure may be above this amount for a couple of reasons – 1. Foreclosures are more likely in higher priced areas, and urban / suburban areas, and 2. The slowdown is worse in higher priced areas such as Southern California. Foreclosures started off in below-median-income households, but I think they are moving up the income ladder.

So lets assume the average mortgage on a foreclosed home is $300,000. This translates into about $850 billion in capital to purchase these foreclosed homes, at a 5% discount. Putting this money to work may help support pricing and keep other homeowners in their homes despite a decline in house prices.

I have previously estimated that the fall in home values could leave aggregate mortgage debt about $1.8 trillion above home values, so a real estate (RE) fund that buys up to $850 billion in property and converts them into rentals could make a serious dent in the problem. I wouldn’t worry too much about the derivatives market if we can bring some stability to the underlying real estate market – the derivative losses may be limited somewhat by the underlying stabilization, and anyway, I would rather use taxpayer money to support both Wall Street and Main Street, not just Wall Street.

Assuming a 4% cost of capital for the RE fund, and a $4000 median property tax, the median rental on these properties would be ~$1350 per month. We would have some people falling behind on the rent as well, so there would be losses on that as well, but I’m guessing that by stabilizing the market, and by charging rent that is probably considerably below what the tenant was previously paying in monthly installments, we might make it easier for the tenant to make these reduced payments.

So this fund would need $850B in capital, hopefully be able to largely produce returns that meet its cost of capital, and have assets that would eventually be sold to recover a fair amount of the principal, with a holding period of 2-5 years. Administratively, this would be a tough challenge to manage, but one could contract with property management agents to take care of some of these issues.

The ultimate cost to the tax payer may be a relatively small portion of the real estate fund. If we assume that about 20% of tenants fall behind on their payments (a conservatively high figure) during the two-year lease period (at a median of 1 year into the lease), that is just a $10 billion shortfall in lease collections. Lets say these 20% of properties are then sold (instead of being rented out to someone else) at a 20% loss. That is a 4% loss to the fund = $35 billion. Finally, assume the rest of the properties are eventually sold at a 10% loss. That would be $70 billion.

By my estimates, the total cost of a tenancy workout would be $115 billion, spread over several years. This is assuming the taxpayer-funded RE fund would actually purchase 3 million homes. But why not bring in private players who would get government backstop funding, based on these assumptions? Let them buy the properties at a 4% cost of capital, manage the process and the landlord -tenant relationship, and participate in the gain / loss relative to these back of the envelope calculations?

I would love to see a plan built around some such framework, and I would support the use of taxpayer money for this purpose.

Wall Street bailout: Not enough, and, without equity, too much of a giveaway?

September 25, 2008 at 3:57 am | Posted in credit, Housing, regulations | Leave a comment
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Bush appeals to Americans to support the $700 billion rescue effort.

I’m afraid, though, that this rescue will not be last of it. As I have examined elsewhere, a 25% drop in prices, which is not improbable, would leave home values $1.8 trillion below mortgage debt. The finance sector is undercapitalized, and is in no position to absorb these losses, or the losses on the derivative positions on these mortgages.

In any case, I oppose overpaying for mortgage assets without the government taking equity stakes in the businesses it rescues. That way, some of the overpayment may eventually be recovered. If it isn’t, at least the taxpayer won’t be worse off. Equity is basically the call option on the underlying health of the economy and financial system – If, as the government insists, the fundamentals are better than current panic conditions suggest (but bad, nonetheless), there is no reason why the government would not want equity as a call option on the bet that they are right.

Unless the rescue includes a workout to keep people in homes (I’ve explored this idea here), home values will keep falling, and the inventory of unsold and bank-owned homes will continue to rise. Not that this wouldn’t happen with a owner-to-tenant transition, but the price trough and the inventory peak may be muted somewhat by taking the urgency out of the foreclosure sale.

One likely consequence could be rental prices would fall as well, hurting landlords, but benefiting tenants, saving them money which they can use elsewhere. Which might be a good thing for broad sections of the economy.

Can we know what regulations were appropriate pre-credit crisis?

September 23, 2008 at 4:26 pm | Posted in credit, Housing, regulations | Leave a comment
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I don’t believe in much regulation, but we need some framework. And what isn’t regulated (just a little bit) could (and often does) need rescuing.
Its easy to figure what should have been done after the fact. The challenge in doing it right before the fact is two fold –

First – For a variety of reasons, the US thinks home ownership is good and must be encouraged. Therefore there is a reluctance to tighten the screws too much if that means undermining the home ownership objective. So, good luck trying to tighten regulations when lobbyists (and, unfortunately many in the government) would be very vocal about how Congress is denying the American Dream. Yes, Mr. Greenspan, I mean you.

Second – If you come to me to borrow money, and I am willing to lend it to you, without too much inquiry into whether you could pay it back, or what your resources and income are, arguably, that is my lookout. Government has no business legislating caution or prudence or intelligence or even basic common sense on my part. Survival of the fittest will basically take me out of the business pretty quickly.

I do think things were overly lax. But I’m not sure just where the regulation should have come in. I mean, yes, Lehman was overleveraged, true, but some of that excessive leverage is actually a result of asset write-downs destroying equity, so it is an outcome of the credit crisis, not a cause. But the leverage was public knowledge. Equity investors should have known this was a risk, as should creditors.

You can regulate disclosure. You cannot regulate intelligent responses to that disclosure.

So the best that could have been done would have been to have tougher lending standards. Perhaps more responsibility for consequences on the part of the rating agencies would have ensured a more rigorous examination of their models. Perhaps tighter capital norms. There are a few things that could have contained this problem (more on this later).

