Monday, December 24, 2007

How to Handle a Mortgage Default

November 12, 2010 Update: Mediation of mortgage defaults has become available in a number of states and other locales. The idea behind mediation is that you and the lender meet with a neutral 3rd party (the mediator) who tries to facilitate an agreement for you to avoid foreclosure and stay in the home. The mediator won't take sides or make a decision. The goal of mediation is to foster an agreement between the homeowner and the lender. You should seriously consider mediation if it is available, because it provides a way to have a dialogue, correct misunderstandings and reach a deal allowing you to stay in your home. For more information about mediation, go the the National Consumer Law Center at You can also check your state or local government's website for the availability of mediation programs.

Foreclosure Documentation Problems have recently been prominent in the news. In many cases, courts have halted foreclosure proceedings until lenders can clean up their acts. In a few cases, judges have found the documentation problems to be so severe that they have awarded homes to the owners free of any mortgage debt. Lenders are appealing these latter decisions. If you want to litigate with the lender, you'll need an attorney. Ask around for references. A resource for finding an attorney would be at the National Consumer Law Center website:

March 9, 2010 Update:
Some states offer loans to struggling homeowners. If you live in Delaware, Massachusetts, North Carolina or Pennsylvania, contact your state's housing finance department or agency for information. California, Florida and Nevada may institute such programs. So if you live in one of these states, contact the state housing finance department or agency to see if anything is available.

July 25, 2009 Update:
The Obama administration has improved the Making Home Affordable program to give homeowners who are not yet in foreclosure an expanded opportunity to refinance. If you've been current on your monthly payments for the past year, you may now be able to refinance even if you are as much as 125% underwater on your mortgage (the earlier standard was not more than 105% underwater). This is a significant improvement over the original program. For more details, see

March 23, 2009 Update:
The Obama administration has announced the "Making Home Affordable" program, an initiative to provide mortgage relief to homeowners who are not yet in foreclosure. This program could help some people who would not be assisted by other programs, such as those discussed below. See for more on the Making Home Affordable program.

Original Blog (with a reference to a discontinued program called FHASecure deleted):

If you’ve defaulted on your mortgage, or are close to defaulting, you’ll find that the resources for assisting you are limited and scattered about. There’s no overall program, and no easy way to access the available resources. That doesn’t mean you won’t find help, though, especially if you have a moderate or low income. Here are some avenues to explore.

Rate Freeze: the federal government has sponsored a voluntary five-year rate freeze for certain subprime ARM mortgages. Covered mortgages may have their rates frozen at the initial level for five additional years past the initial teaser rate period. You could be in luck if you meet the following criteria: (a) you live in the home purchased with the mortgage and took out a subprime ARM loan made between Jan. 1, 2005 and July 31, 2007; (b) the ARM’s interest rate resets between Jan. 1, 2008 and July 31, 2010; (b) your mortgage loan was packaged into securities sold to investors; (c) you have a credit score less than 660, which hasn’t improved by more than 10% since the mortgage loan was first made; (d) the monthly payment will increase more than 10% in the first reset; and (e) you haven’t been more than 60 days late with a mortgage payment more than once in the last 12 months.

This is a narrowly defined group of mortgages. If, for example, your mortgage was not sold to investors but is still held by a bank or savings and loan association, you’re not covered by the rate freeze. If you took out your mortgage in 2004, too bad. If you’ve been conscientious about paying debts on time and your credit rating has improved more than 10% since you took out the mortgage, you’re out of luck. If you’re already in foreclosure proceedings and really need help, the rate freeze won’t be there for you. In many respects, the rate freeze was designed with the interests of Wall Street investors in mind, so its limited scope shouldn’t be surprising.

Call your mortgage servicer to find out if you qualify for a rate freeze. Most borrowers won’t get one. Here are some additional resources. They mostly focus on helping low and moderate income homeowners.

Contact the Hope Now Alliance at 888-995-4673. This organization was established by a group of nonprofits and lenders, and provides counseling services to borrowers having trouble paying their mortgages.

A national nonprofit organization that helps low and moderate income homebuyers is Acorn Housing Corp. Acorn can be reached by email at or by calling 1-888-409-3557. Acorn also has offices in a number of cities. If you are one of the borrowers that Acorn aims to assist, they may help you negotiate with the lender for relief.

Another national nonprofit organization that helps low and moderate income homeowners is Neighborhood Assistance Corp. of America. Its program for distressed homeowners is described at, and you can call at 1-888-302-NACA. NACA also has offices in a number of cities, and may help you negotiate with the lender for relief.

Contact state and local nonprofit organizations that promote home ownership or provide credit counseling. The extent to which they can help you will vary. But for some homeowners, particularly those with modest or low incomes, these nonprofit organizations can provide a degree of negotiating leverage you would never have on your own. Stay away from mortgage brokers and other for-profit businesses that purport to provide mortgage assistance. If you’re in trouble on your mortgage, the last thing you need is someone who sees you as a profit opportunity.

Higher income people and investors will probably have to take care of themselves. If that’s your situation, here are some thoughts.

Dispassionately evaluate your situation and your ability to keep the house. The bank will be dispassionate, and so should you. Emotion won’t save your house. If necessary, assemble your financial records, go to the public library, and find a quiet corner in the reading room where you can work without distractions.

Calculate your net worth to find out what your financial situation is. Add up your assets, and subtract your debts and other liabilities. Don’t count as assets things like household furnishings, furniture and clothing, which you won’t sell to pay your mortgage. Count only financial assets, and physical assets you’re prepared to sell.

It’s very important to figure out if you’re upside down on your mortgage—i.e., whether or not the house is worth less than the mortgage debt. If so, then you have to make a hard decision whether it’s worthwhile to try to keep the house. Mortgage loans are almost always “with recourse,” which means that if the house is sold in foreclosure proceedings and doesn’t raise enough money to cover the mortgage debt, you will be legally responsible for the unpaid difference. But determining if you have positive or negative equity in the house gives you an idea of how much it’s worth your while to try to hold onto the house. The more equity you have in the house, the more it’s worth trying to keep. And it also gives you a sense for the feasibility of selling the house to pay the mortgage.

Estimate your ability to cut back on other spending in order to meet the mortgage payments. Cutting back on spending is the best option, because it preserves the part of your income that is needed to pay other debts and cover basic living expenses. If spending cutbacks won’t get you there, look at how much of your taxable savings and investments you could use for mortgage payments. Don’t forget that the sale of investment assets like mutual funds and stocks could create tax liabilities and you have to set aside enough money to cover taxes. If you have physical assets you are willing sell to raise money, like your 1971 Chevy Camaro SS with a 396 cubic inch engine, add them to the calculation (with reserves for taxes if necessary).

As a general rule, don’t tap into retirement accounts to make mortgage payments. You’ll have to pay taxes and a 10% penalty on withdrawals, and will have only the remainder for the mortgage. For most people, somewhere between a third and a half of a withdrawal will go to pay taxes and penalties. You could quickly deplete retirement savings you took years to build up. The mortgage lender can’t reach into your retirement accounts for payment (these accounts are protected by law from creditors) and you’d only be needlessly risking your retirement.

Once you have a sense of your financial resources (or lack thereof), you can then negotiate an end game with the lender. Have a bottom line, and if the negotiations get there, stop at the bottom line. Don’t give up everything to keep the house. That’s what the lender wants you to do, but you may be throwing good money after bad, and end up with nothing—no house, no savings and no retirement. Whether or not you lose the house, life will continue and you should preserve something for the future.

To stay in your home, ask if you can refinance into an affordable fixed rate mortgage. If the lender won't agree to that, ask for reduced rates and payments, and forgiveness of some of the principal of the debt. Also ask the lender not to add unpaid interest to the principal balance of the mortgage debt. This is called “negative amortization,” and only delays the pain. It really doesn’t do much to help you.

If you're 62 or older, you could think about refinancing with a reverse mortgage. Although the reverse mortgage might provide less money than you owe on your current mortgage, if you're having trouble making payments, your current lender may take what it can get from the reverse mortgage rather than face potentially larger losses from a foreclosure. One important advantage of a reverse mortgage is that you don't have to repay it until you sell the house, move permanently from the house or pass away. In other words, there are no monthly payments and you can't be kicked out of your house by foreclosure. It's worth looking into if you're 62 or older and about to lose your home. For more information about reverse mortgages, go to

If you can't work out an affordable payment plan with the lender, consider selling the house. This may be a viable option if the house is worth more than the mortgage debt. If not, you might be able to negotiate a “short sale” with the lender, where you sell the house for whatever you can get, and the lender doesn’t go after you for the unpaid balance of the mortgage loan. Short sales may generate a better price than an auction, and lenders sometimes will agree to them rather than see you walk away from the house.

If you can’t feasibly pay, refinance or renegotiate the mortgage, and can't sell the house on acceptable terms, abandon the house. But let the lender know that you’re leaving and send them the keys. At a minimum, they might do a little upkeep and maintenance on the property to preserve its auction value. That’s in your interest. The more the house sells for at auction, the less recourse the bank will seek from you.

