Q & A on the Mortgage Bailout

As you might well imagine we might have been doing today, we were well along with some commentary for you on the pending mortgage market bailout legislation. In fact, we were writing what was probably the second-to-last paragraph. Then the House of Representatives vote on the bill took place. And we watched CSpan in disbelief as the House defeated it, 205-228. Sigh.

We, like an overwhelming share of readers on an AOL news service poll this afternoon, believe "some kind of bailout will pass". Thus, we still present our views on this issue, pretty much as we were drafting them. The last paragraph is different than it would have been, though!

Who Gets "Bailed Out"? Aren't the taxpayers getting stung?
First, as someone commented at the church coffee hour yesterday, "Oh, 'they' will make lots of money and the rest of us will just be stuck for the cost". Well, I don't think anyone will make lots of money off this. I know people don't like this giant program. But it's not going to make anyone rich. The shareholders in all the affected companies are seeing those stocks become virtually worthless. The bailout bill contains stringent pay caps for the senior executives of any bank selling mortgages to the Treasury, and at this point those executives are just lucky to still have a job.

The taxpayers do shoulder some cost, but how much that ends up being is presently an open question. Obviously, there are the outlays to buy the mortgage securities. But right away, there will be monthly cash inflows from any of the mortgages the borrowers are paying on. If, over time, some of the loans get rehabilitated, they can be sold back to the private sector and the Treasury may well make a profit on them. And if a foreclosure sale eventuates anyway, the Treasury will get some cash from that. Thus, while the outlays for the government's purchases may run to $700 billion, that should be a ceiling. The eventual cost should turn out substantially less.

So, it seems to us that if anyone is getting "bailed out", it's the homeowners. They've got a second chance here to fix up their loan record and get their financial lives straightened out. Some of this rehabilitation already goes on, sponsored by an alliance of lenders and counselors called Hope Now, and the proposed legislation would intensify these efforts.

What does the bailout do? Will it solve everything?
No, it is not a panacea. What the bailout can do is buy some badly needed time. As you can see from the rapid-fire sales and conversions of heretofore evidently fine financial institutions – Wachovia Bank, Merrill Lynch, others – this situation has moved remarkably quickly. No one has had time to regroup. So this plan will put some assets that are in the worst condition into the hands of the government, an entity that does have time to hold them until they can be "worked out" or disposed of in an orderly fashion. With these troubled assets off their books, the banks facing losses from them can proceed to stabilize and resume growth in lending.

Growth in bank credit is no small matter: it is already the case that total bank lending has been flat for the past six months, especially including consumer and business loans. It's really hard to have economic growth without credit growth, so getting that back on track is a genuine need that affects consumers, small business owners and corporate managers alike.

A specific concern well beyond this legislative plan is the hit to the economy already delivered by high energy costs; these have let up recently, of course, but the heating season will still squeeze consumer pocketbooks hard.

We did see one press statement that the bailout plan wouldn't even help house prices to stop falling. That doesn’t seem to follow, by our way of thinking. If we can stabilize the mortgage markets and slow or stop distress sales, that ought to provide some direct support to home prices.

How Much Is $700,000,000,000?
The value of the mortgage security purchases authorized for the program would be $700 billion. A friend wants to know how much that is in real money? We're not sure exactly how Treasury Secretary Paulson derived this figure, but here are some comparisons we can offer.

The Government's fiscal year 2008 ends tomorrow, September 30. It will have spent just under $3 trillion, so the mortgage program amounts to just under 25% of the current magnitude of the Federal Budget.

On June 30 all home mortgages that were outstanding came to $11.254 trillion. The program size is thus 6.2% of the total home mortgage market.

6.2% is roughly the current fraction of these mortgages that are "seriously delinquent" (60 days or more late in their payments) or in the foreclosure process.

In a completely different context, 1 billion seconds = 31.7 years (60x60x24x365.25). So 700 billion seconds make 22,182 years.

I'd rather think about it from Everett Dirksen's perspective (you do remember that other Senator from Illinois, Everett Dirksen, don't you?): "A billion here and a billion there, and pretty soon you're talking about real money."

Where Do We Go from Here?
This is the new last paragraph after the House defeat of the plan. The next few days look pretty murky at the moment. Major stock indexes fell by 7% to 9% on the day, equal to 777 points on the Dow Jones Industrial Average. At least two major banking merger transactions in the last few days, the takeover of Washington Mutual by JPMorgan Chase and the hasty sale of Wachovia Bank's assets to Citigroup, had valuations that envisioned the plan's passage. Other sizable capital investment transactions were also predicated on the relief the program would bring. As we noted at the outset here, we believe "something will happen" during this week before Congress adjourns to go home and face the people.

