Stabilize House Prices, Part 3

“It’s the borrowers defaulting. That is what’s causing the distress at the institution level. So why not tackle the borrower problem?” – Sheila Bair

Damian Paletta has written a series of excellent articles in The Wall Street Journal on the beyond-the-scenes negotiations of the government’s $700 billion bailout/rescue plan. His October 16, 2008 article FDIC Chief Raps Rescue for Helping Banks Over Homeowners is another argument strongly in favor of addressing the more immediate problems of declining property values, defaulting mortgage loans and subsequent foreclosures, which are at the very core of the financial crisis.

Federal Deposit Insurance Corp. Chairman Sheila Bair on Wednesday criticized the federal government for failing to take more aggressive steps to prevent Americans from losing their homes, highlighting a rift between her and other senior U.S. officials over terms of the $700 billion rescue package.

The government plan will help stabilize financial markets but it doesn’t do enough to address home foreclosures, the root of the crisis, she said in an interview with The Wall Street Journal.

“Why there’s been such a political focus on making sure we’re not unduly helping borrowers but then we’re providing all this massive assistance at the institutional level, I don’t understand it,” she said. “It’s been a frustration for me.”

Ms. Bair’s comments are expected to provide new fodder for critics of the government’s response to the financial crisis, especially among those who say it has done too little to help families falling behind in their mortgage payments.

“I support all the measures; I’ve been a part of all the measures that have been taken,” she said. “But we’re attacking it at the institution level as opposed to the borrower level, and it’s the borrowers defaulting. That is what’s causing the distress at the institution level. So why not tackle the borrower problem?”

The agency’s growing role has given her views a more prominent platform after spending much of this year arguing her point from the sidelines.

Ms. Bair, a one-time Republican congressional candidate and children’s book author, had suggested direct action to modify mortgages en masse before many other regulators in Washington. In April, she pitched a plan that would authorize the Treasury Department to make loans to as many as one million homeowners to minimize foreclosures. In July, after failed thrift IndyMac Bancorp Inc. reopened its doors under FDIC control, the agency said it would halt foreclosures on the mortgages it owned and would try to modify loans for struggling homeowners.  

Ms. Bair is scheduled to be on The Charlie Rose TV program this evening.

The Financial Crisis: Why Were Warnings Ignored?

“Prediction is very difficult, especially about the future” – Niels Bohr

Gary Becker an economist and Richard Posner a judge, both at the University of Chicago, write a joint blog. It is frequently very thoughtful and worth reading, although usually long and a bit academic for some.

Their October 12th post The Financial Crisis: Why Were Warnings Ignored? asks a very important question. Here is a summary of their thoughts.

Richard Posner’s Opinion

Posner thinks the problem was a failure to synthesize all of the warnings. His analogy is the failure to foresee the attack on Pearl Harbor, although there were indications from 1941 on that something like that could happen.

He singles out “a perfectly reputable academic economist, a professor at New York University named Nouriel Roubini who for years had been predicting with uncanny accuracy what has happened.”

In September of 2006–two years ago–he had “announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

Until mid-September, the magnitude of the crisis was greatly underestimated by government, the business community, and the economics profession, including specialists in financial economics.

Why were the warnings ignored rather than investigated? First, preconceptions played a role. Many economists and political leaders are heavily invested in a free market ideology which teaches that markets are robust and self-regulating. The experience with deregulation, privatization, and the many economic success stories that followed the collapse of communism supported belief in the free market. The belief was reinforced, in the case of the financial system, by advances in financial economics, and relatedly by the development of new financial instruments that were believed to have increased the resilience of the financial system to shocks.

Second, doing something to reduce the risks warned against would have been costly. Had banks been required to increase their reserves, this would have reduced the amount they could lend, and interest rates would have risen, which would have accelerated the bursting of the housing bubble…

The deeper problem is that it is difficult and indeed often impossible to do responsible cost-benefit analysis of measures to prevent a contingency from materializing if the probability of that happening is unknown.

Which brings me to the last and most important reason for the neglect of the warning signs, because it suggests the possibility of responding in timely fashion to future risks of financial disaster. That is the absence of a machinery (other than the market itself) for aggregating and analyzing information bearing on large-scale economic risk.

