What I Think About the Bailout
Sep. 27th, 2008 04:03 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
billroperI think that the current economic problems are the result of two regulatory failures and a subsequent market failure that have left us in the unhappy position that we're in. Let's talk about that for a moment and then see if there's a prescription that might make some sense.
The problem started back in the 1990s with the push to make it possible for more people to buy homes. After all, homes were a good investment, real estate only goes up (they're not making any more of it, right?), and encouraging people in lesser economic circumstances to build up home equity gives them a change to improve their economic situation. There's certainly something to be said for that argument, save for that little bit in the middle:
"Real estate only goes up."
That'll get us into trouble later, but not for a while. So what you do is encourage people to lend money to less-qualified borrowers. Of course, they may not have the traditional 20 percent down payment, nor may they be able to handle the payments on a 20-year (whoops, let's make that a 30-year mortgage), but we can accept lower down payments and set up adjustable rate mortgages, because the value of the underlying real estate is only going to rise, so our default risk is low. We can also force the borrowers to pay for private mortgage insurance which will add a bit to their payment, but which will guarantee that mortgage is going to be good when we resell it.
Of course, you have to be able to resell that loan. The biggest buyer and reseller of mortgages in the country are the government sponsored enterprises, Fannie Mae and Freddie Mac. They're able to borrow money at very favorable rates, because there's always been this implicit (not explicit) promise that the Federal government would step in should things really go sour and make everyone good. Heck, Fannie Mae and Freddie Mac debt is darn near as safe as a Treasury bill.
The FMs didn't used to buy junky-looking mortgages like these. This kept them from proliferating completely out of control. Once they were allowed to do so (regulatory failure #1, around 2002), we got a lot more of these mortgages into the marketplace. (See, for instance, the Home Possible program, which seems to have cranked up around 2005.) So now we've got a bunch of junky mortgages out there in bundles with better mortgages, all being bought and sold and guaranteed by the FMs and private insurers.
(You also should understand that the FMs were places where politically well-placed individuals were sent and made a lot of money. This included Obama advisor Jim Johnson and former Clinton administration official Franklin Raines. It turns out that Johnson and Raines got caught manipulating earnings to maximize bonuses. You can look it up. In the meantime, the FMs spent a lot of money lobbying Congress, which seems to have helped keep any improved regulation from landing on them.)
By 2007, the housing market was slowing down. The solution to this appears to have been to let the FMs buy more junk. (Note, by the way, the comments by Democrats Dodd and Schumer who wanted to let the FMs buy even more junk than that.)
Meanwhile, a lot of organizations had money invested in these sliced and diced securities that included some mix of traditional and subprime mortgages. It turns out that some of these loans had been so mixmastered that it wasn't even clear who was entitled to foreclose on a non-paying mortgage. There's nothing like accountability and this was nothing like accountability.
Ok, now, do you remember Enron? One of the long-term results of Enron was FAS 157 that requires companies to mark their securities to market value. In some sense, that's a good thing, because you want to know what a company is really worth and -- under normal circumstances -- mark to market works pretty well.
Unfortunately, the regulation devised to fight the last accounting war isn't working so well right now. (Regulatory failure #2.) Everyone who studies the problem understands that markets are imperfect. (Other systems are usually more imperfect, so markets generally look pretty good by comparison.)
All you have to do is to have enough capital, and you can wait out periods of market imperfection. (That's the market failure I'm talking about.) And here's where FAS 157 gets you in trouble.
There's not much doubt that these bundled mortgages are worth less than their face value. How much less turns out to be the question that no one has a good answer to. And under those circumstances, we've ended up with essentially no buyers prepared to make a market in the securities. When that happens, the mark to market rules call for marking the security down to zero. It's probably worth more than that, but it's a good conservative accounting rule.
