BAD COMMUNICATORS AND MAYBE EVEN BAD ACTORS
The late Paul Newman's portrayal of
Cool Hand Luke (1967) was a classic. Even when old Strother Martin menacingly taunted him with his "what we have here is a failure to communicate" threat, Luke managed to, well, keep his cool. Here is a guy who knowingly refuses to give up his humanity (1960s Hollywood rebel style) at the risk of his own life, yet manages to maintain a brave and cheerful demeanor so that others can retain their dignity and hope.
Just like our political leaders. Is it any wonder the American public has decided to put a kabash on this absurd set of unexplained proposals? As President Bush says, there will be plenty of time later to point fingers (oh boy, will there ever). Meanwhile, just hand over the dough. At least he remains calm while serious--although he has no "vision thing" on this issue whatsoever. He has let his two panicked finance ministers run wild in congress and television with no adult supervision.
Presidential hopefuls Obama and McCain are each grinding away with their own axes. Obama's ax is "burn, baby, burn". After all, what else can guarantee an almost certain victory? The media is helping him appear cool and above the fray. McCain's ax is "reaching across the isle" only to be kicked in the cojones. All process, no cattle. When will he ever learn on this? Bernanke and Paulson managed to simultaneously tell us the financial world is on the edge of Armageddon if we don't buy $750 billion of assets AND that the government will make money if they do buy the $750 billion of assets. Now how can these 2 contradictory statements be true? I can come up with a variety of hypothetical answers. But what is the point in doing that? My answers would be just that, hypothetical. Why aren't they telling us why they think these 2 things can both be true?
Have we ever seen a more repulsive duet than the Pelosi-Frank freak show? No, not in some time. They really have no shame. Its one thing to be partisan, another to express righteous anger blaming "the failed policies of the Bush Administration" for every economic problem any individual has ever had. It is almost pointless to even counter this argument. The trends inherent in the US Economy transcend any one administration.
But great news! The Senate has passed an even more larded tax payer funded package. The House as yet to opine. We are assured for the third or fourth time that this time it will pass the House. The "hard right" voted against this deal (that is, the majority of the Republican members. What are the 40% of Democrats who did not vote for it called---piercingly sharp political realists?). These paragons of conservative free market principles are supposed to be for it now. This is because the bill added even more subsidies, this time to FDIC insurance and a surprise alternative minimum tax reduction. While I am for the latter, what the hell does that have to do with the mortgage problem? I don't know who kidnapped Newt Gingrich's grandchildren, but the "extreme partisan hard right" Republican has suddenly gone limp on his opposition to this bill.
Am I opposed? Yes. My view had been that any bill would work, including this one, as long as the investing public believes it will. Conversely, no bill "will work" if the investing public believes no bill "will work". What is the common thread between these 2 statements? The common thread is that the investing public needs to believe, regardless of legislation, that the financial system is fundamentally sound. It seems to me the government should explain the actual underlying facts of our mortgage problem to the public and how this proposed solution "fixes" the problem. I cannot see how buying $750 billion of loans does anything at all as this commentary will explain. But I am open to persuasion. Why does this bill change anything? The sense I get is the ones who are able to explain this are unwilling. This makes me suspicious.
Lets take ex-Goldman CEO and now Treasury Secretary Hank Paulson for a moment. I will put him in the category of unwilling but able to explain this. He has been the leader of the "just show me the money" movement. I think it is reasonable to question his motives. His partner in obfuscation, the ever compliant Peter Principle Bernanke, is there for political cover. What is the policy coherency of the following set of actions? Bear Stearns is merged with JP Morgan. Countrywide is merged with Bank of America, Washington Mutual is merged with JP Morgan. Wachovia is apparently merging with Wells Fargo. Lehman filed for bankruptcy and is merged with Barclays Capital. Merrill Lynch merges with Bank of America. The US Treasury buys AIG.
Say that last one again? How does that fit into these other market based solutions? One rumor is that global insurance companies wanted this to happen. Really? My understanding, however, is AIG's Financial Products Division is separated from the Insurance operations which have no material problems. Apparently, FP owes billions of dollars in collateral on credit default swaps for mark to market purposes, not for realized defaults. Another rumor is they owe Goldman $20 billion in cash collateral for marks and defaults.
Is it possible this could have anything to do with Goldman staying solvent? If so, should the Treasury tell us why, if Goldman stupidly lent money to AIG, they do not have to pay the consequences of such actions like WaMu, Lehman, and Wachovia? Maybe there is a reasonable answer on AIG. But like every explanation about this whole bail out package and ad hoc policies there is not much coherence or communication on any of it.