A couple of things to keep in mind. Act sooner rather than later. If you expect problems making your mortgage payments, contact the lender up front and try to work things out before you default. Once you default, the stakes are raised and positions can harden. Avoid is asking family and friends for help with the mortgage. If borrowing from friends and family doesn’t give you enough money to prevent foreclosure, you’ll lose the house, and will also have tapped out the last ditch resources you might need to rebuild your life. (Remember, life will continue after your personal mortgage crisis.) Keep family and friends out of your housing problems.

If you do lose your house, there’s one thing you could gain—wisdom. Next time around, be more prudent and conservative with the price of the house you buy and the amount you borrow. A good-sized downpayment is in everyone’s interests. It obviously protects lenders, but also gives you a cushion to refinance or sell if things go wrong. A fixed-rate mortgage that you can afford makes everyone—homeowners and lenders—better off. Since time immemorial, common sense has paid off and recklessness has been costly.

How to Save for a New Truck:

Friday, December 21, 2007

Watch Out For Holiday Season Financial News: Does the ECB Know Something?

Public relations professionals know that one of the best times to release bad news is the week between Christmas and New Year’s. People are busy having fun (or at least going through the motions). There’s vigorous consumption of booze and eggnog. If you have something unpleasant (or worse) to announce, these are the times to ease a press release onto the news wires. Those with capital at risk—such as investors--should watch out for ambushes.

Heightened vigilance is especially in order this year. We all know that the big banks will likely be reporting negative news. Some already have. Others probably will. They’d like nothing more than to disclose it to a bunch of empty offices, whose usual occupants are eggnog-besotted.

It’s fair to expect that the news could be worse than expected. That was true of Morgan Stanley and Bear Stearns. Even the vaunted Goldman Sachs had a little tarnish on its golden financial results.

And the European Central Bank just flooded the European money markets with $500 billion of two-week loans to banks. That’s quite a bit of lunch money, more than the federal deficit. By comparison, the Federal Reserve in the U.S. recently auctioned $20 billion of special 28-day loans to banks through its Term Auction Facility. Someone high up in European finance has to be worried about something pretty big if they’re going to pump into the banking system enough money to buy 50 billion lunches.

Weaker financial results and losses for the banks aren’t necessarily bad. At this point, they are inevitable and it’s better to know what they are. Much of the problem in the financial markets today is a lack of confidence, not a lack of liquidity. Holders of capital and cash don’t know how bad things are at the major banks. That’s why they won’t lend. It’s not that they don’t have the money. It’s that they’d prefer to get 3% or 4% from U.S. Treasuries than invest in a black hole.

Disclosure and writeoffs clear up the picture. Even with large losses from mortgages and real estate, the major banks remain substantial commercial enterprises. With proper disclosure, they can probably continue to attract funding and capital, albeit at a higher price. The higher price is simply the way the markets work, and payment of the higher price is necessary to get the markets working again.

What doesn’t work is continued obfuscation of the facts. The SIVs and Super SIV cloud the picture. So does the administration’s mortgage rate freeze, with a near-impossible to predict impact on values of mortgage-backed securities and derivatives. Asset values become harder to determine, and some banks may delay recognition of losses that, given the continued decline of real estate, they almost surely will have to take sooner or later. Nothing good is likely to come from stalling and delaying. A four-corner offense doesn’t work when you’re trailing.

So, if you’re invested in the markets, keep an eye on the financial news. Enjoy the holidays. But remember, there are some out there who would gladly pour you another eggnog as they slip a press release onto the news wires.

Crime News: Santa in helicopter shot at. Next time, big guy, stick with the reindeer and sleigh.

Wednesday, December 19, 2007

How to Spot an Ongoing Asset Bubble

As 2007 draws to a close, the notion of price has been resurrected in the financial markets. Less than a year ago, it seemed that prices for some asset classes simply didn’t matter any more. Disregarding price is tantamount to suspending belief in markets. There were a lot of nonbelievers for a while. Witness the apostasies.

Real Estate. The subprime mess and mortgage crisis can be traced to one fundamental problem: buyers paid too much for real estate. This insensitivity to price was enabled by a flood of easy credit, which often was extended in looney loans that for many borrowers were impossible to repay. The resulting rapid rise in prices was used as a justification for paying even higher prices, on the theory that a rising market would allow anyone, however lacking in creditworthiness, to sell or refinance. This recklessness soon became foolishness, and fools and their money are (and were) soon parted.

Derivatives. Vast numbers of mortgages were financed through mortgage-backed securities that were then engineered into derivatives contracts sold to investors. Many of these derivatives purported to construct AAA-rated investments from subprime loans. This alchemistic feat of turning lead into gold involved Wall Street using computer models to assign valuations to the derivatives (while chanting incantations, we now suspect). When things got ugly and investors tried to sell the derivatives, they found that there was a bit of a chasm between the computer valuations and the cash prices real human beings were willing to pay. Ultimately, all financial assets are measured by the amount of cash they command. Computer models don’t buy food, clothing, rent, college educations or retirements. When push comes to shove (and eventually it will), derivatives contracts have value only to the extent they can be transformed into cash. Since these investments are largely unregulated, caveat investor.

Risk. The summer and fall of 2007 will be remembered as the Great Repricing of Risk. Recall that previously, risk was viewed as something that could be whisked away by clever financial engineering. We now understand that risk never dies. Even if banished to distant lands, it has a way of wending its way back, across great oceans if need be, to pop unexpectedly out of closets and cellars, and work its evil. The financial markets now price risk as if it were real, which is a good thing since it is real.

Market dysfunctions always end in an ugly way. But Alan Greenspan notwithstanding, asset bubbles can be spotted while they’re happening. When price becomes increasingly insignificant to purchasers, you have an asset bubble in the making. Maybe it’s hard to precisely identify when an asset bubble begins. But the limitations of statistical methodology shouldn’t be used as an excuse to refrain from seeing what’s right in front of you. Price insensitivity in the real estate and mortgage markets was hard to miss in 2005 and 2006. Wall Street executives and the regulators could have spotted this one in the offing. Indeed, a few did but could make no headway toward action against the Panglossian self-satisfaction of the conventional wisdom. Next time (and there will be a next time) remember that when price sensitivity diminishes, economic insanity will soon follow.

Legal News: right to cuss out a toilet upheld.

Monday, December 17, 2007

A Tale of Two Currencies

Today, the world has two principal currencies. One, the Euro, is the officially adopted currency of the 13 countries of the Eurozone, which includes of most of the economic powers of Europe. The other, the U.S. dollar, is the officially adopted currency in six nations (the U.S., Panama, El Salvador, Ecuador, East Timor and certain Pacific islands). It is also officially or not quite officially pegged to certain other currencies, which in effect makes it a de facto currency of the pegging nation (such as China, Hong Kong, Macau, and Saudi Arabia). Although China has officially delinked the yuan from the dollar, it unofficially maintains currency parity, allowing the yuan to drift up ever so slightly from time to time without disrupting its fundamental relationship to the dollar.

We all know that the dollar has been falling and the Euro rising. Hordes of European tourists flood Manhattan, Florida, dude ranches and upscale shopping venues nationwide. Canadians lose their customary restraint whenever they cross the border and approach a mall. Fashion models demand payment in Euros.

Foreign and American investors are allocating more capital to non-dollar denominated investments. The foreign capital that is coming into the U.S. is being used to buy pieces of crown jewels of the American financial system. America continues to attract foreign investment, only at greater cost.

Short to medium term, foreign financial markets will probably provide returns that are as good or better than the U.S. financial markets. Foreign economies are less burdened by the losses emanating from the U.S. mortgage mess, and will probably grow faster. The U.S. economy may or may not fall into a recession, but it will surely slow down and bring corporate profit growth down with it.

But long term, bet on the dollar. Why?

Because the greatest economic potential remains in the dollar zone nations. With Germany, France and Italy at the lead, the Eurozone consists primarily of mature, highly structured economies with substantial social welfare systems. They have short work weeks and generous amounts of vacation time. Innovation and risk-taking are not greatly encouraged. Their cultures are highly developed and continental--meaning they indulge in a condescending cynicism that sometimes makes Americans feel inferior, but ultimately saps Europe of economic vitality.

The two principal nations of the dollar zone are the U.S. and China. Although politically quite different, they are economically almost two parts of the same nation. Numerous U.S. manufacturing and retailing companies rely heavily on Chinese suppliers. The U.S. government's budget deficit is financed to a significant degree by the central bank of China. Low American inflation rates and the flood of inexpensive consumer goods we have today are attributable in large part to America's economic ties to China. China's new found prosperity is heavily dependent on sales to America.

America is a nation of dreamers. Founded by immigrants, its aspirational qualities form the core of American culture. The American dream, and the gosh, golly enthusiasm of American tinkerers and entrepreneurs, continue to be vital.

The Chinese, too, are a nation of dreamers. Traditionally, dynastic China provided young, talented boys--including those from humble families--with the opportunity to advance by taking a series of imperial examinations. Those that were successful were given educational opportunities, and, ultimately, university professorships and high ranking government positions. Thus, the talented and ambitious could advance and confer the benefits of their abilities on the nation as a whole.