It also means that companies with substantial amounts of these securities on their balance sheet discover that they have a lot less assets than they are supposed to have. And when you're a bank or an insurance company, being out of asset balance triggers all sorts of regulatory and contractual disasters. You have to have assets on your balance sheet to support your lending activities. So you can't lend money.
And credit dries up. And the people who have money aren't willing to lend it to you, because they don't know if you're going to arrive in technical bankruptcy and fail to pay them back which is why inter-bank lending rates went nuts. Mind you, the vast majority of the mortgages that you're holding in these mixmastered securities may still be performing assets, but their market value is zero this week.
Now, given all that, how do we fix the situation? Well, as they frequently say, the first rule of getting out of a hole is to stop digging and to some extent we're doing that, because mortgages are a lot tougher to get. Of course, that depresses the prices of the existing housing stock which doesn't help all those subprime mortgages out there, but there's a very reasonable argument that cheap mortgage money resulted in a classic inflationary bubble in housing prices (too much money chasing too few goods), so I don't really think there's a lot that we can or should do to try to support current housing prices. Keeping them pumped up is likely to make the situation worse rather than better.
The next step is to relax the mark-to-market rule in a very specific way. We're pretty sure that the mortgage-backed securities are worth less than par and more than zero. We're not able to figure out what the right price is, but we can take a guess.
And that's what we should do. Congress should pass legislation allowing the Secretary of the Treasury to declare an emergency and set a price that the mortgage-backed securities can be listed at on a company's balance sheet. This price is subject to change at any time based on our experience with the securities. Congress should also appropriate money, let's say up to the $700 billion total in a series of available installments, and allow the Secretary of the Treasury to buy tendered securities at 90% of the value that they're recorded at on the company's balance sheet.
In effect, the Treasury becomes the market of last resort for these securities. But the Treasury is allowed to adjust the price. If too many securities are being tendered, then the price is too high and needs to be reduced. If the price is too low and no securities are being tendered, then we may be putting companies into technical bankruptcy for no good reason. Since we're buying the securities at a discount to the balance sheet, companies have an incentive not to tender the securities unless they really need the cash in hand. We may also put some other incentives into the legislation to discourage excessive tenders -- it's certainly worth looking at limits on executive pay (although, as I observe elsewhere, this may have certain agency problems associated with it) or dividends to shareholders or corporate warrants that would allow the Federal government to claw back some gains from the tendering companies.
Eventually, the Treasury should be able to sell these securities in a functioning market once the uncertainties are better understood. If there are any profits from this venture (and I hope there would be), then they need to go to reduce the amount of the National Debt, not be redirected into any Congressman or Senator's pet program (as Senator Dodd is currently suggesting).
Finally, we need to pass legislation that encourages the banks and borrowers to renegotiate existing mortgages which are likely to be foreclosed. Part of this is setting rules so that we know who is empowered to negotiate on the part of the security holders, since that seems to be unclear now. Part of that is changing the tax law (if we haven't done so already; I may have missed the change) so that the amount that a mortgage is being written down doesn't become immediate taxable income to the person who owns the property while still allowing the folks who loaned the money to recognize the loss. Loathe as the IRS might be to recognize it, there are some transactions where my loss doesn't mean your gain. And given the costs involved in foreclosure, there is a range of negotiable values where the homeowner is better off than if he were foreclosed on and the bank is better off than if it foreclosed on the property. A win-win situation is possible, but we have to make sure that the tax code isn't preventing it.
So that's my thought on the situation. Probably imperfect, but I think it's better than some of the alternatives that are being kicked around Congress.
The problem started back in the 1990s with the push to make it possible for more people to buy homes. After all, homes were a good investment, real estate only goes up (they're not making any more of it, right?), and encouraging people in lesser economic circumstances to build up home equity gives them a change to improve their economic situation. There's certainly something to be said for that argument, save for that little bit in the middle:
"Real estate only goes up."
