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.

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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.

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.

AIG bailout – Necessary, unfortunately

September 17, 2008 at 7:53 am | Posted in credit, Housing | 1 Comment
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So the US government is deeper into the business of being in business. This NYTimes article
http://www.nytimes.com/2008/09/17/business/17insure.html
talks about the Fed’s $85 billion loan to AIG.

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.

Financial institutions need a certain amount of capital to remain solvent – basically, when they borrow money, they need to be able to pay it back, or go bankrupt. So they need enough of their own money -equity – to cover any losses they make, so that they are still able to pay off the debt.

Here’s an example of this works – Say I borrowed $80, and put in $20 from my pocket. I then lent the $100 out to borrowers – some borrowers want to borrow to buy a house, others, to buy products for sale in their store, others, to build a plant or buy a shop – whatever. The people I borrowed from don’t really care where I lend the money – they only care that they can get back their money. So let’s say that a storekeeper went bankrupt and couldn’t return the $10 he borrowed from me. I still have the other $90 lent to other people – I owe my lenders $80, and have basically lost $10 of the $20 I put in. Now, if a homeowner went bankrupt and I lost $20 more, I’m in trouble, because my assets (the stuff I own) are now just $70, but I owe my lenders $80. Either I put in another $10 from my pocket (this won’t be enough, because then I have $80, and owe $80, and if another of my borrowers goes under, I will again need to add more from my pocket), or I go bankrupt too. But like I could go bankrupt because somebody who borrowed from me went bankrupt, so could somebody who lent me the money go bankrupt if I cannot pay them back. And this could cascade through the system. That’s why the government had to step in – They don’t really want to save any one company – but if each bankruptcy or other, less serious event were to trigger another such event, the entire system can get into a lot of trouble.

That’s why the government had to step in as the last resort, to prevent the system from collapsing. I think better regulation can help protect the taxpayers from some of the consequences. I don’t think regulation has all the answers – we can’t anticipate everything that can go wrong, or how things can go wrong, but we can certainly assume that something will go wrong, and regulate risk norms accordingly. That wouldn’t fix everything, and we must be careful not to over-regulate, but what we did have is not enough.

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