ABOUT OUR NET WORTH AND LEVERAGE
I think a few facts are in order. As of June, 30th 2008, the national net worth at the household level was $57 trillion, up 45% since the failed Bush economic policies began in 2001. The national debt at the household level is $14 trillion. This means assets are $71 trillion. These numbers are published by the
Federal Reserve. There are those who dispute the economic accuracy or significance of these numbers, but it is still the best estimate of our economic national health.
Total housing mortgages outstanding are $10.6 trillion. Total housing is worth $19.4 trillion. Remaining consumer credit is almost $3 trillion. Household debt as a percent of total assets have risen from 18.4% to 20.6% over the past 6 years. The absolute debt level per se has had nothing to do with the current crisis. However, it is in the housing sector where most of this leverage increase has occurred. Mortgage debt as a percent of housing values increased from 44% to 55% since 2002. The marginal leverage was 80% (increase in debt divided by increase in housing values) as mortgages outstanding increased 75% while housing values increased only 42%. 80% is huge and it captures the essence of the current problem. Foreclosures are rising.A look at foreclosure data on Realty Trac provide some interesting reading. A look at their" foreclosure heat map" tells us where almost all the real problems are, California and Florida.
The Big Picture | Foreclosures
CALIFORNIA NIGHTMARIN'
Last week I wrote about housing prices in California.
"California Dreamin"? The thrust of the article was California, and in particular the area around San Francisco, was "Suspect Zero" in this housing crisis. I had it partially correct. In addition to the San Francisco exurbs, the central "north-south" corridor between Bakersfield in the south and Sacramento in the center of the State (north east of San Francisco) is also part of "Suspect Zero". Route 99 connects these 2 cities. A second California black hole exists in San Diego and Southern California.
Some of the following analysis is derived from data on the Trulia website.
Trulia - Real Estate. As mentioned in my previous article, the 6 worst and 12 of the worst 20 metropolitan regions in the country (the OFHEO lists 299 such regions) are in California. 7 are in Florida and 1 is in Nevada. Stockton, California is typical. Values quadrupled from 2000 to 2005 in Stockton from $100k to $400k during this period. Since the end of 2005, median prices have dropped 60% to about $165k. Bakersfield went from $88 to $303 back to $170k. Sacramento went from $110k to $354k back to about $175k. The "corridor" seems to be finding an equilibrium price at about the $170 level.
When the final tally is taken, California will be front and center of this entire problem. Ironically, 100 years ago, another California "real estate" problem triggered the Great Panic of 1907. That real estate problem was San Francisco burning down from massive fires triggered by a devastating earthquake. According to Trulia, the market in California appears to be functioning to clear up the problem. The 3 representative and devastated markets mentioned above (Bakersfield, Sacramento, and Stockton) each are having the highest sales rate of this decade.
Trulia lists every home sold in the country on its website (including condominiums), the date and price at which it sold, maps, photographs, and its address. It is updated weekly. 13,159 homes were sold in Sacramento this year, higher than any year this decade. Another 11,948 are in foreclosure, also a record. The same record sales and foreclosures are occurring in Bakersfield and Stockton (and the whole corridor) as well as Southern California. The mess appears to be clearing out. It is impossible that California did not have incentives which caused this crisis. Why this is not being discussed arouses suspicion in me. As President Bush said, there will be plenty of time later to assign blame---to Republicans and Wall Street.
WHAT HAPPENED, BUT NOT WHY
Golden West and Washington Mutual were large banks doing business in California and they are dead and buried inside Wachovia/Wells Fargo and JP Morgan, respectively. The way this became a fiasco is easy to describe, but less easy to explain. Mortgage brokers would offer 100% loans at teaser rates or with low interest rate ARM structures. Then a bank would buy the mortgage and "package it" with other mortgages. They would place these loans in a so called "Special Purpose Vehicle". The SPV would in turn borrow money by selling bonds to other banks, mutual funds, insurance companies and hedge funds. Other banks would in turn purchase these bonds and repackage them all over again. The investor at the end of the chain has almost no idea what housing collateral is behind his money. One thing he can be sure of is that a good chunk of it is on California's route 99 and Southern California (and certain places in Florida, particularly Orlando and Miami).