That'll get us into trouble later, but not for a while. So what you do is encourage people to lend money to less-qualified borrowers. Of course, they may not have the traditional 20 percent down payment, nor may they be able to handle the payments on a 20-year (whoops, let's make that a 30-year mortgage), but we can accept lower down payments and set up adjustable rate mortgages, because the value of the underlying real estate is only going to rise, so our default risk is low. We can also force the borrowers to pay for private mortgage insurance which will add a bit to their payment, but which will guarantee that mortgage is going to be good when we resell it.
Of course, you have to be able to resell that loan. The biggest buyer and reseller of mortgages in the country are the government sponsored enterprises, Fannie Mae and Freddie Mac. They're able to borrow money at very favorable rates, because there's always been this implicit (not explicit) promise that the Federal government would step in should things really go sour and make everyone good. Heck, Fannie Mae and Freddie Mac debt is darn near as safe as a Treasury bill.
The FMs didn't used to buy junky-looking mortgages like these. This kept them from proliferating completely out of control. Once they were allowed to do so (regulatory failure #1, around 2002), we got a lot more of these mortgages into the marketplace. (See, for instance, the Home Possible program, which seems to have cranked up around 2005.) So now we've got a bunch of junky mortgages out there in bundles with better mortgages, all being bought and sold and guaranteed by the FMs and private insurers.
(You also should understand that the FMs were places where politically well-placed individuals were sent and made a lot of money. This included Obama advisor Jim Johnson and former Clinton administration official Franklin Raines. It turns out that Johnson and Raines got caught manipulating earnings to maximize bonuses. You can look it up. In the meantime, the FMs spent a lot of money lobbying Congress, which seems to have helped keep any improved regulation from landing on them.)
By 2007, the housing market was slowing down. The solution to this appears to have been to let the FMs buy more junk. (Note, by the way, the comments by Democrats Dodd and Schumer who wanted to let the FMs buy even more junk than that.)
Meanwhile, a lot of organizations had money invested in these sliced and diced securities that included some mix of traditional and subprime mortgages. It turns out that some of these loans had been so mixmastered that it wasn't even clear who was entitled to foreclose on a non-paying mortgage. There's nothing like accountability and this was nothing like accountability.
Ok, now, do you remember Enron? One of the long-term results of Enron was FAS 157 that requires companies to mark their securities to market value. In some sense, that's a good thing, because you want to know what a company is really worth and -- under normal circumstances -- mark to market works pretty well.
Unfortunately, the regulation devised to fight the last accounting war isn't working so well right now. (Regulatory failure #2.) Everyone who studies the problem understands that markets are imperfect. (Other systems are usually more imperfect, so markets generally look pretty good by comparison.)
All you have to do is to have enough capital, and you can wait out periods of market imperfection. (That's the market failure I'm talking about.) And here's where FAS 157 gets you in trouble.
There's not much doubt that these bundled mortgages are worth less than their face value. How much less turns out to be the question that no one has a good answer to. And under those circumstances, we've ended up with essentially no buyers prepared to make a market in the securities. When that happens, the mark to market rules call for marking the security down to zero. It's probably worth more than that, but it's a good conservative accounting rule.
It also means that companies with substantial amounts of these securities on their balance sheet discover that they have a lot less assets than they are supposed to have. And when you're a bank or an insurance company, being out of asset balance triggers all sorts of regulatory and contractual disasters. You have to have assets on your balance sheet to support your lending activities. So you can't lend money.
And credit dries up. And the people who have money aren't willing to lend it to you, because they don't know if you're going to arrive in technical bankruptcy and fail to pay them back which is why inter-bank lending rates went nuts. Mind you, the vast majority of the mortgages that you're holding in these mixmastered securities may still be performing assets, but their market value is zero this week.