But ultimately, if a few firms went bankrupt, and others stopped trusting S&P and Moody’s, the taxpayers may have had a few laughs about Wall Street’s follies and hoped that the bankers learned a lesson.

It is only because, after the fact, we realize that the system is at risk that we want to rescue the system, and care about what it would cost us to rescue it.

Wall Street is now Bank Street

September 22, 2008 at 11:07 am | Posted in credit, regulations, Stock market | Leave a comment
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Goldman and Morgan Stanley – the last remaining independent investment banks – have now requested they be treated like traditional banks, with all the regulations, oversight and capital requirements. While this is voluntary, it acknowledges the risk in the traditional model, and brings to a close the era of investment banks (created by the Glass Steagall Act after the Depression). Glass Steagall was slowly dismantled in the 1990s, but now, it is completely rolled back.

NYTimes has the story here

Goldman Sachs and Morgan Stanley, the last big independent investment banks on Wall Street, will transform themselves into bank holding companies subject to far greater regulation, the Federal Reserve said Sunday night, a move that fundamentally reshapes an era of high finance that defined the modern Gilded Age.

As bank holding companies, the two banks, whose shares have lost about half their value this year, will have to reduce the amount of money they can borrow relative to their capital.

That will make them more financially sound but will also significantly limit their profits. Today, Goldman Sachs has $1 of capital for every $22 of assets; Morgan Stanley has $1 for every $30. By contrast, Bank of America’s has less than $11 for every $1 of capital.

So how would this work? If MS has to go from $1 capital for $30 assets to a more bank-like $10-11 assets per dollar of capital, one of two things have to happen – Either MS sells $20 worth of assets (2/3rds of what it has), and returns the proceeds to debt holders, or raises $2 more of capital.

The first would be disruptive to the markets, bringing a lot of selling pressure while every intervention is aimed at relieving the selling pressure. The second would be dilutive to existing shareholders – The share of existing shareholders would drop by 2/3rds. This is obviously bad for the stock, but, at least the losses are private and limited to shareholders, who kind of took on the risk in the first place.

So they will need time to adjust their balance sheets. Given enough time to get to the required capital ratios through a combination of asset sales and capital raising, and using additional classes of capital (such as preferreds and convertibles), they should be able to emerge as stronger institutions. And they can now buy a commercial bank to help get to the target ratios.


September 21, 2008 at 5:30 pm | Posted in credit, Housing, regulations | 2 Comments
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Here’s an idea. How about, the government acquire toxic mortgages and modify the foreclosure process. Maybe the title transfers over to the government. The government then transfers it over into what is, essentially, an apartment REIT, and appoints a property manager to manage its rental portfolio.

The erstwhile homeowner is now a tenant of the property. They’ve lost equity – if they ever had any- but not the roof over their head. They now owe rent instead of the monthly mortgage payment, and perhaps the rent can be modified to the interest payment on the outstanding balance at a reasonable interest rate (Perhaps the current average 30-year fixed rate), rather than either a low teaser rate or a too-high post-reset ARM rate.

The tenant is basically locked in to a 2-year lease, so they have to pay rent for two years. If they fail to do so, they have a foreclosure on their credit report; if they do make the payments, they walk away with no equity, but also no dings to their credit. The foreclosed home stays occupied, so there isn’t a flood of bank-owned real estate boosting supply and depressing prices. The neighborhood doesn’t start emptying out, and foreclosed homes don’t drag down values – or boost crime in vacant homes.

Perhaps the government could in turn sell these rental REITs to investors – They buy into the rental cash flows + the value of the property. We know that the government will lose on this – The REIT cannot be valued at what the government paid for the assets in the REIT, but at least this will provide liquidity to both the financial markets as well as support the real estate market, helping borrowers in trouble.

I think this might be a workable idea, although it needs developing further.

Regulators – absentee parents

September 20, 2008 at 7:03 pm | Posted in credit, economics, Housing, regulations | Leave a comment
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I think regulations and regulatory agencies failed to create an adequate framework for the credit markets.

In essence, while lenders invented 5% down, even the 0% down, no documentation, stated-income loans with down payment assistance, regulations allowed lenders and investors to get away with similar low equity / high leverage balance sheets. Lehman, for example, had a debt-equity of 30-40x (admittedly boosted by prior write-downs of its assets).

This is just like parents raising kids – Some parents regulate kids more than others (I think less- but not too much less- is better, generally), but if you fail to regulate them, sooner or later, they are going to need rescuing – whether you rescue them or want to teach the kids a lesson.

High noise-to-signal in SEC actions

September 20, 2008 at 1:20 pm | Posted in regulations, Stock market | Leave a comment
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This NYTimes article discusses the market reaction to the SEC rules banning short sales. A number of trades in the market were involuntary, forced on by the new regulations. As such, I doubt the strength in the market is sustainable. Nothing fundamental has changed; just a few rules changed, which made some people make transactions in the market in order to comply with the new rules, and made others make transactions in response to the market response. There is not much other information in the response, other than the fact that one can expect the government to continue to rescue and to regulate and market participants have to figure out where the heavy hand will fall next.

The pendulum swung far away from regulation during the “Bush expansion”, now, it is going to swing even further in the other direction.

We already know this. I think the SEC is saying that things are not as bad as they seem (as I said previously here), but then, is that what the SEC really believes, or is this just empty reassurance?

I guess, looking ahead and trying to decide what to do in the markets, this last week was mostly noise and  little signal.

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