The primary middlemen in this mess were Fannie Mae, Freddie Mac, Countrywide, Goldman Sachs, Lehman Brothers, Merrill Lynch, Citibank, WaMu, Wachovia (through its Golden West purchase at the tippy top of the market), UBS, and Bear Stearns. Almost everyone had a hand. AIG got into the act by "insuring" the performance of these bonds. With 60% declines in certain places, it is understandable losses are substantial. All of these firms not only sold this stuff, but even better, kept the worst of it for themselves. Not even their clients were dumb enough to buy that junk.
The middlemen thought they could "hedge" the junior securities with "insurance", (so called credit default swaps), or use dopey models that short stocks. Or more likely, not hedge at all and just hope the market would keep going up. By the spring of 2007, the music stopped. Not only did they now own the worst of the old deals, but they were now stuck with the entire bond issuance of the "SPVs" they had committed to over a several month period. A market wide Battan like Death March toward a Keynesian Liquidity Trap now ensued. No one wanted to hold any mortgage backed security, even AAA performing mortgages. The secondary market for the old paper became frozen, even as new and better mortgages were being written. Everyone feared what they were buying was bad paper.
Even bonds that have a 97+% chance of paying off interest and principal are selling at deep discounts to "par". Which brings us to the seeming contradictory statements of Paulson and Bernanke mentioned above. How is it that it is almost Armageddon yet also a profit opportunity for the taxpayer? The following tries to provide some insight.
A SIMPLIFIED EXPLANATION OF THE PROBLEM
We have all heard about this issue of "mark to market" versus "cost" or "book value" accounting in recent days. The former simply means the price at which you can sell something you own. If you bought a bond for a $100 and you now can only sell it for $90 then "mark to market accounting" says you just "lost" $10, even if the borrower is paying interest and principal in a timely fashion. "Cost accounting" means its value stays at 100 until there is clear and present evidence the borrower will not be able to pay.
According to "modern finance theory", the reason you can only sell it for $90 is that the market's "expectation" is that there is a 10% chance the borrower will default on their loan. The bank now records a loss. The capital ratios of the bank decline. The bank needs to sell loans, or raise capital in order to maintain their capital ratios. But the more bonds they sell, the more they drive bond prices down. Not only do they lock in the loss of $10 on the bond they bought for 100 and sold for 90, but all other similar bonds they bought for 100 have now got to be valued at 90. This causes more losses, more sales, etc., etc., down and down into a death spiral. This is a special case of the so called "Keynesian Liquidity Trap". By trying to raise cash and selling securities, you inadvertently drive yourself into bankruptcy. Additionally, your actions affect other banks' "marks" and vice versa.
One might think this "mark to market" accounting is an insane policy. But it is more complex than that. In a theoretical world of so called "rational expectations", markets obviously value securities at the price they collectively think they are worth. In our example, the reason the bond is bought for 90, is that the market's "best guess" is there is a 10% chance the borrower will default and not pay back the loan. A related theory called the "efficient market hypothesis" states in part that the current price of a security is empirically the best guess as to its actual value. Another way of saying this, is that no one is able to predict the direction or magnitude of future prices any better than they can predict a coin turning up heads or tails. There is a very strong empirical body of academic work, particularly in equity markets, that is unable to contradict this contention.
The reason "mark to market" accounting was instituted to begin with is that banks would make horrible loans that had a high probability of default and "cost accounting" permitted these values to be "managed". Investors required more transparency. They needed a "signal" provided by market pricing to inform them whether a particular financial institution was holding good or bad loans. I have a very strong tendency to support mark to market accounting for the above stated reasons.
Except when it is insane to do so, like now. My opinion is without question arbitrary. I think we need to stop the forced liquidation that continues in mortgage markets. Temporary relief on marking mortgages to market helps with this. In the mean time, we can discuss as a nation how to protect ourselves from these issues arising again in the future. My "Part 3" next week will discuss this.
I do not want to spend time on derivatives. Despite the idiocy of the "street" to extend unlimited credit to AIG, the derivative issue is largely a red herring. Derivative trades are an inside the financial institution system phenomenon. Virtually all are "cash zero sum" transactions. Even as AIG defaulted against its counterparties, it is still cash zero sum. Of course, the wrong guy got the cash in that situation. Derivatives can cause havoc, but they are largely offsetting. Think of the OTC derivative market as a very poorly run futures exchange. It can be and probably is a problem, but it is a side issue.