Now, given all that, how do we fix the situation? Well, as they frequently say, the first rule of getting out of a hole is to stop digging and to some extent we're doing that, because mortgages are a lot tougher to get. Of course, that depresses the prices of the existing housing stock which doesn't help all those subprime mortgages out there, but there's a very reasonable argument that cheap mortgage money resulted in a classic inflationary bubble in housing prices (too much money chasing too few goods), so I don't really think there's a lot that we can or should do to try to support current housing prices. Keeping them pumped up is likely to make the situation worse rather than better.
The next step is to relax the mark-to-market rule in a very specific way. We're pretty sure that the mortgage-backed securities are worth less than par and more than zero. We're not able to figure out what the right price is, but we can take a guess.
And that's what we should do. Congress should pass legislation allowing the Secretary of the Treasury to declare an emergency and set a price that the mortgage-backed securities can be listed at on a company's balance sheet. This price is subject to change at any time based on our experience with the securities. Congress should also appropriate money, let's say up to the $700 billion total in a series of available installments, and allow the Secretary of the Treasury to buy tendered securities at 90% of the value that they're recorded at on the company's balance sheet.
In effect, the Treasury becomes the market of last resort for these securities. But the Treasury is allowed to adjust the price. If too many securities are being tendered, then the price is too high and needs to be reduced. If the price is too low and no securities are being tendered, then we may be putting companies into technical bankruptcy for no good reason. Since we're buying the securities at a discount to the balance sheet, companies have an incentive not to tender the securities unless they really need the cash in hand. We may also put some other incentives into the legislation to discourage excessive tenders -- it's certainly worth looking at limits on executive pay (although, as I observe elsewhere, this may have certain agency problems associated with it) or dividends to shareholders or corporate warrants that would allow the Federal government to claw back some gains from the tendering companies.
Eventually, the Treasury should be able to sell these securities in a functioning market once the uncertainties are better understood. If there are any profits from this venture (and I hope there would be), then they need to go to reduce the amount of the National Debt, not be redirected into any Congressman or Senator's pet program (as Senator Dodd is currently suggesting).
Finally, we need to pass legislation that encourages the banks and borrowers to renegotiate existing mortgages which are likely to be foreclosed. Part of this is setting rules so that we know who is empowered to negotiate on the part of the security holders, since that seems to be unclear now. Part of that is changing the tax law (if we haven't done so already; I may have missed the change) so that the amount that a mortgage is being written down doesn't become immediate taxable income to the person who owns the property while still allowing the folks who loaned the money to recognize the loss. Loathe as the IRS might be to recognize it, there are some transactions where my loss doesn't mean your gain. And given the costs involved in foreclosure, there is a range of negotiable values where the homeowner is better off than if he were foreclosed on and the bank is better off than if it foreclosed on the property. A win-win situation is possible, but we have to make sure that the tax code isn't preventing it.
So that's my thought on the situation. Probably imperfect, but I think it's better than some of the alternatives that are being kicked around Congress.
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no subject
Date: 2008-09-29 08:14 pm (UTC)Also, that price is only going to work to make these securities sellable-to-other-companies (which I gather is what you have in mind--the Treasury is only the market of last resort if there are other resorts) if the other companies believe the value that the government puts on them.
And even then, if the only guaranteed value is the price the Treasury will buy them at, I'm guessing nobody else will be willing to pay more for them.
Of course, having a guaranteed value, even if it is a fiat value, may make it possible to borrow money against that value and free up the credit markets I suppose. But the fiat value can be changed depending on how many companies are actually selling their securities to the Treasury--but there must be ways to deal with that because companies can use stocks as assets, and stock values change.
I like the idea of establishing the ability to renegotiate mortgage payments, though.
I know the FMs have contributed to Democrats, because I know perfectly well that they have contributed to practically everybody in Congress, Democrat and Republican alike--that's one of the ways they got the rules changed to favor their profits more. But when you single out only Democrats to complain about it makes you look biased, and that kind of undermines the ethos of the rest of your argument, which is really pretty good.
no subject
Date: 2008-09-30 03:31 pm (UTC)