The Communist Chinese government, in making its turn toward capitalism, funneled these ambitions toward commercial endeavor. Chinese entrepreneurs responded with vigor, producing the economic juggernaut we see today.

The common tendency of Americans and Chinese to dream, aspire, and indulge ambition is probably one of the main reasons for the economic partnership of the two nations. While many third world nations can provide low cost labor, few peoples try as hard as the Chinese to win and please customers. There have been some stumbles along the way, most recently with some poorly manufactured toys. But Americans and Chinese find that they often work well together. And, given the interconnections between their economies, they have a strong interest in continuing to work together. Whatever it may say, the central bank of China will maintain close parity between the yuan and the dollar.

America is the center of high tech innovation. Nothing happening anywhere else in the world is about to change that. The best computer hardware and software is American. The ubiquitous Internet, an innovation that allows mass, simultaneous communication, could only have been made in the U.S.A. The core of technological knowledge here is an ocean compared to ponds in other nations.

China has become a manufacturing giant. Its engineers are becoming skilled at applied engineering, although they need to derive most of their inspiration from technological advances in other countries. The dollar-based economies of both nations links them together tightly, and they cannot (and would not want to) go their separate ways. Moreover, their aspirational qualities and drive will lead to more innovation and risk taking, qualities that will enhance productivity and economic growth.

In centuries past, nations became wealthy by building empires. The military aggression that required is no longer possible today. The Eurozone nations have tried to become wealthy by lowering trade barriers and currency translation costs. But you can build only so much wealth by cutting expenses. Ultimately, the wealth of nations now comes from technological advancement and risk taking. This is where the dollar zone nations have the distinct advantage.

The nation's and the world's economies, as we are now learning with the mortgage mess and credit crunch, move in cycles. No amount of overly clever financial engineering changes that basic fact. At some points of the cycle, conservative economies like the Eurozone will have the advantage, just as Japan had the advantage in the 1980s. But the long term advantage rests with the dreamers and schemers, the plungers and gamblers, the max-out-your-credit card entrepreneurs. For your long run investments, bet on the dollar.

Crime News: the rising popularity of pink penitentiaries.

Friday, December 14, 2007

The Fed's TAF Reveals Credit Crunch Policy Conflict

The Federal Reserve’s newly announced Term Auction Facility (or TAF) reveals a conflict between the Fed’s goals of spurring economic growth and easing the credit crunch.

The Fed’s reductions of the fed funds rate, done to stimulate economic activity, may have the perverse effect of making interbank loans scarcer. The fed funds rate is the interest rate for overnight loans between banks. The credit crunch has manifested itself most acutely in the reluctance of major banks to lend to each other, for fear of undisclosed mortgage and related losses. That, in turn, has constrained lending by banks to others. By lowering the fed funds rate, the Fed reduced the remuneration banks receive for taking the now heightened risks of lending to each other. Let’s return to Econ 101 for a moment. If you want more supply, using a government price control to reduce prices isn’t exactly the most effective way to go. Lenders want more compensation for lending to banks, not less.

There is some evidence that the lower fed funds rate conflicts with market perceptions of the creditworthiness of banks. LIBOR, the interest rate charged in dollar-denominated interbank loans in the overseas financial markets, has remained stubbornly high around 5% in spite of the Fed’s cuts of the fed funds rate to 4.25%. LIBOR is a market rate, set in London without any Fed oversight. It would appear to indicate that people in the business of making loans judge banks to be lousier credits than would be justified by the fed funds rate.

The TAF purports to address the problem with 28-day government loans to banks at rates expected to be lower than LIBOR. The TAF will auction loans to be made through the Fed’s discount window. In general, banks prefer not to borrow from the discount window, which they have regarded as indicating weakness and therefore a last resort. The Fed has been steadily reducing the discount rate charged for loans made from its discount window, and has stated that it will not regard borrowing from the discount window as a sign of weakness. That, however, has done little to change the reluctance of banks to borrow from their regulators. It remains to be seen whether they will view TAF loans, even at bargain rates. any differently.

The credit crunch is driven by lack of information and uncertainty. Investors and lenders don’t know how bad the banks’ mortgage and related losses are, and are understandably reluctant to invest in or lend to them. Lowering the fed funds rate and providing a government subsidy through TAF won’t do a lot to resolve these problems. Requiring banks to disclose exposures, write down losses and bolster their capital would clear the air. That would hurt, but the ongoing credit crunch isn’t exactly painless. Given the magnitude of the mortgage and other losses we’re dealing with, there isn’t a way to avoid major pain. The only question is what is the sensible way to deal with the pain.

Holiday News: decorations for the Garden State Parkway.

Tuesday, December 11, 2007

We've Got Bailouts. How About Fixing the Banking System?

Just in time for the holiday season, the federal government is trying to climb down the chimney with bailouts in hand. It's brought a rate freeze for some mortgage borrowers, a super conduit for SIV-bedeviled banks, and another interest rate cut courtesy of the Federal Reserve Board. There have been many of the usual holiday-season reactions to these gifts. Many borrowers claim that the rate freeze doesn't benefit enough homeowners, and the stock market threw a hissy fit today when the Fed's interest rate cuts felt too much like anthracite from a stocking. Unfortunately, regifting isn't possible here.

The government has only been treating symptoms. If things go well, it might stabilize the situation. But all of the government's announced measures simply re-allocate the mammoth risks and losses from the mortgage mess. The rate freeze benefits some borrowers and hurts banks and investors. The super conduit will provide liquidity to certain SIVs and their affiliated banks, but at risk to the investors in the super conduit and its commercial paper. The Fed's latest interest rate cut, like all its other rate cuts, benefits banks and reckless speculators while shifting some of their losses onto savers and other holders of capital. Re-allocating losses, often in seemingly arbitrary or random manner, does little to promote rational future behavior. It might, indeed, exacerbate the credit crunch as holders of capital simply avoid the asset-backed investments that have given rise to the current financial mess.

That points to the missing piece of the government's response to the mortgage crisis and credit crunch. Securitization of loans is big business today. Most types of loans that banks made and held 25 or 30 years ago are now bundled into investments with various alphabet soup acronyms and sold to investors. These include home mortgages, home equity lines of credit, credit card balances, auto loans and corporate loans. Those things called "banks" are in many respects just administrative functionaries that screen borrowers' creditworthiness (we hope) and process paperwork associated with loans. But actual loans are made by investors. The real bank is the securitization process.

Asset backed securities, as we all know, are not protected by federal deposit insurance. That's much of the reason for the credit implosion this past summer. Investors, who functionally speaking are depositors, were frazzled by mortgage losses and tried to offload their mortgage-related exposure. Cash values of these investments plummeted or became unavailable. Hedge funds and other investment vehicles shut down. If you step back, it all has an uncanny resemblance to the financial panics and bank collapses of the pre-FDIC world. That shouldn't be surprising, since the asset-backed securities market is now a crucial de facto segment of the banking system.

Neither J.P. Morgan nor Jimmy Stewart is around to calm the panic. Federal insurance of asset-backed securities wouldn't fly, for both political and practical reasons. The $100,000 limit on federal insurance of bank accounts is a trivial amount in the multi-millions and billions world of asset-backed securities. A higher amount would look like a bailout of the wealthy, and would probably result in federal examiners moving into the offices of the investments banks peddling these investments in order to prevent undue risk to the U.S. Treasury.

There are ways to improve the asset-backed securities market and thereby strengthen the true banking system:

1. Simplification and standardization. Many asset-backed investments, such as CDOs, are a witch's brew of different loans, including mortgages, credit card balances, auto loans and corporate debt. An important reason why these things can't find cash buyers right now is because a cash buyer would need a supercomputer to analyze the constituent components of the asset pool and calculate a value. On Wall Street's trading desks, buy and sell decisions are often made in seconds. There's no time to dally around with complex, hinky derivatives of derivatives. Simplifying and standardizing asset-backed investments, such as limiting them to just one type of loan--e.g., home mortgages with a first lien, auto loans for new cars, or credit card balances with credit ratings of at least a certain minimum--would go a long way to ensuring that they can find a ready market. Overpaid financial engineers have mixed and matched too many different kinds of debt in a now discredited effort to squeeze AAA ratings out of risky investments. Their cleverness and a half has been costly for all of us.

2. Margin Regulations for Derivatives. Much of the reason for the sudden and severe losses of the past six months is the mainlining of leverage by the investment community. The reckless lending by banks and reckless borrowing by money managers magnified every flaw in the securitization process, and rubbed vats of salt into the wounds suffered in the financial crisis. Borrowing with abandon to buy stocks was one of the reasons for the stock market boom of the 1920s and the flood of margin calls that aggravated the stock market crash of 1929. The Fed has successfully regulated margin lending on stocks ever since. It should get and exercise regulatory authority over margin lending on derivatives.

3. Regulation of Hedge Funds and Derivatives Trading. One of the major reasons for the make-it-up-as-you-go-along quality of the government's response to the financial crisis is that regulators don't know much about the problems. Getting firm information about the full extent of derivatives holdings and trading has apparently been extremely difficult or impossible. It's really hard to formulate effective policy if you can't see the complete contours of the problem. Federal regulators don't effectively regulate either hedge funds or derivatives trading, partly because of a lack of inclination and partly because of questions about their lawful authority. Both of these problems can and should be fixed. Given the hundreds of billions of dollars of losses that now appear certain, there remains no excuse for a regulatory void. The regulation need not overstep reasonable bounds--the crucial things are to be able to gather information about who holds what, who has sustained what losses, and what the trading activity has been.

