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.

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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.

Is it a rescue if you don’t overpay?

September 23, 2008 at 6:24 am | Posted in credit, economics, Housing | 1 Comment
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There are various rescue proposals out there. The Paulson plan has run into some serious opposition, with Congressional Democrats offering alternative suggestions. I believe whatever solution is implemented, it must overpay for the assets acquired, and thus, there will be losses in the $700B (or whatever) real estate fund. The question is – how bad will the losses be?

But the fundamental question is- Is this credit crisis a liquidity crisis, or a solvency crisis? I think it is increasingly obvious this is a solvency crisis.

Say you put in $10, borrowed $90, and invested the whole $100. But a couple of investments went bad, and the $100 is now worth just $80. What do you do? You have assets worth just $80, and owe $90. Borrowing more won’t help – If you borrowed $10, you would have $90, but would owe $100. You could sell some of the assets, but if you sold half and used the money to pay off your creditors, you would have assets of $40 left, and still owe $50.

How does one get out of this solvency crisis? Well, either the current owners of the firm put in new money to meet the shortfall, or we get new owners to come in. Or we get a “rescue”. The current owners may not have enough money to meet the shortfall. The current or potential new/ additional owners may not want to put in new money, because they know that the new money will not be invested in something productive that may generate a profit – It will be used to meet the shortfall in what we owe our creditors.

It seems pretty clear that we are in a solvency crisis. Lending money to troubled institutions will, in many cases, only postpone the day of reckoning.

When the US government (or anyone else, for that matter) “rescues” an institution, they are the last-resort savior. So, clearly, they are the highest bidder – they are willing to pay more than anyone else was – for the firm, for parts of the firm, or for some of the assets of the firm, or as a guarantor of some of the assets. They may even be the only bidder.

The government is paying more than anyone else thinks it is worth. But, as we saw, what others think it is worth (the firm or its assets), is less than the debts – thats why we have a solvency problem.

The only way a rescue could work is if the rescuer paid whatever was necessary to solve the problem. In this case, enough above what others think it is worth to close the asset-liability gap.

If the market said the assets were worth $80, and the firm owed $90, we saw there was a solvency problem. The rescuer can solve this problem by basically being willing to pay $90 or more for the assets, allowing the firm to pay off its liabilities and stay solvent. Here, $10 of every $90 the US government spent is a dead loss – unless, eventually, it turns out the market was wrong in valuing the asset at $80; it was really worth more. The rescuer is could buy the asset for $80, but is choosing to pay $90 for the asset as a favor to the institution.

Whatever the final rescue package looks like, whatever securities the rescue fund buys, or invests in equity, or whatever else; whether the fund buys mortgages, or mortgage backed securities, or derivatives, or whatever else – It will all be distressed.

Since the government is only going to buy the junkiest of junk – the stuff that absolutely needs rescuing, the only way a rescue works is if the government pays much more than the market price.

Liquidity vs. solvency

September 23, 2008 at 5:41 am | Posted in credit, Housing | Leave a comment
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I think the response to the credit crisis has to be dictated by a determination of whether the crisis is principally one of liquidity or of solvency. So here is a basic attempt to clarify what this means.

A liquidity crisis basically means that firms have enough assets, but they cannot be easily converted to cash in time. This is a temporary problem and can be tided over relatively easily. An example of a liquidity crisis for an individual could be – You have $50,000 in a bank CD or savings account, $500 in your checking account, and your car needs major repairs over the weekend. You have the money to cover the repairs, but not right now. You need credit – Of course, you could put it on your card. But suppose you couldn’t? Or didn’t have a card. You would need to borrow from a friend or family member – Just for 2-3 days, till you can get your own money into cash.

A solvency crisis means you just do not have the money or other assets to meet your liabilities – your borrowings and your other obligations (taxes, condo fees etc). Borrowing from someone won’t help you much. Say what you owe on the house and car and cards etc. all came to $400k, but the value of the house and car and furniture and savings all add up to $350k. Maybe you still keep making your payments, but if those debts needed paying (say you had to sell your house to move for a new job), you would come up short, and borrowing from somewhere else will still leave you just as short.

