Our Clueless Congress Strikes Again

I know I keep harping on this particular issue but it's driving me up the wall at the moment, the clowns in Congress keep insisting that the banks increase their lending and/or lend out the TARP money, despite the fact that doing so would put us back at square one:

(From the WSJ): "WASHINGTON -- House Speaker Nancy Pelosi suggested Monday that Congress will force the Treasury Department to do more to help struggling homeowners if the administration seeks access to the second half of its $700 billion financial-rescue fund.

Ms. Pelosi's comments reflect frustrations of lawmakers from both parties who feel Treasury Secretary Henry Paulson has not spent the funds the way Congress intended. Specifically, they say the Troubled Asset Relief Program, or TARP, hasn't been used to directly aid homeowners having trouble paying their mortgages.

"As you will recall, there were no votes to pass this legislation on the Republican side, very few, and it wasn't until we intensified the provisions that related to keeping people in their homes that this legislation even passed," Ms. Pelosi told reporters.

"But it's been totally ignored by this administration," she added. "Absolutely nothing has been done with respect to that part of the legislation."

Rather than spending the money to help struggling homeowners, lawmakers complain, the Treasury Department provided cash infusions to banks, which haven't used it to start lending their funds to businesses and consumers again. As a result, they say, little of the money has trickled down to ordinary homeowners and the expenditures have done little to energize the economy.

Ms. Pelosi's comments suggest the administration faces obstacles if it asks for the remaining $350 billion, which may happen soon. The TARP has become entangled in the push for an automobile industry bailout now that the Bush administration suggested it may dip into the fund to help the Big Three auto companies. Financial markets could be unnerved if the loans to Detroit empty the fund, leaving the administration with little flexibility in case of an unexpected financial problem.

A $14 billion aid package to the auto industry failed on Capitol Hill last week in part because lawmakers were unhappy with how the TARP funds were being spent."

It's a common complaint we hear from Congress, various political pundits and/or read in the media on a daily basis: the Treasury somehow dropped the ball by deciding to take direct stakes in the banks (in the form of preferred shares) instead of buying bad mortgage assets, the banks are not holding up their end of the bargain by increasing lending and both parties have failed struggling homeowners as TARP funds haven't found their way into their hands.

There are multiple problems with that line of thinking:

Our banks are undercapitalized and overleveraged thus making them (in some respects) functionally insolvent; they're also having to deal with rapidly rising lending losses and are operating in a credit environment where it's difficult to raise the capital needed to maintain their current operations. As a result the primary use of any raised capital has to be to recapitalize the bank in question, followed by being used as a hedge against future lending losses, the capital can only be used to fund increased lending if the bank has managed to raise capital in excess of its primary needs.

Needless to say if you look at the balance sheets of many banks, consider their future lending losses, etc, the amounts received by many banks don't exactly qualify as "surplus capital".

Therefore demanding that the banks increase their lending volumes because they've received TARP capital, is functionally equivalent to asking them to make themselves insolvent (again) at the behest of Congress.

Now what sense does that make?

Lending Volume Expectations: the other problem with the lending volume argument is that many people are still looking at based on expectations that were set during the credit bubble, as opposed to considering the financial state of the banks and looking at lending volumes/standards from before the credit bubble.

In other words we've been spoiled with easy credit, and on a go-forward basis lending standards need to be tougher and lending volumes need to be dialed down if we're going to have a stable banking system.

Screaming for the banks to increase their lending volume due to receiving TARP funds is the same as saying: "can you please go back to the same irresponsible behavior that caused this mess in the first place?"

Preferred Shares vs. Buying Toxic Mortgages: I understand the desire to be critical of the Treasury for changing course on this one, but many people are doing it for the wrong reasons. We shouldn't be critical of the Treasury for changing course in of it self as if buying toxic mortgages was a good idea, we should be critical of them for not having gone with strategy of taking direct stakes in the banks via preferred shares in the first place.