4. Listed Markets for Asset-Backed Securities. A logical corollary to the preceding measures would be the creation of exchanges or similar markets for asset-backed securities with publicly displayed price quotations and transaction reports. Nothing would instill public confidence and investment interest as much as an open and readily observable market. That's exactly what happened with stocks and bonds. It can happen with asset-backed securities.

The securitization process isn't going to go away. The regulatory structure of the formal banking system, with its risk-based capital requirements, will continue to subtly push banks to offload credit risk. And the securitization process is a primary means of accessing the vast amount of capital it takes to fund banks' lending activities. Back of the envelope bailout proposals won't make the banking system truly functional. Only meaningful reform can accomplish that.

School News: parents with high school age kids, rethink your plans to move to Montpelier.

Sunday, December 9, 2007

Happy New Year for Investment Banks?

Fiscal 2007 closed at the end of November for major investment banks like Morgan Stanley, Goldman Sachs, and JPMorgan Chase. They will probably announce preliminary financial results in the next couple of weeks.

Large write-offs for mortgage exposure and other credit crunch losses wouldn't surprise anyone. The problems in the financial markets are known to just about everyone who has a pulse and is literate. Moreover, unlike the third quarter results announced this past September, the year end results will be audited. So the investment banks may tread cautiously in terrain now known to contain mines.

Look at what the banks do with their Level 3 assets. These are the financial assets for which there is virtually no market information--in other words, they're the derivatives that have been valued according to computer models. As we know, there have been problems with the models. (See A substantial dose of management discretion goes into establishing the values of Level 3 assets. Finding bona fide cash buyers for these assets hasn't been so easy lately. Management will have to be careful in exercising its discretion, lest it be accused of indiscretion.

Level 2 assets can also present interesting challenges. These are financial assets for which some market information exists, but management discretion also plays a significant role. For level 2 assets with mortgage exposure, the market information is probably not encouraging. So management must proceed with care. Taking a highly optimistic outlook when the outside world is frowning may, for accounting purposes, not equate to the better part of valor.

Perhaps one of the most interesting developments, if it occurs, would be a report of strong financial results. Goldman Sachs issued such report this past September. Goldman has a goodly share of Level 3 assets, more than its capital. But it apparently was able to hedge its exposure to the mortgage mess. Good for Goldman. But bad for its counterparties.

Whenever a market player like Goldman hedges a risk, someone else takes the opposite side of the transaction. If Goldman wins on the hedge, the counterparty loses. Since Goldman did so well in the third quarter, a lot of counterparties must have done rather badly. Goldman appeared smart and a bunch of other people appeared dumb.

It's not a good idea in the financial markets to appear too smart. If other market participants think you're way ahead of them, they'll be less likely to trade with you, for fear that your superior information will put them at a disadvantage. And if they do trade with you, they may demand a larger premium for the risk you could present. Credit default swaps for mortgage-backed securities aren't exactly cheap any more. And if the counterparty is dealing with a Goldman, who may have superior information about the risks involved, the trade might not happen at all.

Perhaps Goldman's hedges are still in place and it can still announce solid gold results. On the other hand, perhaps some of its hedges have expired and it's needed to replace them. That may have proven more difficult in the last couple of months. Perhaps some of its counterparties have been so badly crippled by mortgage losses than their creditworthiness has been impaired and their ability to stand behind their losing positions vis-a-vis Goldman has come into question. If so, Goldman's financial performance may glow less brightly now.

Anyway, time passes and we move on. 2008 is a new year. Maybe things will be sunny and bright. But then again, if all the predictions have even a modicum of accuracy, 2008 is likely to be another year in which we'll have to scrutinize the financial results of the investment banks closely.

Investment Idea: if you're tired of the stock market, consider Scotch.

Thursday, December 6, 2007

Federal Policies for Mortgage Crisis Contradict Each Other

With today's announcement of a freeze on adjustable mortgage rates, we see federal policy for the mortgage crisis moving in contradictory directions. The federal freeze on rates focuses on mortgages whose monthly payments would adjust between Jan. 1, 2008 and July 31, 2010. Eligible borrowers would include those that cannot afford the increased payments, but can afford the initial rate. If you're more than 30 days late on a payment at the time the mortgage would be modified with a frozen rate, or were more than 60 days late with a payment in the 12 months before that time, you're not eligible for a rate freeze. The rate freeze is aimed at borrowers who would be able to stay in their homes if their rates are frozen, but not if monthly payments are increased. Borrowers who cannot afford even the initial rate are out of luck. Those that can afford the payment increase get the privilege of making increased payments (consider it a character building experience). Those lucky enough to be poor enough to be eligible would get a five-year freeze.

Press reports indicate that well over a million mortgages will reset in the time period covered by the rate freeze, but only somewhere between 145,000 and 240,000 borrowers would satisfy the criteria for a freeze. In other words, the rate freeze would benefit about 20% or less of the borrowers facing resets.

The rate freeze is, in essence, a shifting of losses. Homeowners who would have very possibly lost their homes get to stay in them, at least for the five-year duration of the freeze. The owners of the mortgages that are frozen--who are likely to be banks or investors in mortgage-backed investments--lose some of the value of their holdings.

A problematic question for investors and the mortgage markets is what impact the rate freeze will have on the values of mortgage-backed investments. Mortgage-backed investments are based on pools of individual mortgages, and one would have a difficult time figuring out which individual mortgages in a particular pool might reset. Determining eligibility for a reset requires reviewing the borrower's income, assets, liabilities, payment history and perhaps other factors. This kind of detailed review is exactly what wasn't done when many of the mortgage loans in question were first made. So figuring out how many mortgages in a pool might reset would be difficult or impossible.

But knowing the answer to that question is crucial to determining the impact the rate freeze will have on the price of mortgage-backed investments. In effect, the rate freeze creates more uncertainty for mortgage-backed investments at a time when they are already highly uncertain. This uncertainty extends from AAA-rated CDO tranches to the depths of the subprime sewer, and detracts from other policy goals of the federal government.

The Treasury Department has been working with major banks to create a super conduit or super SIV to bail out troubled bank-affiliated SIVs that invested heavily in mortgage-backed securities. The potential efficacy of the super conduit is hindered by the rate freeze, since the investments it was supposed to buy from the bank-affiliated SIVs may now be harder to price. Banks may be more reluctant to sink capital into the super conduit, now that there is less certainty it won't turn out to be a dog of an investment.

The Federal Reserve has been working to maintain the stability of the banking system. The lending and investment exposure of banks to mortgage-backed investments is Brobdingnagian. The increased illiquidity of these investments caused by the rate freeze would likely produce more losses to banks. That would detract from banking stability.

Banks that have been trying on their own to work through their mortgage problems will have a harder time. Investors have had their nerves frazzled by repercussions of the mortgage crisis in myriad nooks and crannies, including unpleasant surprises with money market funds and the municipal bond markets. The increased uncertainty in valuations of mortgage-backed investments caused by the rate freeze will make investors less willing to buy these puppies from banks in distress. With fewer buyers available, banks will have to dance with the ones they brung, and become long term mortgage investors and financiers. Less bank credit will be available for other purposes.

The rate freeze, like the super conduit proposal and the Fed's reactive interest rate cuts and discount window lending, is a means of treating the symptoms. The government has yet to tell us how it proposes to deal with the causes of the mortgage mess and prevent anything like this from happening again. With the Fed set to ease interest rates again next week, one suspects that their strategy (witting or unwitting) is to re-institute the easy money policies that created the mortgage mess in the first place. But you can't just keep throwing money at people and expect them to spend and invest as recklessly as they did in the past. The Silicon Valley learned prudence from the tech bust of 2000. $90-100 a barrel oil hasn't led to the speculative boom in oil and gas exploration of the early 1980s. The Japanese central bank learned in the 1990s and 2000s that simply throwing money at consumers after a real estate and stock market bust doesn't revive an economy.

Franklin Delano Roosevelt's New Deal included a variety of measures that treated symptoms, such as the National Recovery Administration and the Works Progress Administration, and utilized policies such as price controls and limits on competition. The New Deal also included measures to deal with underlying problems, such as the FDIC and the SEC. It is not coincidental that the measures that treated symptoms are largely gone today, while the measures that treated underlying causes remain actively involved in today's financial markets. The mortgage rate freeze, with its contradictory impact on other federal policies, has all the hallmarks of policy making by scribbling on the backs of envelopes in the coffee shop of a Washington hotel. It's at times of crisis like this that public servants distinguish themselves--or not. Having sound proposals for dealing with the causes of the mortgage crisis is essential to restoring the public confidence in the financial and real estate markets. With bated breath, the citizenry continues to wait.

Auto News: what's the most popular car color?

Wednesday, December 5, 2007

Will the Federal Government Response to the Mortgage Crisis Pick Taxpayers' Pockets?