These events emphasize two concepts we now intend to devote more space to: the mortgage loan rehabilitation efforts, which are far more developed than we'd understood before. If a loan goes into foreclosure, that marks defeat for the homeowner and for the lender. We'll talk in some detail about what they do to try to prevent that.

Second, we want to talk about "capital" and "liquidity". Both of these crucial supports to business activity have played enormous rolls in the rapid developments among the world's major financial institutions. What are they, and why does Main Street care about Wall Street's capital? We hope we can provide at least some better feeling about that.

Prayers during Current Financial Turmoil

"Episcopal Life Daily", an online news service of the Episcopal Church, brings us a prayer resource today from the Church of England which addresses the present financial turmoil. We'll be back "soon" with more commentary on the events themselves, but these prayers are surely needed right now!

Lord God, we live in disturbing days:
across the world,
prices rise,
debts increase,
banks collapse,
jobs are taken away,
and fragile security is under threat.
Loving God, meet us in our fear and hear our prayer:
be a tower of strength amidst the shifting sands,
and a light in the darkness;
help us receive your gift of peace,
and fix our hearts where true joys are to be found,
in Jesus Christ our Lord. Amen.

And then, directly from the Church of England website:

Father, we pray for the many who are trapped by growing burdens of debt,
who see no way out, and who despair for their future:
give them courage to tackle the problems they face,
clarity in taking decisions which will turn their situation around,
and faith that, as they cry to you in their trouble,
you will deliver them from their distress;
through Jesus Christ our Lord. Amen.

The accompanying comments on the Episcopal Church website:
http://www.episcopalchurch.org/81808_100986_ENG_HTM.htm

and the Church of England prayer selection (a useful connection anyway . . . . )
http://www.cofe.anglican.org/prayers/#debt

Facing the Financial Crisis

We said yesterday that "all the bad news is out" about the current financial chaos. It is, but unfortunately, knowing what is causing all the hew and cry and fear doesn't immediately cure all those ills, it just helps us understand what we're up against. How to deal with "what we're up against" is thus a perfectly valid concern.

As we've been following the news since the weekend, we've come to at least one good place where there is some reasonable-sounding concrete advice. It's the Wall Street Journal columnist Brett Arends whom we quoted yesterday. Since 3:30 yesterday when we posted that article, he has posted two more columns. Read them both.

"Ten Ways to Protect Your Finances From the Crisis
As the country's financial system teeters on the brink of disaster, you need a game plan to minimize the damage."

http://online.wsj.com/article/SB122150347951037511.html

and

Is Your AIG Insurance Policy Safe?
If you have a life, home, auto or long-term care insurance policy with AIG, you probably have one question on your mind: will the struggling insurer be able to meet its financial obligations? Here's what you need to know.

http://online.wsj.com/article/SB122159859013744663.html

Regarding this second item about AIG: As you may have read or heard by now, the Federal Reserve this evening has granted a loan to American International Group (AIG) for as much as $85 billion. The Fed has the right, under the Federal Reserve Act, to lend to anyone it wants if it sees a great need -- an "unusual and exigent need", the Act says -- that cannot be handled by other lenders. This action is a comfort to markets, but adds to the confusion over the philosophy being applied here by Fed, Treasury and other officials about the proper role of government. However, AIG's "need" for cash is "exigent"; this characterization is widely accepted. The philosophical discussions will have to wait until later.

Finally, this morning, I asked a stockbroker of my acquaintance what he is telling his clients this week. Rob replied quite directly, using words one doesn't often look for from a stockbroker: "There's probably some more downside. This isn't a time to be a hero."

So you all be careful out there!

If you have some specific questions about all this, please ask them. Let us know what aspects are most important to you. If we don't know much about the answer, we'll look or ask around until we can find something. carol@geraniumfarm.org!

Wall Street Was Too Busy To Watch Football on Sunday

"Omigod!" Brett Arends of the Wall Street Journal spells this exclamation differently, but he suggests we thrust open the windows and shout it out three times, "Omigod! Omigod! Omigod!" Then he advises in his column this morning, since we have gotten the screaming out of our systems, we can try to calm down and take in the weekend's astonishing financial market events more thoughtfully.

We thought we had gotten over a hump last week at this time with the Federal Government rescue of Fannie Mae and Freddie Mac. Markets bounced in relief for exactly one day. Then Tuesday, they began to reassess their view of Lehman Brothers, a major player on Wall Street since 1850 which helped finance the Civil War. More recently Lehman had been a major player in the mortgage markets and the reversals in that sector have turned out to be their undoing.