In any event, no effort to determine the probability of financial disaster was made and no contingency plans for dealing with such an event were drawn up. The failure to foresee and prevent the 9/11 terrorist attacks led to efforts to improve national-security intelligence; the failure to foresee and prevent the current financial crisis should lead to efforts to improve financial intelligence.

Becker’s Opinion – Why the Warnings Were Ignored: Too Many False Alarms

Becker has “a somewhat different take than Posner on why warning signals were ignored.”

The period since the early 1980s until the crisis erupted involved both rapid economic growth for most of the world, and unprecedented stability in this growth. Inflation rates were low and fluctuations in real output, as measured by the size and duration of recessions, were modest compared to the past. Economists and central bankers like Greenspan believed that we had learned how to keep inflation low, and also had the capacity to smooth out fluctuations in output and employment.

The second relevant development has been advances in financial instruments, such as derivatives, securitization, credit-backed swaps, and other even more esoteric instruments. These instruments seemed to work quite well in managing, spreading and even reducing the risk of the assets held by banks and other institutions. However, in the process they encouraged greater risk-taking ventures, as reflected by the large increase in the leverage-that is, in the ratio of assets to capital- of banks and financial institutions like Fannie Mae and Freddie Mac. What has been insufficiently understood is that the growing use of these instruments, and the growing leverage of financial institutions, created considerable aggregate risk for the system as a whole that could not be diversified away.

This combination of growing central bank confidence in its ability to iron out various wrinkles in economic performance, and the belief that the new financial instruments would help manage and reduce risk, blinded the vast majority of economists (I include myself), bankers, and government regulators to the vulnerability of the whole system. This vulnerability was especially important for aggregate shocks akin to a classical run on banks. When institutions are highly leveraged, they have great difficulty coping with a massive loss of confidence in the system.

While giving credit to Roubini, Becker lists several disasters during the past several decades that were predicted but never happened:

After the huge one-day stock market collapse in October 1987, Business Week and other magazines and newspapers warned that a Great Depression might soon be coming. These dire forecasts turned out to be completely wrong. Similar highly negative, but wrong economic forecasts, were made during the Asian financial crisis of 1997-98, the internet bubble, and the aftermath of the 9/11 attack.

In an atmosphere where the world economy showed great capacity to withstand difficult shocks, it is not at all surprising that some forecasts of disaster that turned out to be more correct were ignored.

In addition, one should not minimize the great economic achievements of the past 25 years in the form of rapid growth in world GDP, low world inflation, and low unemployment in most countries. Perhaps these achievements will be overshadowed by a deep world recession, but that remains to be seen. If the impact of this financial crisis on the real economy is not both very severe and very prolonged, and time will answer that question, the combination of the past 2 1/2 decades of remarkable achievement, and the economic turbulence that followed, may still look good when placed in full historical perspective.

Conclusion

I appreciate Becker’s perspective that for more than 25 years, the world has seen substantial growth and short recessions. However, this long term success led to overconfidence and excessive risk taking. While everything was working well, investment banks and other financial institutions could achieve large profits. With interest rates so low, borrowing money to increase profits seemed to make sense.

Cassandras are often wrong. The prevailing belief is that markets are usually right in sorting out risks and rewards. (George Soros disagrees with this ideology.)

The problem is that too many people based their decisions on the belief that housing prices could only go up. Unfortunately, too many houses were built and too many people who could not afford the houses were able to get mortgages, often with artificially low “teaser rates.” Now we are dealing with the fallout.

To see how Wall Street took on too much risk, see How Wall Street Became a Giant Hedge Fund.

photo credit: pangalactic gargleblaster

Criticism of the U.S. Bailout Plan, Part 5

“The unblinkable fact is that Americans own too much house. We overpaid and overborrowed, and many of us are ‘upside down,’ as the car dealers say. What to do? Recognize the losses and write them off. What not to do? Inflate the currency and debase accounting standards.” – James Grant.

An October 5th Washington Post editorial entitled Bad Medicine by James Grant, the editor of Grant’s Interest Rate Observer, criticizes the Government’s bailout plan. He blames our current problems on the bursting of the housing bubble exacerbated by the Federal Reserve’s low interest policy.