On Tuesday, December 4, 2007, the financial press reported that the Bush Administration had proposed that states and municipalities be authorized by Congress to issue tax exempt bonds to raise money for refinancing distressed homeowners unable to pay their mortgages. The aroma of a taxpayer-funded bailout of the mortgage crisis has been in the air for a while, and now we see the first concrete manifestation.

Details about the proposed bonds were not provided. However, one could reasonably expect that they would be revenue bonds, where the states and municipalities issuing them would have no liability for repayment. No government in its right mind would today assume liability for anything that's mortgage-backed. Governing bodies would simply lend their official status as a means of providing a tax exemption. The investors' right to repayment would presumably come only from the refinanced mortgages.

Given the toxicity of the phrase "mortgage-backed" these days, how could such a program work? The number of people clamoring to invest in mortgage-backed securities wouldn't fill a phone booth. But here's a likely scenario: the tax exemption would allow the bonds to pay a relatively low interest rate. Investors will accept lower returns when those returns aren't taxed. This would allow distressed homeowners to refinance at low rates they can afford. Since these refinanced mortgages wouldn't need to find a home in the ordinary market for mortgages (in which interest is taxable), they can be used to bail out distressed borrowers and still be sold to investors. Sounds like a win, win combination, yes?

No. In spite of all the brilliant financial engineering available on Wall Street and a Federal Reserve Board that talks tough, but hands out candy on demand to the financial markets, there still ain't no such thing as a free lunch. If tax exempt bonds ride to the rescue, giving both distressed borrowers and investors a break, someone else has to be paying for lunch.

And that would be John and Jane Taxpayer. Tax exempt bonds would increase the amount of interest income that isn't taxed. There would be a negative impact on federal tax revenues. Either taxes will have to be raised, federal borrowing increased, or both. If federal borrowing increases, greater interest costs will be borne by taxpayers.

The burden won't be spread evenly among taxpayers. People who invest in tax exempt bonds typically are wealthy or very wealthy. Most taxpayers are neither wealthy nor very wealthy. So ordinary people would pay the price of a mortgage bailout while wealthy investors get a tax break.

Tax exempt revenue bonds have been used for decades to finance industrial development, hospitals, pollution control equipment, and other activity deemed socially desirable by the state or municipality issuing the bonds. However, they've typically been used for relatively small projects, where millions or tens of millions of dollars of bonds were issued. A bailout of the mortgage mess would probably require tens of billions, or even hundreds of billions, of dollars of bonds. Such a program would shift a vast amount of capital from investment in taxable bonds and other debt investments into mortgage bailout bonds, with a large, regressive impact on taxpayers.

It may be that the tax exempt bonds proposal is just political football. The Republicans know that any such program cannot be adopted without Congressional action. They also know that the Democrats have a policy of tax revenue "neutrality," where the Democrats would not approve any tax cut or spending measure without a way to offset the revenues that would be lost. There may be no feasible way to find enough offsetting revenues to compensate for the revenue losses of a meaningful tax exempt bond program for refinancing distressed homeowners. So Congress may be unable to act. Then the Republicans would blame the Democrats for their inaction. And that may all there really is to the tax exempt
bond proposal--more political gotcha and fingerpointing.

Crime News: a new low for a high--toad smoking.

Monday, December 3, 2007

Mortgage Interest Rate Freeze Proposal

The federal government and a number of mortgage lenders are working on a temporary freeze of interest rates on some adjustable rate mortgages. In other words, monthly payments would remain where they are today for longer than the mortgage provides. Although the details aren’t clear yet, some general outlines of the proposal have emerged. For eligible borrowers, the mortgage interest rate would remain at its initial level for at least a few years. Since the initial rate is often a “teaser” rate that doesn’t reflect the full cost to lenders of making the loan, a rate freeze means losses for lenders and gains for borrowers.

The discussions about the mortgage rate freeze have reportedly separated borrowers into three categories: those that can pay their adjustable rate loans even if the monthly payment is hiked, those that cannot pay the adjustable rate loans even if the rate is frozen, and those that need the rate freeze to stay in their homes. Only those persons in the last category, whose need is clear and who are likely to benefit, are under serious consideration for a rate freeze. Borrowers who took out “no doc” loans (i.e., without documenting their income and assets) would reportedly not be eligible for a rate freeze.

The idea behind the rate freeze is evidently to prevent a meltdown in real estate values. When a large number of homes go into foreclosure, neighborhoods are filled with vacant homes for sale, which may be sold at distress prices. This reduces the values of the remaining homes in the neighborhood and hampers additional homeowners that need to refinance or sell. Home values can spiral downwards, which creates more defaults and foreclosures that worsen price declines. Everyone—homeowners, banks and other lenders, and mortgage investors—could be losers in such a scenario. A rate freeze on some adjustable rate mortgages would reduce the numbers of homeowners that default and ease some of the downward pressure on real estate prices.

The rate freeze would reportedly last for about three or four years. A short freeze, such as one year, would do little good, and a longer freeze would apparently be unacceptable to the investors that hold many of the mortgages in question. That gets to the crux of the rate freeze.

The mortgage rate freeze isn’t a bailout so much as a shifting of losses. Borrowers who would otherwise lose their homes get to stay in them, at least for now. Losses they might have sustained in a foreclosure are borne by lenders, or by investors if the mortgages were sold. Given the huge quantities of dumb mortgages that were written in the last few years, these losses are large and were inevitable. The only question is where they would land.

Assuming the rate freeze is implemented, losses will shift to banks and mortgage investors. That won’t necessarily be the end of the story. Many large banks are already staggering under losses from CDOs, SIVs, lbo loan commitments, and other fallout from the subprime mess and the credit crunch. Losses from a temporary mortgage rate freeze will only make things worse for them. Will they need a bailout from the taxpayers? One hopes not, but the banks and their lobbyists are probably working day and night to find some way to foist the costs of these problems (including those from a mortgage interest rate freeze) onto the Chevy Cavalier-driving, standard deduction-taking middle class folks who make up the backbone of the work force.

Some mortgage investors—such as millionaires who own interests in hedge funds—can afford to bear the losses from a rate freeze. Other mortgage investors—say, municipalities in northern Norway or the Intermountain West of the U.S.—are much less able to bear these losses. The rate freeze may not be the end of the story, since investors can hire lawyers and sue the banks that sold them mortgage-backed investments.

Another probable goal of the temporary rate freeze would be to prop up Fannie Mae and Freddie Mac. These two companies, which serve as key players in the secondary mortgage market, are booking big losses as it is. A downward spiral of real estate values could push them into insolvency. Après ça, le déluge.

The temporary term of the rate freeze—perhaps three or four years—pushes many mortgage payment increases into the next president’s term. Things could really blow up then if interest rates haven’t decreased or if real estate values remain low. Both could happen. The specter of inflation—fueled by the declining dollar and high petroleum prices--hovers above us in Damoclean fashion and could prevent interest rates from falling much more. The real estate markets will probably need a number of years to recover from their current doldrums. (See for a discussion of why the real estate markets will be limping for years.) The temporary rate freeze is another example of the government winging it as a crisis unfolds. Let’s hope these people leave us in better shape than they left New Orleans.

Legal News: jailbirds ignore food police.

Thursday, November 29, 2007

Alternative Minimum Tax Mess Delays IRS Refunds

You can expect your income tax refund next year to be delayed. Despite fervent promises, Congress didn’t deal with the alternative minimum tax before Thanksgiving. Although Congress can be expected to fix the AMT (at least for this year) after it gets back from the Thanksgiving break, the IRS will need about ten weeks to program its computers to incorporate the fix. Consequently, refunds will be delayed.

The alternative minimum tax is the shadow tax system that affects more and more people. It was originally enacted in 1969 because of outcries over a few wealthy persons who paid little or no any income tax under the regular tax code. The AMT was meant to prevent the wealthy from using a variety of deductions and other provisions to avoid paying taxes.

However, the AMT is seriously flawed. It does not adjust for inflation. Thus, it reaches farther down the economic ladder as nominal incomes rise with inflation. The regular income tax brackets are raised to account for inflation, so the federal government doesn’t get an automatic revenue boost simply from the cheapening of the currency. But the AMT is the ace up the government’s sleeve. Depending on how much additional income it wants each year, the government enacts the “patch” on the AMT annually to bring in extra revenues the regular tax code wouldn’t have provided. It's true that the patch prevents full application of the AMT (which would reach into the middle middle class), but the patch nevertheless results in taxation of a lot of people who will never own a yacht.

The lurking presence of the AMT means that taxpayers have to do two calculations of their tax liability each year: once for the regular tax code and a second time for the AMT. Both calculations are required even if you don’t owe any AMT, because you can’t determine that you owe no AMT until you do both calculations. Thus, the AMT means more work for you at tax time even if you don’t owe more tax.

The AMT is schizophrenic, as taxes go. Some of the benefits it penalizes are long term capital gains, accelerated depreciation, percentage depletion allowances, and income from specified private activity municipal bonds (i.e., revenue bonds). This sounds like the AMT as it was originally intended. Most people who work in cubicles and drive Dodge Neons or Honda Civics don’t report many of these items on their tax returns.