THE SIZE OF THE LOSSES AND SAYING "NO" TO THE BAILOUT
Realty Trac estimates that 1 of 171 houses went into some stage of foreclosure in Q2 '08, more than double 12 months ago. An estimate of total foreclosures during the last 6 quarters is approximately 2.55% of all homes in the country. At the current rate of foreclosure another 3.55% of homes will foreclose during the next 6 quarters. Using this approximation, 6% of all homes will have foreclosed between 2007-2009. Lets further assume 9% of all mortgages outstanding default, under the assumption the most leveraged homes are in default. This represents approximately $950 billion of defaulted mortgages between 2007 and 2009. If these houses get sold at 35% of the mortgage value, this means banks will have taken a total of $615 billion in losses for this 3 year period on US housing. The top 100 banks have already taken $500 billion in write downs. Since banks typically reserve part of their loans in advance (i.e., take some small predetermined write downs, in effect) that can theoretically be added to the $500 billion write down number. Either way, somewhere between 80-90 % of all write downs for the last 18 months and the next 18 months have arguably been taken already.
In my numbers above, I am implicitly accounting for delinquencies by assuming some percent will in fact default and then be foreclosed. What does any of this mean? It means 94% of loans are making full payments and perhaps can reasonably be expected to continue. From this perspective, one could say the problem is largely behind us. Why does the federal government need another $750 billion to bail us out? This goes to the heart of the Paulson-Bernanke "paradox". This paradox is "if we don't buy $750 billion of mortgages, all is lost; if we do buy them, we get our money back and maybe more". The only way I can solve their "paradox" is if they believe the above argument. But if they do, why do this at all?
Some would say this is the ultimate whistling past the graveyard wishful thinking estimate. I have seen estimates, using the Case-Shiller index as a starting point, that the real "mark to market" number is $6 trillion. That would not be good. But that estimate is no more real than me guessing where the stock market will be in 3 years. Putting aside whether the author did the arithmetic correctly, his point is if every house which had a mortgage was sold at its current estimated value according to Case-Shiller, $6 trillion would be lost. Or using "rational expectation" and "efficient market hypthesis" lingo one could say "the market's best guess as to the values of homes is $6 trillion lower than banks have marked them to market today".
Welcome to no man's land. Houses are not currencies or even stocks. It is ridiculous to use the same methods of valuation for an extraordinarily illiquid asset even in the best of times as one would a freely traded highly liquid asset like a currency or a stock. I am not saying one can ignore such an analysis, but to treat it as "the real losses" is absurd. Of course, if we were to all act as if it were true, it certainly would become true. Like it or not, we live in a world of "conventions". There are no hard and fast ultimate rationally derived values. The philosopher economist John Maynard Keynes recognized this when he said:
"... human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist ... it is our innate urge to activity that makes the wheel go around ..."
The mortgage sector is currently in a liquidity trap. "Everyone" wants out. If everyone wants out, the remaining mortgages will be further written down, causing more financial institution distress, leading to an inability to extend new credit to the economy. Paulson and Bernanke claim to believe that having the ability to purchase $750 billion of loans will restore "confidence" and stop the death march to liquidation. They may very well be right. I certainly agree we should do everything we can to stop this stampede.
But why do they believe this bailout will accomplish such a goal? Why should any one believe this? This has not been explained. What if they take that $750 billion and just purchase the same loans that have already been written down? How can that help? Maybe it can, but our Imperious Duo has yet to explain exactly or even approximately how. They may as well tell us to pray to the Sun and everything will all be OK. By the way, I do not discount this bail out as potentially having such talismanic powers. But I ultimately find it unnecessary. Some transparency would be nice. Some serious but optimistic Cool Hand Luke leadership would be nice. When people act like they have something to hide, I just assume they do.
What are they going to buy with this money? The point is they are not telling us what they know, assuming they do know. Just today Wells Fargo seems to have stepped in front of Citibank to buy Wachovia. Citibank had been guaranteed a cap on losses. Wells did the deal without the cap. The Imperious Duo, the despicable Congress, the confused Candidates, and the disengaged President are not explaining anything. Just show me the Damn Money and shut-up. Meanwhile, the market in combination with the powers already inherent in the Executive branch seem to be dealing with this issue. If these guys just communicated maybe they would not need our money.
Why am I suspicious they need this money for more than merely "toxic" loans and providing "confidence"? Like for bailing out favored companies, maybe Goldman for example? Once they have the money, who is going to stop them from doing with it what they please? I am not pushing for a conspiracy theory. I am pushing for transparency. Nothing about this bill suggests what the "mechanism" is which will "free up" capital in the mortgage market and provide, magically, confidence to the market. Why shouldn't we be suspicious?