Grant’s main points are:

• The bubble was brought on by too low interest rates and too much optimism.
• Wall Street investment banks were quick to cash in on the boom, but were slow to recognize the turn in the market and the attendant losses in their portfolios.
• The answer is to let prices reflect their market values, not to mask those reduced values by artificial government intervention.

Low interest rates, easy money and malleable accounting rules are what plunged Wall Street into crisis. Yet it is low interest rates, easy money and malleable accounting rules that top the list of federal fixes.

The unblinkable fact is that Americans own too much house. We overpaid and overborrowed, and many of us are “upside down,” as the car dealers say. What to do? Recognize the losses and write them off. What not to do? Inflate the currency and debase accounting standards.

But inflation and debasement are the very policies being put in place. The Federal Reserve, not waiting for Congress, embarked last month on a radical program of money-printing. Reserve Bank credit — the raw material of bank lending — is growing at the year-over-year rate of 61 percent.

After the stock market broke in 2000, then-Fed Chairman Alan Greenspan set about easing policy. In company with Fed Governor Ben S. Bernanke, the man who wound up succeeding him, Greenspan warned against “deflation.”

So it pushed the “federal funds rate” — the interest rate that the Fed directly controls — to 1 percent in mid-2003 and kept it there for a full 12 months.

American consumers pinched themselves. Could they really borrow more than 100 percent of the price of a house at an unimaginably low teaser rate without so much as presenting proof of employment? Indeed, they could. House prices went up and up.

When, in 2006, the roof began to fall in, Wall Street was in a quandary. It held outsize volumes of triple-A-rated mortgage-backed securities (MBSs). That they were not, in fact, triple-A, had become painfully obvious.

Prices can be unwelcome pieces of information. When an especially unwelcome batch wells up after a financial collapse, governments try to quash it. So it is today. The SEC has suppressed short selling. The bailout bill will open the door to the suspension of market-value accounting. The Fed is moving heaven and earth to cheapen the value of the dollar.

Long after the crisis burst into the open, the Fed and Treasury downplayed it. It was, they insisted, “contained.” Last week they asserted that, unless the House voted “yea,” the wheels would come off this $14 trillion economy. President Bush himself has broadly hinted that the nation is on the cusp of disaster.

How can they be so sure? And how can they know that the unintended consequences of the radical policies they are pushing through won’t be worse than the panic that they themselves are helping to foment? When the Fed insists it has no choice but to print up hundreds of billions of new dollars and when the keepers of accounting standards bend in the face of criticism that market prices hurt, what they are really saying is the that financial truth is too awful to bear. Heaven help us all if they’re right.

photo credit: Matti Mattila

Is It Different This Time? Part 3

“We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.” – Burton G. Malkiel.

Alex Berenson’s October 11th article in The New York Times Those With a Sense of History May Find It’s Time to Invest is well worth reading, especially if you are discouraged enough to be considering selling your equity mutual funds and putting the money in CDs.

The four most dangerous words for investors are: This time is different.

In 1999, technology companies with no earnings or sales were valued at billions of dollars. But this time was different, investors told themselves. The Internet could not be missed at any price.

They were wrong. In 2000 and 2001 technology stocks plunged, erasing trillions of dollars in wealth.

Now investors have again convinced themselves that this time is different, that the credit crisis will push economies worldwide into the deepest recession since the Depression. Fear runs even deeper today than greed did a decade ago.

But in their panic, investors are ignoring 60 years of history. Since the Depression, governments have become far more aggressive about intervening when credit markets seize up or economies struggle. And those interventions have generally succeeded. The recessions since World War II, while hardly easy, have been far less painful than the Depression.

Berenson goes on to quote various investors and economists who believe that the pessimism is overdone and that this is a good time to buy rather than sell stocks.

If there is good and wise policy, and government moves effectively, this need not play itself out in ways like the Great Depression, which is the image that is playing itself out in people’s mind. . Government action typically does not work immediately, and banking crises around the world often require multiple interventions. – Stephen Haber, an economic historian and senior fellow at the Hoover Institution.