But other deductions that are penalized by the AMT include state and local taxes, and personal exemptions (read, exemptions for dependent children). What are they smoking on Capitol Hill? Do people sneak around and pay state and local taxes with sly smiles in order to slip one by the IRS? Do people have children in order to flip off the tax man? Given America’s demographic problems, with increasing numbers of older people expecting smaller numbers of younger people to cover their Social Security payments, why does it make sense to tax parents more for having children?

The flaws of the AMT notwithstanding, there is little hope for serious change. The AMT provides tens of billions of dollars of extra tax revenues each year. It reaches into the upper middle class and extracts extra payments from millions of people who are not tax-dodging filthy rich, but rather those with large families who live in states with high state income taxes. The federal government is now mainlining revenues from the AMT and, with the mammoth budget deficits it runs, it won’t kick the AMT habit any time soon.

So the most you can expect is another ad hoc patch in the next few weeks, whose tardiness will delay your refund. Hopefully, Congress and the IRS will also give us extra time to get our tax returns filed, since we probably won’t be able to get instructions and forms on how to comply with the “patched” AMT at the crack of dawn on Jan. 2, 2008. But heaven forbid that we should hope for dispensation from the tax system.

Legal News: the judge that didn't like cell phones.

Tuesday, November 27, 2007

Did Mortgage Bankers Puff Up Appraisals?

The attorney general of New York, Andrew Cuomo, has sued a mortgage appraisal firm for allegedly inflating its appraisals under pressure from a major mortgage bank, Washington Mutual. At the same time, the New York A.G.’s office is reportedly conducting an investigation of other participants in the mortgage markets, including Fannie Mae and Freddie Mac.

If it turns out that appraisals have been puffed up due to pressure from mortgage bankers, the impact on the mortgage mess could be enormous. Appraisals are supposed to verify for lenders the value of the property being bought. If its value is less than the mortgage loan, the lenders, rationally speaking, wouldn’t want to make the loan. The borrower would have little or no stake in the house. If the borrower has trouble making payments, refinancing would be impossible and the borrower might just walk away. The loan wouldn’t be well-supported by its collateral, and the lender would be likely to take losses.

The NY AG alleges that at least one mortgage lender pressured an appraisal firm to inflate its valuations. In other words, the lender supposedly did something that would be economically irrational—lean on an appraisal firm to phony up documentation so the lender could make a risky loan that had an increased risk of nonpayment. Why would a banker do that?

The defendant in the NY AG’s case has denied liability. But if the facts are as alleged, a possible motive might be that the lender would make a lot of money from fees while selling the loan in the mortgage markets and thereby dodging the risk of default and foreclosure. In other words, the availability of the securities market as a dumping ground for phonied up loans may have made it all too tempting to play this game. And the more you play the game, the more money you make. As we know, huge quantities of dumb mortgage loans have been made. Did mortgage lenders lean on appraisal firms to phony up the numbers so the mortgage lenders could make and sell more loans in order to get more fees?

A rising market covers up a multitude of frauds. And a rising real estate market would have covered up appraisal fraud, if it occurred. Indeed, phonying up appraisals would have boosted the market higher. Thus the fraud could have assisted in covering up the fraud with more fraud.

However, we know from the Dutch experiment with tulip bulbs that no market can rise continuously forever. And so it was with the real estate markets. This, like all balloons, deflated; and we are left to sort things out.

If appraisals were phonied up, the consequences would have rippled out in many directions. Homes will be worth less than expected. That will hinder refinancings and resales, which will heighten the risks of defaults and foreclosures. Investors in mortgage-backed securities and CDOs will have paid too much for their investments, and might become new best friends with plaintiffs lawyers. Banks that pressured appraisers to pretty things up and then sold the mortgages into the secondary mortgage market might face increased capital requirements, and mega civil and even criminal liability. Investors will be hurt when losses from mortgage-backed securities and CDOs prove to be even greater than already expected as recoveries from foreclosures disappoint. Insurers of mortgage-backed securities and CDOs may face even greater liabilities on their guarantees. Consequently, other investments they’ve guaranteed, such as municipal bonds, could suffer as the insurers’ creditworthiness declines. In short, a lot of people might end up in a deep, dark vat.

The NY AG deserves credit for acting. Appraisal fraud, if it occurred, would present a fundamental threat to the integrity of the real estate market; and, derivatively, to the secondary mortgage market, the CDO market, and any other markets they might affect. We need to do more than provide liquidity to distressed banks and accommodations for victimized borrowers. We need to deal with wrongdoers, and ensure that there are consequences for engaging in fraud.

Legal Footnote: standing on a New York sidewalk is not a crime.

Sunday, November 25, 2007

A Lesson From the Subprime Mortgage Mess: Risk Never Dies

If you own municipal bonds, you might think you’re far removed from the subprime mortgage mess. After all, muni bond holders are probably the last vestige of the coupon clippers of yore, cautious, conservative, parsimonious with their tax liabilities, and about the last people who’d have an interest in illiquid, opaque, alphabet soup derivatives.

But the muni bond market has been shuddering lately, because insurers of muni bonds, such as MBIA, Ambac, CIFG, and FGIC, have subprime mortgage exposure. These companies insured billions of dollars of CDOs, derivatives contracts based on pools of mortgages. They have evidently been taking writedowns on account of their CDO exposure. That, in turn, has raised questions about their ability to stand behind their guarantees of municipal bonds. Guaranteed muni bonds are suddenly less valuable than they were a little while ago. Coupon clippers living in Beacon Hill are seeing dips in the value of some of their muni holdings because an investment bank in midtown Manhattan underwrote opaque and illiquid CDOs that purported to turn low-grade, high risk mortgage loans into AAA-rated investments that were bought with extreme levels of margin debt by a 34-year old hedge fund manager in Darien who has a very good resume but not much common sense.

This was made possible courtesy of the derivatives markets, the famed bazaar where risk could be bought, sold, swapped, insured, sliced, diced, stripped, mixed together and synthesized, all served with your choice of ketchup, mustard, mayonnaise, relish, pickles, onions, sauerkraut and horseradish. Holders of risk could, for a price, offload just about any can of worms they found too slimey to keep. From their perspective, risk could miraculously be eliminated.

But muni bond investors are spilling their tea on account of fly-by-night mortgage brokers selling impossible-to-repay option ARM mortgages to poorly educated home buyers in places like Detroit, Cleveland and Fresno. This illustrates a simple, but frequently overlooked, truth in the financial markets: risk never dies. All financial transactions involve risk of one sort or another. These risks can be and often are transferred. That’s what insurance is for, and that’s what the derivatives markets do. Transference of risk, though, doesn’t mean the risk ceases to exist. It’s still around, supposedly in someone else’s hands, but nevertheless maintaining a pulse and brain wave activity. If the risk blows up, somebody will take a loss. The only question is who.

When an insurance company insures a CDO, it will initially take the loss from a mortgage default. In the ordinary course of business, insurers maintain reserves to cover anticipated losses and can take mortgage defaults in stride. But, as we discussed before, the risks created by the subprime mortgage industry were enormous (see The insurers evidently didn’t have large enough reserves for the amount of risk that was out there. Perhaps they weren't aware of the enormous amount of dumb mortgage loans that were made, or how intertwined liabilities in the derivatives markets have become. Whatever the case, there was more risk than they were expecting.

If the Department of Motor Vehicles were to lower its standards and license a large number of poorly trained and unskilled drivers, the public (as well as auto insurers) would be outraged. Maybe there’s an argument that society is better off if more people can drive. Then, they could drive to where jobs are, and unemployment levels would drop. Auto manufacturers and dealers would probably enjoy increased sales. But this shouldn’t happen if it comes at great cost to the rest of us in the form of accidents and injuries.

Vast numbers of mortgage loans have been made that won’t ever be repaid. There is an argument that society may be better off if more people are homeowners. But that’s true only if it doesn’t involve great cost to the rest of us. The surfeit of subprime loans made in the last few years resulted from the illusion that the risks of these things could somehow be made managed or diffused. From the standpoint of mortgage loan originators, lending risk seemed to disappear. Since financial engineering made the risks seem to disappear, too many mortgage brokers and bankers apparently thought it would be okay to make enormous amounts of risky and downright lousy loans, especially if they got a lot of fee income in the process. Now, with losses from the subprime mess popping up in unexpected places, we are painfully reminded that risk never dies.

The dollar is declining, and foreign and American capital is gradually shifting into investments denominated in other currencies. This trend can only have been exacerbated by the subprime mess. After all, sudden investment losses, not currency fluctuations or balance of trade deficits, are the root cause of capital flight. The subprime mess has led to losses in the stock market, real estate market, bond market, derivatives market and now the municipal finance market. What’s next? All of these losses make the dollar seem like a lousy bet. The rating agencies are reportedly reviewing a number of bond insurers, and if they downgrade them, zillions of dollars of insured bonds will drop in value. Is there a good dollar-denominated investment still standing? Is it a wonder that capital is buying a ticket on the next plane to anywhere, as long as it’s out of the country?

