“If the conservative members of the GOP derail this deal and there is an economic collapse, no one will care that they were trying to save the taxpayers’ money.”
[Posted by WLS]
That’s from an -email to Rich Lowry over at NRO’s Corner. I think it encapsulates the problem exactly.
The collateral consequences of doing nothing extend far beyond having a few Wall Street firms fail. Frankly, I couldn’t care less if a few Wall Street firms fail — others will be created to take their place.
EF Hutton, Paine Webber, Dean Witter Reynolds? Not all Wall Street firms “fail” — some are simply taken over by more profitable enterprises when the price is right, just as Bank of America did to Merrill Lynch.
And, this article in today’s Wall Street Journal by Andy Kessler suggests the very possibility – maybe even likelihood – of a significant financial upside for the Treasury to the “bailout” plan now on the table.
The first myth that needs to be punctured is that a $700 billion plan means taxpayers are stuck shelling out $700 billion for nothing. In fact, what the money buys are collateralized securities – bonds backed by home mortgages. Any “loss” that results from these instruments will only be the difference between what the Treasury pays for the paper, and what the Treasury ultimately receives either in payment on the loans by the mortgagee if there is no foreclosure, or what Treasury sells the property for in the event of foreclosure.
There is a lot of handwringing among conservatives about how much the Treasury will pay private enterprises for these securities — this is the worry about “socializing” the losses of private industry. But the Treasury is in the driver’s seat in setting the price which it will pay for these assets. The institutions holding them – whether they be investment houses, commercial banks, or other financial institutions that bought them from Fannie/Freddie or some other seller – are in need of ridding them from their balance sheets because the UNCERTAINTY surrounding their value is preventing those institutions from being able to secure credit to continue daily operations. That is the “credit crisis” being talked about in the news media without much explication on what the phrase means.
Without question, most of these securities are no longer worth the price that the holders paid for them. But that does not mean they are worthless. The problem the credit market has right now is that due to a lack of transparency in the marketing of these instruments (thank you Fannie/Freddie), it’s hard for the holders to know, much less disclose to their creditors, the actual value of the security. Because the value is unknowable, lenders can’t evaluate the risk of lending to an institution that holds such paper on its balance sheet. Larger than disclosed debts could wipe out a company’s entire capital stake and cause it to close shop overnight. That would make any lender just another creditor to be listed on the bankruptcy petition. Lenders prefer to lend money when they have a high confidence that they will be paid back. Without such confidence, they’ll simply buy government T-Bills with their cash – which is what they have been doing now for a couple weeks.
These instruments are a conglomeration of many, many mortgage obligations. Some of them are more risky than others, some are in default, and some are in foreclosure. It requires an individual analysis of each instrument, and within each one an individual analysis of its component parts – the individual mortgages – to determine what value to place on the instrument as a whole. There isn’t enough time to do so, nor is there a mechanism for the market to validate whatever value the holder tries to establish to the satisfaction of its prospective lenders.
So, the Treasury is going to be a “lender of last resort,” so to speak. It’s going to purchase these securities with its pool of $700 billion — making it the owner of the underlying mortgage obligations. This will transfer cash to the holders of the securities, which restores their liquidity and sets right their balance sheet. It will allow financial institutions to go back to lending money, and investment houses can begin borrowing again. They’ll still have to book the losses, so shareholders are not being bailed out, except to the extent that the firms don’t otherwise go under.
In return, the government gets billions in mortgages, to go along with the $1.8 trillion in mortgages it assumed from the portfolios of Fannie and Freddie a couple weeks ago. While the “national debt” will increase by virtue of being on the hook if these mortgages are not held to maturity and paid off, or refinanced at some earlier date. But the other side of the balance sheet is that Treasury will be the “owner” of a couple trillion dollars worth of real estate as well. Think of it as the “Louisiana Purchase” all over again.
So, how might the government treat these mortgages differently than they are being treated by private industry holding them? First, the government doesn’t have to play by the same accounting rules as the finance industry. It doesn’t have to “mark to market” the loans, thereby destroying its balance sheet. “Mark to Market” for accounting purposes means the institution holding the paper must value them on its balances sheets at their fair market value, not at the value that they paid for them. The government doesn’t have to do this, so there is no collateral consequence on its balance sheet to holding distressed loans.
In addition, the government can work with mortgagees to restructure the terms of their mortgages so that they can stay in their houses and resume making their mortgage payments. This will require writing down the value of the homes –- no one is going to want to get back on the hook for a $500,000 loan, even on favorable terms, for a house now worth only $400,000. So, the government can foreclose that person out and have one more empty house sitting on the market waiting for a buyer, or it can bite the bullet and rework the deal to make it affordable to the homeowner. If the government bought the mortgage for only $250,000, rewriting it to $350,000 puts the government $100,000 to the good.
But the biggest difference the government can make is to restructure all these ARMs into fixed-rate 30-year mortgages, thereby easing the wave of foreclosures that happens each time interest rates on these ARMs reset. But they have to do so based on traditional underwriting requirements. It doesn’t do any good to give someone a mortgage when that person doesn’t have the financial ability to repay it, and it makes no difference if their mortgage is an ARM or a 30-year fixed rate conventional. If the best a particular homeowner could do was a “no down, interest only, ARM” then that person is really a renter and not a homeowner by any normal risk profile.
As these mortgages are returned to stability –- or at least the stable ones are identified through an orderly process that is possible with the government standing in for companies that would otherwise fail –- the securities in which they are packaged will regain their value. Once that happens, the securities can be resold. Or, the Treasury could eliminate the securities, and simply resell the performing loans back into the private market. If the Treasury bought a performing loan at 60% of its book value, and could then establish that it was a solid loan with little risk of default, it could easily resell that loan at a substantial profit.
If Treasury bought non-performing loans at 30%, but then reworked the terms of the mortgage so as to bring them back to performing, then the government will see a nice profit. Same for mortgage loans currently in default, which the Treasury is going to be able to buy at a steep discount. If the loan was rewritten to be a more affordable fixed rate, 30-year mortgage, and the homeowner keeps the loan current, the loan could then resold by the Treasury into the private market at a substantial profit to the taxpayer.
Is this outcome guaranteed? Of course not. But it has the benefit of buying not just assets, but also the time with which an orderly market can be restored.
Which takes me back to the quote in the caption. The truth is that John McCain was right last week when he said the underlying fundamentals of the economy are strong. But the economy runs based on financing. Right now it’s the financial sector of the economy that is ailing. That’s like getting blood poisoning. Sooner or later it is going to spread throughout the healthy tissue of the body if it’s not fixed.
People won’t care that $700 billion in taxpayer money was not spent if they watch their pension/retirement funds crater and small businesses close due to a lack of available financing to keep their operations going.