“I think in years to come — I wouldn’t say months to come — we will perceive this as being a great value-buying opportunity. Two and three years from now, it will seem very smart.” - David P. Stowell, a finance professor at Northwestern and a former managing director at JPMorgan Chase.

“This is the opportunity of a lifetime. The most important securities are being given away.” – Martin J. Whitman, a professional investor for more than 50 years.

photo credit: Sheffield Tiger

Recession or Depression? Part 3

“In their 1963 book A Monetary History of the United States, 1867-1960, Milton Friedman and Anna Schwartz laid out their case for a different explanation of the Great Depression. … The failure of the Federal Reserve to deal with the Depression was not a sign that monetary policy was impotent, but that the Federal Reserve exercised the wrong policies. They did not claim the Fed caused the depression, only that it failed to use policies that might have stopped a recession from turning into a depression.” – Wikipedia.

Definitions: Bear Market or Crash?  from the October 10th Forbes magazine provides useful background information.

Stocks are falling, unemployment is rising and even banks seem to be hiding their money under mattresses. It’s tough to measure how bad things are and impossible to say whether they’ll get worse. With commentators throwing around words usually reserved for the worst of economic times – crash, recession, depression – the one question we can answer is what those words mean.

The economy expands and shrinks in cycles, with times of growth followed by times of contraction.

In an expansion, manufacturers build new factories, retailers open more stores and, most of the time, companies hire additional workers. The 1990s saw a decade of growth, the longest peacetime economic expansion in U.S. history.

In a recession, the economy shrinks for months. Factories produce less, cutting shifts, or laying off workers altogether. Incomes fall. Sales drop. The last recession lasted nine months ending in November 2001.

A depression is a more severe and prolonged version of a recession. In a depression, prices often fall as unemployment rises. Shoppers drastically cut their spending. In the Great Depression, which began in 1927 and lasted for more than a decade, unemployment peaked at nearly 25 percent, and many of those who did work were only able to find part-time jobs. By contrast, the current unemployment rate is 6.1 percent.

Recent talk about depressions has been sparked by worsening economic data and the frightening drop in stock prices, which has been almost as steep as the 1929 crash that began the Great Depression. Most professional investors call a 20 percent decline within a few days a crash.

A 20 percent decline over a longer time is called a bear market. A bear market is a prolonged decline in prices for stocks, bonds, commodities, or all three. While there’s debate about whether the decline of the seven trading days ending Thursday was a crash, there’s no argument that we are in a bear market. The Dow Jones industrial average is nearly 42 percent lower than it was at its highest point last October; marking the largest decline since 1973-1974.

The opposite of a bear market is a bull market, which brings a prolonged increase in the price of stocks, bonds or commodities. Market historians may point to Oct. 9, 2007 as the crest of the most recent bull market – notching a 48 percent rise over five years – and the beginning of a bear market of undetermined length.

photo credit: Lee Jordan

Recession or Depression? Part 2

 

“The Great Depression was a worldwide economic downturn starting in most places in 1929 and ending at different times in the 1930s or early 1940s for different countries. It was the largest and most important economic depression in modern history, and is used in the 21st century as a benchmark on how far the world’s economy can fall.” – Wikipedia.

From the PBS’s Nightly Business Report, October 9th here is Allan Sloan, Senior Editor-At-Large at Fortune magazine:

Everything has been so gloomy lately, I thought I’d play against type, and find something reassuring to say. The problem, though, is that it looks like things will keep getting worse for a while, as the economy and the banking system inflict more and more pain on more and more people.

The one cheerful thing I have to say is that this isn’t going to turn into another Great Depression. That’s the comparison you keep hearing. And it’s wrong. The Great Depression had 25 percent unemployment. It had millions of people losing their life savings when their banks failed and took their money down with them.

Old people had no income and no health insurance. Neither did unemployed people.

Now we have federal insurance on bank deposits. We have Social Security and health care for old people. We have unemployment insurance and other safety nets.

What’s going on now isn’t any fun. It’s not fun to see your retirement accounts get hammered. It’s not fun to have your mortgage foreclosed or lose your job. And it’s not fun if you can’t borrow money except at rates that would make a loan shark blush.