The weekend was extraordinarily dramatic for them, for Merrill Lynch and for other big Wall Street firms and banks. The Federal Reserve Bank of New York hosted numerous executives from Friday evening until late Sunday night, pushing those people to conceive a plan to keep Lehman in business or to make its closing an orderly process. Significantly, Treasury Secretary Paulson, who is a former head of Goldman Sachs, and the NY Fed President Tim Geithner, a lawyer by profession, facilitated the meetings, but insisted that no government funding or guarantees would be available.

Secretary Paulson drew a line. Moral hazard was not to be part of this. Security dealers who were in over their heads would have to solve their own problems this time. The Bear Stearns event in March came suddenly and caught everyone by surprise; we learned then that lack of liquidity – that is, short-term funding, as much as capital – permanent long-term financing – could cripple a company. The government and the Fed stepped in to prevent a world-market-shattering breakdown of trading. Last week's actions with Fan and Fred addressed issues with institutions founded by the Government itself. But Lehman doesn't match either one of those conditions. Yes, short-term funding likely was being strained, but there was no surprise in that circumstance this time. And there is, of course, no government franchise here either.

So Lehman was allowed to fail.

As that outcome was emerging yesterday afternoon, an industry trade association, the International Swaps and Derivatives Association, conducted an extraordinary Sunday trading session involving the outstanding transactions Lehman is party to. Personnel from other firms met to exchange information with each other on the multitude of Lehman's contracts and begin to create a chain for concluding them that doesn't involve Lehman. Thus, the most immediate disruption in debt market trading could be averted. Again, there's no abrupt surprise in these developments, so they can be tackled in a somewhat orderly way.

Lehman is not the only firm in trouble. Merrill Lynch was perceived as possibly being the next in line for real trouble. Its stock price dropped 38% last week alone in recognition of its stretched condition and its recent heavy losses. Its leaders, seeing a most murky road ahead, began negotiations on Saturday and arranged the sale of this venerable American institution to Bank of America by Sunday evening. American International Group, an insurance company known mainly for its unique international dealings in political risk and business insurance, has seen this core undermined by an over-aggressive move in domestic mortgage lending. It continues this morning to negotiate asset sales and other actions to stem its losses. Finally, the big thrift Washington Mutual, also faces big losses and will likely require some major structural shift to right itself.

The boom in mortgage lending and the subsequent reversal have thus generated enormous fallout on Wall Street. Probably the recent wide swings in commodity prices haven't helped, but the massive write-downs at these firms are occurring overwhelmingly in mortgages gone bad.

What happens now? I wish I knew! I own some stock in one of these companies!

What we can say is that the bad news is out. The negative factors are all out in front of us, so as began to happen yesterday with the Swaps and Derivatives, market participants can set about reordering their own positions in light of the changed circumstances. This is good. And possibly few would concede it today, but it is also good that a failing firm is allowed to fail, rather than being kept on life-support, prolonging the day of reckoning and dragging out the uncertainty.

While we bemoan the over-sized and excessive use of the mortgage market by imprudent traders and money managers, we do want to repeat a favorable argument we've made before. We think subprime mortgages are a great innovation. No, of course, not the predatory kind that suck in uninformed borrowers and play with them like pawns. But the good kind that extend credit in an "emerging" neighborhood and promote economic development and personal growth. As of June 30, some 30% of subprime mortgages were in foreclosure or delinquent in their payments, but the other 70% were not. 70% of these loans were current and in good standing. Good for those people! May they enjoy their homes for many years!

And as for us investors, Mr. Arends of the Wall Street Journal cautions us not to panic, not to rush out or in. "Invest little, often and broadly," he urges. Stocks have already fallen. ". . . there are a lot of good stocks out there that are pretty reasonably valued. Even long-standing bears, skeptics and curmudgeons are starting to say this. These stocks may not be dirt cheap. Times may get much worse before they get better. But if history is any guide, buying good stocks when they are reasonably priced and hanging on for five years or more has tended to be the best thing you can do with money."

Good luck. And while you're at it, pray for the folks who will be laid off from Lehman and the other firms and for those mortgage traders and borrowers who got themselves – and us – into this mess in the first place.

The Takeover of Fannie Mae and Freddie Mac

Yesterday, we saw the other shoe drop in the current mortgage crisis as the Federal Government took control of the Federal National Mortgage Association, "Fannie Mae", and the Federal Home Loan Mortgage Corporation, "Freddie Mac". These two big firms, which we have discussed before, were not in imminent danger of collapse, but their financial condition has continued to deteriorate since Congress' enactment of regulatory legislation in late July. Investors saw the new regulatory powers as beneficial, but without knowing exactly what form the Government's intervention would take, they weren't any more willing than before to buy the companies' bonds.