Risk places stress on the financial system. The more risk that’s created, the greater the levels of stress. The challenge for the banking system and its regulators is to keep risk levels under control. That means constraining the amount of risk that’s created. With blowback from SIVs, guarantees on CDOs, proprietary mortgage-backed investments, LBO commitments, and the like, banks are learning the hard way that you can’t truly shift risk away, not when you create shiploads of it. There are too many interconnections in the financial system. This leads to the horrifying conclusion that, of all things, prudential lending standards will have to be imposed. But we’re living in a horror movie already, as risks that were thought to be long dead pop up out of every closet, attic and basement.

Art News: Million dollar painting found in trash.

Sunday, November 18, 2007

Thankfulness Amidst Subprime Mortgages, SIVs, Conduits and Credit Crunches

Let us note, in passing, that Thanksgiving will be this Thursday. Christmas decorations already festoon many stores. A few homeowners have put up their holiday lights. Retailers have shamelessly leaked to the media word of special sales beginning as early as midnight of the day after Thanksgiving. But, before we move on to the year end spenderama, perhaps we should reflect on a few things we should be thankful for.

Less financial lunacy. Before this summer, large numbers of highly educated and extremely well-compensated people on Wall Street acted as if they believed that the real estate markets would rise continuously forever, and that people with poor credit histories and no demonstrated ability to pay were good risks for adjustable rate mortgages, no matter how onerous the terms. Many fewer people today subscribe to these notions. A reduction of lunacy is always good.

Unregulated banking activities revealed. Many major banks have quietly financed a lot of activity through unregulated vehicles called SIVs, conduits and other odd names. Until recently, not much about these entities was known to bank investors, depositors or regulators. But we now know that they played a significant role in fostering the still ongoing credit crunch. Even though many problems remain to be addressed with respect to these off-balance sheet vehicles, more information in the market is better than less information. Had they remained buried in the footnotes of Forms 10-K, the problems they present might have remained unknown, and the risks they present to the financial system could have grown even greater than they are.

Derivatives defenestrated. Contrary to the mantras tediously chanted by their acolytes, derivatives have proven not to reduce volatility and make markets more efficient. Instead, they have turned out to increase risk levels and ensnare market participants worldwide in intertwined liabilities that can't be easily unwound without seriously wounding the financial system. Derivatives have been used, not as the hedging mechanisms they were advertised to be, but rather for speculation. And, because they are unregulated and information about them is either scant or nonexistent, the thicket of entangled exposures they created among major financial institutions went virtually undetected by regulators until both the worms and the can had become very large. The asset-backed securities market has already shrunk. Other derivatives markets, such as for default insurance and other credit derivatives, may be shrinking as underwriters demand increased premiums for the fact that risk never dies. Derivatives, to be sure, are no more magical or bulletproof than common stock or convertible subordinated debentures. They are just another type of financial instrument, with advantages and disadvantages. And that's good for people to know.

Hedge funds humbled. The new masters of the universe for the 2000s have proven, as they did in Tom Wolfe's superb novel, to have feet of clay. For the sake of getting a few basis points over Treasuries, they dove into an impenetrable mass of opaque asset-backed investments that proved illiquid when one would have given a kingdom for liquidity. Holders of capital who invested in the hedge funds that took losses are now finding out that when you invest in an unregulated vehicle, you're on your own when things go badly. There are no regulators to help you out. Good luck, because you'll need it.

Regulators required to rethink. The financial regulators have largely been caught flat-footed by the subprime mess and the credit crunch. They evidently didn't know how bad things were in the subprime mortgage market until it was too late. They apparently didn't realize how much stress had built up in the financial system with the creation of so many poorly conceived loans. They seem to have been unaware of the risks and problems presented by the bank-sponsored SIVs and conduits that are now desperately seeking a bailout. The regulators have muddled through thus far without a serious breakdown in the financial system. But the smarter ones among them know that muddling through isn't good enough for the future. It appears that basic regulatory issues are being reviewed and reconsidered in Europe. U.S. regulators, on the other hand, seem to be doing a pretty good imitation of Calvin Coolidge on a slow day. But with more losses to come from the subprime mess, and a presidential election coming in less than a year, that may change.

Executives exit. Two high profile CEOs and various other senior executives at a variety of financial institutions are now pursuing other interests as a result of losses at their firms. This is good. Nothing promotes accountability as much as holding people accountable. Given the magnitude of the losses, most of which fall on innocent investors, accountability is badly needed.

Markets like mattresses. Like a well-made mattress, the stock market has absorbed blow after blow from the subprime mess and credit crunch, and dropped only about 7% from their all-time highs. The Dow, S&P and Nasdaq remain up for the year. Unemployment is around 4.7%, virtually full employment level. Inflation remains moderate, albeit with hints of less moderation to come. A visitor from another planet might wonder why the enormous uproar. Of course, there's a point where the markets will turn south in a big way. But we're not there now, and perhaps won't get there.

Terrific fall colors. Perhaps it's because of the drought, which may be due to global warming, but the fall colors of leaves, at least in the mid-Atlantic area, are gorgeous. If you remember that some things in life are timeless, your time in life will be improved.

Babies smile at parents. Regardless of the fact that the ABX index, which tracks credit default swaps, continues to decline, babies still smile at their parents. Thirty years from now, that's what you'll remember best about these times.

Happy Thanksgiving.

Collector's News. If you want something very few other people will have, buy a piece of the Eiffel Tower.

Friday, November 16, 2007

The Mortgage Crisis at the Intersection of Main and Wall

On Thursday, November 15, 2007, the House passed a bill that would provide for licensing of mortgage brokers, require that mortgage loans be within the capability of borrowers to repay, and place liability for loan violations on banks that package mortgages into mortgage-backed securities. Bankers were quick to complain, and are reportedly seeking aid and comfort in the Senate. They may get a friendlier reception there, but the outcome remains unclear.

This legislation was predictable. The history of government regulation in America follows a well-established pattern. An industry grows and becomes economically powerful. It overreaches. A lot of people are injured. Public outcries for government action lead to regulatory initiatives. Thus it was for the railroads, whose monopolistic pricing led to the creation of the Interstate Commerce Commission. Thus it was for insurance companies, whose legendary use of impenetrable legalistically worded exceptions, exclusions and limitations gave the term "fine print" its popular meaning. Their reward was regulation by every state of the Union. And, so, too, for the banks, whose inability in the late 1800s and early 1900s to deal with a series of credit crunches left numerous depositors ruined, not through any fault of their own but because of faulty lending by the banks. The result was the creation of the Federal Reserve System.

In the manner of greased pigs at the county fair, businesses try to slip out of the grasp of regulators. For the financial services industry, the tactic was to convince the government not to regulate derivatives. And for the better part of the last 30 years, as derivatives were developed, the government largely refrained from regulating them. Realizing that they had the government where they wanted it, the financial services industry then slipped the business of banking into the unregulated derivatives market. Loans, the traditional province of banking, were packaged into asset-backed securities and sold to investors. The vehicles that connected investors to loans became, functionally speaking, the real banks. These vehicles, like Detroit's products, came in various shapes, sizes, models and colors. They have names like ABS, MBS, CDO, CLO, CMO, CBO, SIV, SPE, and so on and so forth. They were the actual source of funding for loans, using money from investors who effectively were depositors.

Given the absence of regulation in the derivatives sector of the banking industry, it's not surprising that this sector grew phenomenally. Without the limitations imposed by regulation (such as fair treatment of customers or adequate capitalization) and the costs of complying with regulation, revenues could flow faster toward the bottom line and gratifyingly large bonuses. Thus, bankers had every incentive to slip quietly out of the purview of the regulators.

Unfortunately, a lot of mortgage borrowers were trampled on the bankers' way to the Bentley dealer. Granted, many of those borrowers are in places like Cleveland and Detroit, cities that Wall Streeters might hardly deign to fly over. To a Leona Helmsley, these borrowers might have been little people. But in a democracy, they're the people, and they have votes.

Markets and market-based economies are harsh. They make some people winners, and some people losers. They have no code of chivalry. All too often, a small number of people become extremely wealthy by exploiting and victimizing many other people. This creates enormous imbalances of power and wealth that foster envy and social instability.

Government regulation enacted through democratic processes is how society regains its balance. Americans believe in the free enterprise system, and have no problems with a person accumulating dollars honestly earned, even a lot of dollars. But our economy is national and even international in scale. Only governments and their regulatory power can restrain the worst excesses of unregulated businesses. And we have certainly seen excesses in the subprime mortgage mess.

The legislation that passed the House will begin the process of bringing the unregulated portion of the banking industry under government oversight. It may not get through the Senate. And if it does, it will probably get a really big frown at the White House. (The big guy at 1600 PA Ave will probably forget that it was FDR, not Herbert Hoover, who was mourned by thousands of weeping people lining the streets of Washington when his horse-drawn caisson passed by; but W seems to have a problem with the vision thing.)

This is a win, win situation for the Democrats. If legislation is adopted, they can claim credit. If the Republicans block it in the Senate or the White House, the Democrats gain ammunition for the 2008 elections. All indications are that mortgage defaults for 2008 will be worse than they've been for 2007. More pain will be inflicted on Main Street, and the people will respond through the political process.