But trust me, no matter how bad this gets, it won’t be a second Great Depression. And remember that sooner or later, this mess will work itself out. Just as booms don’t last forever, neither do busts. And in this case, that’s a good thing.

I’m Allan Sloan.

photo credit: Eoghan OLionnain

Criticism of the U.S. Bailout Plan, Part 4

Economics Unplugged: A conversation with Professors Allan Meltzer and Marvin Goodfriend is a just released 60 minute interview which took place on April 22, 2008. Meltzer and Goodfreind, two professors of Economics at Carnegie Mellon, discuss the current financial crisis and how we got here.

As free market economists, they continue to be very skeptical that increased federal regulation and oversight will be enough to avert future problems. In their opinion, increased regulation will not work, because although lawyers write regulations and accountants enforce them, the management of banks and investment banks will always find a way to circumvent them (regulations).

Bank management has an incentive to take big risks to earn large rewards, and the rewards are incorrectly based on short term results. Meltzer thinks bank executives should be paid “on the average of their performance over five years, not quarter by quarter. There are other ways of doing that, but we have to change their incentives, otherwise we are going to have these problems.”

If you believe that better regulation is the solution to the financial crisis, you might find a different viewpoint interesting.

Their key points are:

• The main problem is that financial institutions lend on a long term basis, but borrow on a short term one. Periodically, there is going to be a problem.
• Regulation has a limited role to play in disciplining markets.
• Think about incentives when writing regulations.

Other observations are:

• The current situation is very different from the Great Depression.
• Banks have to recognize their losses and raise more capital.
• We will not know how bad the economy will get, until we see how far housing prices will fall.
• We are seeing the end of the American Century, where the United States had a dominant influence on what happened in the rest of the world.

Although this interview is almost 6 months old, Professor Meltzer recently expressed similar conclusions. On September 23rd on a PBS News Hour program, he was asked whether he thought the bailout plan was a good idea. His response, “It’s a terrible idea. It’s undemocratic. It’s bad economic policy, and it’s bad social policy. And it has a very little chance of solving the problem in a meaningful way.”

photo credit: Matti Mattila

Recession or Depression? Part 1

 

“Unlike during the Great Depression the government is now a huge part of the economy. And officials have moved quickly, if clumsily, to contain the crisis.” – Robert J. Samuelson.

In the October 13th Newsweek, Robert J. Samuelson asks a provocative question – Is This a Replay of 1929?  The short answer is No. There are many differences.

Watching the slipping economy and Congress’s epic debate over the Treasury’s unprecedented $700 billion financial bailout, it is impossible not to wonder whether this is 1929 all over again. Even sophisticated observers invoke the comparison. Martin Wolf, the chief economic commentator for the Financial Times, began a recent column: “It is just over three score years and ten since [the end of] the Great Depression.” What’s frightening is not any one event but the prospect that things are slipping out of control. Panic—political as well as economic—is the enemy.

There are parallels between then and now, but there are also big differences. Now, as then, Americans borrowed heavily before the crisis—in the 1920s, for cars, radios and appliances; in the past decade, for homes or against inflated home values. Now, as then, the crisis caught people by surprise and is global in scope. But unlike then, the federal government is now a huge part of the economy (20 percent vs. 3 percent in 1929) and its spending—for Social Security, defense, roads—provides greater stabilization. Unlike then, government officials have moved quickly, if clumsily, to contain the crisis.

Unlike postwar recessions, the Depression submitted neither to self-correcting market mechanisms nor government policies. Why?

Capitalism’s inherent instabilities were blamed—fairly, up to a point. Over borrowing, overinvestment and speculation chronically govern business cycles. Herbert Hoover was also blamed for being too timid—less fairly. In fact, Hoover initially expanded public works to combat the slump. The real culprit was the Federal Reserve. Depression scholarship changed forever in 1963 when economists Milton Friedman and Anna Schwartz argued, in a highly detailed account, that the Fed had unwittingly transformed an ordinary, if harsh, recession into a calamity by permitting a banking collapse and a disastrous drop in the money supply.

The Great Depression resulted from the perverse mix of a weak economy and government policies that magnified the weakness and that were only partially neutralized by the New Deal. If we can avoid a comparable blunder, the great drama of these recent weeks may prove blessedly misleading.

photo credit: jillclardy

How Wall Street Became a Giant Hedge Fund

 “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett (2003).