In the financial institution context: The FI has borrowed some money (direct borrowing or securities issued or public deposits), has put in its own money as well, and invested the whole amount, buying shares and/or lending money to various borrowers. Say some of the depositors want their money back, and the FI doesn’t have that much cash handy. They would either need to borrow from someone else to pay off the first guys, or sell some of the investments to get the cash. But what if the investments are hard to sell, like an individual mortgage or individual loan to a small business owner? Or, what if they can be sold, but selling too much all at once can cause the price to drop, forcing the firm to take a loss? This is a classic “Its a wonderful life” scenario, and borrowing from someone for a few days or months until some of the investments come due is a ready (though not always easy solution) to the liquidity problem.

With a solvency problem, the assets / investments may have gone bad, and so are now worth a lot less than the firm paid for them. Some borrowers may be out of business, others are struggling, and their assets, which were offered as security when they borrowed the money, may not be worth as much as you thought they were (housing is a prime example).

There is no easy way out of a solvency problem.

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.

$700B real estate fund!

September 21, 2008 at 6:02 pm | Posted in credit, Housing | Leave a comment
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In round numbers, total residential mortgages outstanding are about $11 trillion (See the time series on OFHEO’s website here).

Roughly, 65% of Americans live in owned housing, of which a third own the property free and clear. About 45% of about 108 million households have mortgage debt. Thanks to easy credit and the record low interest rates in 2003-2004, a majority of properties were recently refinanced, so the average age of mortgages are 3-5 years, with relatively few loans of pre-2001 vintage.

So basically, the government wants the authority to buy up about 6.3% of all outstanding mortgages, by initial value.

The government won’t buy a sample of mortgages – they will buy the worst of the lot, so we can expect that a very large number of the mortgages in the taxpayer’s portfolio will go delinquent at some point – in fact, many may already be delinquent by the time the government acquires them. With home prices sinking and very little equity to start with, in these toxic mortgages, the homeowners (I use the word loosely, its more like occupants) are basically upside down – They owe more in the mortgage than the house is worth, so many of them will walk away and go through foreclosure, unless the government also works out some kind of foreclosure avoidance package.

Otherwise, the US government is about to become the world’s largest residential real estate owner.

Own-to-rent?

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.

Moral hazard for main street

September 21, 2008 at 5:15 pm | Posted in Housing | Leave a comment
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Let me see – These guys are finding it difficult to make the payments, and they owe more than the house is worth, and many of these are 2006 /07 vintages – i.e., They are still on the original ARM terms, they cannot claim to be in trouble because the interest rate reset to some unaffordable level.

How, exactly, would the government help them? Do we artificially lower the interest rate they have to pay? Do we forgive a part of their debt and lower the principal balance? Do we give them a longer repayment term?

And why does someone who took a mortgage they couldn’t afford, and is delinquent, deserve rescue? I could have taken a larger mortgage – I could have cashed out, or be living in a larger house – I didn’t. I’ve made all my payments on time. Do I have to continue to owe the full principal at whatever my rate is, while this guy misses a few payments, has 20% shaved off his balance, and the interest rate lowered by 2%?

Maybe I should consider skipping a few payments too.

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.

Crisis of risk aversion

September 20, 2008 at 6:55 pm | Posted in credit, economics, Housing | Leave a comment
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I think, and some people wiser than me think, that this whole crisis was created, not by too much risk taking, but by too little. Investors had money to invest, and tons of potential investments. They could invest in startups, or corporate debt, or in biotech R&D ventures, or in retail – They had the option of investing in just about any area of our economy.

But they invested disproportionately in two areas – First, in treasuries – safe paper. The other area they invested in was also supposed to be just as safe, but could let them eke out a few extra points of interest – mortgage securities of all stripes. They were very complex, and a single security contained as many as tens of thousands of underlying mortgages. This was too much data to handle, in terms of the quality of each underlying mortgage, and the derivatives on this became ever more complex. The investors did not have the time, the data or the ability to understand them fully.

But the credit rating agencies said that they had studied these mortgages, and their models predicted that the losses in the portfolio would be modest, so the investors piled in. The problem was, the models were wrong. The models assumed that house prices would always keep going up, and thus, that refinancing would never be a problem. Wrong on both counts.

All it takes is a close look at the economy – where have all the record profits of the past 5 years gone? Where is the big spending? Where is the corporate expansion? Where is the massive R&D? The investments?

It all got crowded out by the least risky option – Not by someone swinging for the fences with their investments, but by someone hoping to approximate the safety of a treasury with 27 extra basis points of return.

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