So now we know.

The Backstory: Mortgage Rates Still High
To recap the backstory briefly: Fannie Mae and Freddie Mac buy mortgage loans from banks and mortgage companies and, through the wonder of modern computer technology, they package groups of loans together into "pools" and sell them to investors worldwide. The instruments are called "pass-through" securities, since the borrowers' monthly payments of principal and interest are passed through to the ultimate bondholders. About half of all home mortgages outstanding have been handled this way, and that share has increased during the last year as some independent mortgage lenders have pulled back.

What happens to Fannie Mae and Freddie Mac matters to us as homeowners and would-be homeowners. If those mortgage-backed pass-through bonds can be sold easily because investors have confidence in the process, then the interest rate you and I pay on our mortgage loans can be lower.

As it is, such confidence has been lacking. Investors have taken the bonds only with notable premium rates. Consequently, despite the Federal Reserve's cuts over the last year in its key policy target rate from 5.25% to 2.00%, that is, by 3.25%, rates on standard 30-year fixed-rate mortgages have fallen a mere 0.11%. In fact, mortgage rates have risen since January, from a low of 5.48% to 6.35% last week. Thus, virtually none of the Fed's monetary policy easing has found its way into mortgage rates, a sorry end, since that was one of the main factors driving the policy action.

Conservatorship
What is the Government doing? The Treasury and the main mortgage industry regulator, the new Federal Housing Finance Agency, have taken management control of Fan and Fred in an arrangement called "conservatorship". Technically, the government did not assume ownership, but in stock trading today, the prices of both companies' common stock are about 75 cents/share, down almost 90% from Friday's already drastically reduced amounts.

The companies, which already have new CEOs effective yesterday, will continue to operate more or less normally, but now have strict limits on the volume of business they can do. "Growth" and "risk-taking" are no longer part of their strategies. The firms have as their only objectives the regaining of their own financial footing and of investor confidence. The nominal goal of the Federal Government is to provide an environment where this can happen with eventual return of the companies to private control. Whether this actually occurs or not remains to be seen, but it strikes us as a constructive beginning. Already, the firms' direct debt (their own bonds, not the pass-throughs) has improved today, with the premium over Treasuries down by some 0.35%.

Treasury Investments: Costs – and Benefits
The Treasury will invest as needed in a special class of preferred stock to shore up the firms' capital. It will also purchase for itself some of the mortgage backed pass-throughs. So we taxpayers are definitely on the hook here, and right now, there are no concrete estimates of the amounts these actions might ultimately cost us. At the same time, since the government will own some financial assets, to the extent that those generate income, there will be some returns. And since the Treasury will augment market demand for the mortgage-backed bonds, there is the clear benefit to those of us who buy homes in the prospect for lower mortgage rates, and thence to those who build and furnish those homes. A boost to the economy and more tax receipts could result.

Foreign Investors
There's another group of interested parties here. Foreign central banks own substantial amounts of the straight bonds of Fan and Fred, and other foreign investors own quantities of their mortgage-backed securities. We noted here in late July that the central banks had increased their holdings at the time Congress was acting on the enabling legislation. But this soon reversed, according to weekly data published by the Federal Reserve; over the last seven weeks, these banks have been net sellers of $18 billion worth of the debt. A large commercial bank in China lately announced that it had reduced its portfolio of Fan's and Fred's bonds by 25% just since June 30, some $4.5 billion worth. So the Federal Government has a role in conducting international financial policy affairs, especially in the run-up to a Presidential election, when investors everywhere might be concerned about the status of Government-related institutions. [Both Presidential candidates were briefed on the takeover by Treasury Secretary Paulson prior to Sunday's announcement.]

Moral Hazard: Opening A Can of Worms?
Finally, what about moral hazard, the topic of our article on July 28? Are we setting a precedent that only leads to more and more calls on Government support? How will that play out? Already, we see activity in the auto industry, for instance. Nominally there's a good reason for government intervention here too, utilizing government-guaranteed debt to finance retooling of plants to build more fuel-efficient cars, as required by a law passed last December. But press coverage today indicates that the companies believe the $25 billion of these guarantees authorized then won't be enough – they'll need $50 billion, some now say. This resembles some investor comments about the Fannie Mae and Freddie Mac plan. During the Treasury's preparations in August, some investors were surveyed about specific amounts of intervention; whatever number the Treasury proposed in its survey, the investors wanted more. If Treasury said $20 billion, they said $30 billion would be better. But the Treasury proposed $30 billion to another group, who said, oh we'll really need $40 billion. The Government is still tiptoeing through a minefield, isn't it? Nobody said this would be easy . . . .