Some people are placing the blame for our current financial crisis squarely on the shoulders of greedy Wall Street financiers. They have a valid point. At least part of the problem can be attributed to greed. How and why greed undid some of the great financial institutions is best told by a Wall Street insider.

“Andy Kessler is a former hedge fund manager turned author who writes on technology and markets.”

His article, The Demise of a Giant Hedge Fund - The old Wall Street is dead. Long live the new Wall Street, appeared in the October 13, 2008 The Weekly Standard.

Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.

By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with, were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.

Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.

Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

…all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company.

Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on Wall Street in 2007 will be doing something else by January.

And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes-blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ‘em public, bank ‘em, and grow with ‘em. It may not be as exciting as the last few years, but it beats getting dumped in the East River.

My Conclusion

In the end, greed was a big factor, but so was a complete failure to manage risk, properly. Top management at some investment banks, supposedly intelligent people, essentially bet their whole company on a strategy that amounted to putting too many eggs in one basket. They ending up owning “exotic securities, derivatives, pieces of paper backed by pools of assets.” They did not understand these securities any better than the people they sold them to.

And because there was no transparency or regulation, the investment bankers could take on as much risk as they wanted to. So they used way too much leverage. They simply took more risk than they had the ability to take. These bets were very profitable, until things went the wrong way. And, because they used such a large amount of borrowed money, there was just no margin for error.

And when many on Wall Street tried to “deleverage” at the same time, i.e. they all tried to sell at once, there was no one on the other side of the trade. There were not enough buyers, so there was no liquidity, just when it was most needed.

See the quote at the top of this post.

To be continued …

Stabilize House Prices, Part 2

“The features that Congress added to the initial Treasury plan do nothing to achieve sustained confidence in the financial institutions….They do not address falling home prices.

We need a firewall to break the downward spiral of house prices. ” – Martin Feldstein.

In an October 4th Wall Street Journal editorial, The Problem Is Still Falling House Prices, Martin Feldstein outlines his very direct plan for solving the current financial crisis. Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard University, and a member of The Wall Street Journal’s board of contributors.

A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.

The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.

Because of the 20% fall in the price of homes since the bursting of the house-price bubble, there are now some 10 million homes with mortgages that exceed the value of the house. Residential mortgages are generally “no recourse” loans, meaning that if the homeowner stops making payments, the creditor can take the property but cannot take other assets or attach income. Individuals with loan-to-value ratios greater than 100% therefore have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. When individuals default and creditors foreclose, the property is added to the stock of unsold homes. That depresses prices further, increasing the number and magnitude of negative equity houses.

The prospect of a downward spiral of house prices depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions.

Briefly, Feldstein proposes a plan that would stop the downward spiral in house prices by reducing incentives that allow homeowners to merely walk away from home ownership. His plan is for the government to make mortgage replacement loans. These replacement loans would be at a reduced interest rate, but with full recourse. The homeowner would save on mortgage expenses but would no longer be able to walk away, from at least a portion of the mortgage.

Here’s how it might work. The federal government would offer any homeowner with a mortgage an opportunity to replace 20% of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2%. The loan would not be secured by the house but would be a loan with full recourse, allowing the government to take other property or income in the unlikely event that the individual does not pay. It would by law be senior to other unsecured debt and not eligible for relief in bankruptcy.

Although the total size of the mortgage-loan program might be as much as $1 trillion, this would not be comparable to other government spending or to a swap of government bonds for impaired assets. The government would instead have a fully offsetting claim on individuals who could be counted on to repay their low-interest government loans. The cash that the banks and other creditors would receive from the government to replace the existing mortgages would be available to finance new loans.

So, Martin Feldstein, who has impeccable, conservative credentials, is proposing a $1 trillion government program. I find this quite remarkable. It will be interesting to see whether or not Professor Feldstein’s plan or the one proposed by R. Glenn Hubbard and Chris Mayer gets any traction.

Incidentally, Professor Feldstein was recently a guest panelist on the September 30th episode of the Charlie Rose Show. 

 

photo credit: respres

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