Could the bankers have avoided this outcome? Yes, if they had refrained from excess. But that would have required long term thinking and strategic planning. With the year-end bonus beckoning, why think about some schlemiel in a rundown Midwestern city who has a mortgage reset in a couple of years?

A few banking executives will perhaps realize that there may be other areas of banking with the potential for blowups like this. After all, mortgages aren't the only thing you can ease off the balance sheet through structured finance legerdemain. Perhaps they will quietly consult with their Audit Committees, auditors and attorneys about whether or not prudence might be the better part of valor. And perhaps this time, they will act before the government does.

Food News: world's record for downing hot sauce. What follows? The world's record for downing antacids?

Tuesday, November 13, 2007

How to Heal the U.S. Economy

Today, November 13, 2007, the business news was dominated by the mortgage mess. Recently announced bank losses make clear that the Federal Reserve's interest rate cuts in September and October haven't made the boo boos go away. Instead, they've returned with a vengeance, bigger than ever, and are knocking chief executives out of corner suites. All predictions are for further losses this current quarter and next year. While the Federal Reserve expects an economic slowdown, but no recession, many private sector prognosticators are more pessimistic.

Clearly, the financial services sector is wagging the entire U.S. economy. The New York Times reported on Sunday, November 11, 2007, that the financial sector accounts for 31 percent of all corporate profits in America. That's too much. You can't build a thriving economy on financial services. Banks don't produce anything tangible--you can't eat a financial service, wear one or seek shelter under one. Financial services are simply an adjunct to the true heart of any economy--the production of goods. People survive by extracting resources from the environment around them. That's why the production of goods remains the foundation of true economic strength. (If you don't believe this, think about China.)

Financial services firms are unquestionably necessary in a modern economy. They facilitate the process of economic exchange on a large scale, across long distances and even over international borders. They pool excess savings and make it available to businesses that hope to make productive use of it. They provide investment services to those who hope to save for the future.

But, as any good economist will tell you, there is a limit to the value of anything. Too much of anything and it loses value. The first bite of Belgian chocolate is much better than the 20th bite. And so, too, with financial services. Financial services firms used to make their money by providing savings and investment vehicles for the thrifty, underwriting offerings of securities for companies that needed capital, and making loans to businesses and other borrowers that were creditworthy. Today, financial services firms are obsessed with booking fee income, even if it means creating and selling opaque, complex, risky and illiquid investments that ultimately are causing a lot of pain and doing little or no good. The recklessness of the bankers involved in this stuff has resulted in hundreds of billions of dollars of accrued or likely losses. That's still a lot of money, even today.

Financial losses such as these cannot be eliminated. The only question is where they will land. They've been landing on hedge fund investors, banks, mortgage lenders, mortgage brokers, and last, but certainly not least, homeowners. And if there is a government bailout, as some on Wall Street and in Washington are crying for, losses will land on the taxpayers.

The subprime mess is the product of taking financial services too far. We don't need this much financial engineering. We don't need this much investment in real estate. Trying to turn people with poor creditworthiness or no creditworthiness into homeowners is like trying to build a house in a rain forest with mud bricks. And the worst part of it is that this was national policy. Homeownership was encouraged, not only for its supposed civic benefits, but because a rising real estate market would provide home equity that consumers could tap into in order to continue their merry escapades at the mall.

But you can't build wealth by creating asset bubbles. Home prices and equity can't rise continuously forever. Why all the brilliant and highly educated people on Wall Street couldn't figure this out is a very good reason not to rely on financial services to be a future engine for the U.S. economy. These are not people who should receive government subsidies or bailouts. The financial services firms should be forced to take responsibility for their actions, and book their losses.

The wealth of the U.S. is shrinking, with the dollar dropping in value and foreign capital quietly exiting with scarcely a tip for the hat check girl. Given our zero percent savings rate, America's limited capital base shouldn't be funneled toward more financial engineering or further attempts to make home loans to the non-creditworthy. Instead, it should be guided toward production.

America is a creative nation. Its creativity has made it the science and technology center of the world. More Nobel Prize winners in the sciences live and work in the U.S. than anywhere else. The Silicon Valley is a magnet for geeks from all corners of the globe. Formal and informal venture capital is available for almost every manner of tinkerer and garage-based technology startup. With its advantages in science and technology, America is a natural for the production of high tech products. Biotech is another area of great potential. Entertainment, including movies and television programming, is a major export. Okay, 98% of it is dreck, but it's better dreck than the movies and TV programming other nations produce. With global warming and industrial pollution in the third world rising, pollution control and environmental protection technologies are another area where America could do well. America is perhaps the world's largest producer of commercial aircraft.

International trade agreements make direct government subsidies of particular industries problematic. But let's stop diverting undue amounts of capital into real estate. It's only encouraged a degree of financial engineering that was too clever by half--and then half again. And we should require adult behavior from Wall Street. The Fed should keep the overall financial system liquid enough to function. But it should require losses to be booked, and managements to be held accountable. We have a crisis today in the financial markets because of a severe misallocation of capital caused in part by government policy and in part by monumental misjudgments by financial services firms. Extending or perpetuating that misallocation will prevent the U.S. economy from healing. The pimply-faced kid in a garage attic working on a pocket-sized device that makes phone calls, brews coffee, browses the Internet, picks up the dry cleaning, takes photographs, writes a novel, cooks a meal, displays TV programs, and drives your car automatically using GPS, is the future of America. He shouldn't have to compete for capital with a bunch of real estate speculators who have access to government subsidies.

Animal News: cows flee McDonalds. Who can blame them?

Monday, November 12, 2007

Is There Something About the Subprime Mortgage Mess the Federal Reserve Hasn't Told Us?

On Friday, November 9, 2007, the Wall Street Journal (page A2) reported that Federal Reserve Board Chairman Ben Bernanke proposed at a Congressional hearing that the federal government guarantee jumbo mortgages up to $1 million so that they can be resold into the secondary mortgage market. If you’re experiencing cognitive dissonance, you’re not alone.

Jumbo mortgages are mortgages greater than $417,000. Fannie Mae and Freddie Mac cannot, by law, purchase mortgages greater than this amount. Smaller mortgages (“conforming loans”) can be bought by Fannie and Freddie, and are readily resold because they benefit from the implicit federal government guarantee of Fannie and Freddie. Since the subprime mess and the ensuing credit crunch, jumbo mortgages have generally been shunned by investors and are now available only at significantly higher interest rates than conforming mortgages.

A federal guarantee of jumbo mortgages up to $1 million would be a subsidy for the upper middle class and the wealthy. Once enacted, it, like all government benefits for the well-off, would never be repealed. Although Chairman Bernanke said the government should impose a fee for the guarantee, do we really believe that it would be a fair amount? With the political influence of the well-to-do, might not the fee be set at a level that would warm the hearts of Lexus drivers everywhere?

This proposal includes moral hazard of the first degree. If a federal guarantee of jumbos becomes available, you can bet that lenders will require borrowers to pay for it, so that they, the lenders, can continue their business as usual of making loans and selling them to dodge responsibility if a loan goes sour. With federally guaranteed loans easily sold in the secondary mortgage market, lenders will have no incentive to enforce meaningful credit standards. Perhaps some federal agency somewhere will try to impose credit standards through the process of issuing guarantees. But what federal agency has the staff and resources to process trillions of dollars of loans to hundreds of thousands of people? The political pressure to process large quantities of loans very fast would be enormous. Eventually, ordinary taxpaying citizens could end up subsidizing the McMansion fantasies of the more fortunate in America.

Market based economies work well only if their markets are allowed to function properly. People who qualify for a jumbo mortgage can take care of themselves, even if they have to pay higher interest rates. Their creditworthiness, if properly packaged in transparent mortgage-backed securities, should be marketable in the secondary mortgage markets. There is private insurance for these securities, and for jumbo mortgages, if investors really want it. Why not let all these well-to-do people pay their own way for a product that they have the means to pay for? The federal government has enough burdens with Social Security, Medicare and Medicaid. Why should it now take on the housing needs of the upper middle class?

More important than this being bad policy, though, is the suspicion that something really scary must be going on. This idea is right out of the European Social Democratic play book. A really big bogeyman must be out there in the subprime world to make a free market Republican like Chairman Bernanke even think of federal guarantees of jumbos, let alone say it out loud at a Congressional hearing. Is the subprime mortgage mess and credit crunch worse than anyone is admitting publicly? Is the banking system so bedeviled with real estate losses that the entire U.S. housing market--conforming loans and jumbos--has to be federally guaranteed? Are there an enormous number of jumbo loans out there that are likely to default, and can only be refinanced with federal guarantees? Is the U.S. banking system insolvent, or likely to become insolvent shortly?

The lack of transparency about the subprime mess is one of the reasons why the financial markets are so unsteady. Yes, if the picture is really bad and everyone finds out, there is a risk of a run on U.S. banks and the dollar. But runs can, and have been, precipitated by uncertainty. Chairman Bernanke’s proposal only adds to the uncertainty. Before U.S. taxpayers become liable for every upper middle class mortgage issued in America, perhaps they should be given the full picture of what’s going on.

Crime News: a Robin Hood banker. Was he helping subprime borrowers?