Holders of preferred shares receive dividends in exchange for the cash they inject into a company, they're ahead of other debt holders in case of a bankruptcy proceeding and in many cases (as with TARP) owners of preferred shares receive warrants to purchase shares in the company at set price that will (hopefully) be significantly lower than the future share price of the company. In other words injecting cash into the nation's banks in exchange for preferred shares locks the taxpayers into any upside from the bank's recovery.

Doesn't the above sound like a more responsible use of taxpayer money, as opposed to purchasing bad mortgage assets that may or may not ever increase in value?

Helping Homeowners: the final problem with many of the criticisms being levied by Congress towards the Treasury is that regardless of whether you buy bad mortgages, take direct stakes in banks, or if the banks receiving the cash infusions increase lending, is that none of those things are capable of directly helping homeowners. Just think about it: the problem facing struggling homeowners is that they can't afford their mortgages, how exactly does re-capitalizing an undercapitalized bank, and/or buying their bad assets, affect their customer's income, mortgage balances, etc?

While I suppose (perhaps) that Congress was operating under the assumption that Treasury would use pressure the banks it bought mortgages from (or invested in directly) to modify mortgage terms, the fact remains that you can't modify someone out of a mortgage they couldn't afford in the first place. How else do you explain the apparent futility of mortgage modifications as depicted in a government report last week? The fact that 36% of all homeowners receiving mortgage modifications are 30 days (or more) past due after 3-months, suggests that some individuals only made one payment before falling behind again or didn't make any payments at all.

Outside of the indirect assistance for homeowners via the Treasury putting pressure on lenders to modify mortgages, nothing about the program (whether it's buying bad mortgages or buying direct stakes) would've provided direct assistance to homeowners struggling with their mortgages. Unless Congress expected the Treasury to directly subsidize the mortgages of homeowners in trouble, complaining about the lack of homeowner assistance is just fatuous.

In other words many in Congress (on both sides of the aisle) don't fully understand the problems facing the banking industry, didn't understand the potential impacts (on banking, the economy and homeowners) of the TARP program, the difference between buying preferred stakes vs. toxic mortgages, and the reasons why so many homeowners are in trouble.

If these people don't understand the problems the economy is facing, why are we letting them craft any of the solutions?

I'm starting to feel as if we would actually be better off if the government would just sit back and do nothing, as opposed to forcing companies to do engage in the same types of behaviors that caused the crisis, directing resources towards the wrong things, and/or creating solutions to resolve red herrings as opposed to actual problems (or their root causes).

It's not that I'm totally against government intervention in the current crisis, it's that our government is so bloody clueless that many of their efforts are just going to make things worse.

Resolving the crisis calls for our leaders to make smart business decisions even if those decisions are unpopular and/or requires them to tell the public things they don't want to hear, leading us in the wrong direction due to their own ignorance and/or because it's popular is only going to make things worse for all of us.

If all Congress has to offer is leadership that takes us in the wrong direction, we would be better off they would just do nothing at all.

You can read more on the issue here.

Sources:

The WSJ: "Treasury Pressured to Help Homeowners" -- Naftali Bendavid, December 16, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Comments

[fatcat:]

Just wait for the next congress and administration....you ain't seen nothin yet!

2008 Dec 17 07:27 AM

[sstro:]

All you have to do is look at what part of the country Pelosi represents and you can see why she is so screwed up. The only people who should get loans are the ones who didn't ramp up their spending buying stuff they could not afford. If you want a home loan then have a 20% down payment and a payment in line with your means. If Pelosi gets her way then we'll be giving millions of dollars to deadbeats.

2008 Dec 17 09:00 AM

[CLH:]

Very good article. Congress has no understanding of economics and should do nothing.

2008 Dec 17 09:25 AM

[Prof. Samue...:]

I would like to bring a very important bit of information to your attention that relates to this economic crisis that was overlooked until now. As you read this, keep in mind that the borrower whether a small business or individual has been proven to be like a "boat without a paddle" when it comes to financial understanding. There is need for immediate and specific financial guidance for all borrowers if we want to get out of this crisis. Loan mods will not work, unless the borrower has a financial understanding. This must be addressed, immediately.

On Sunday, 12/14/08, CBS 60 Minutes aired a segment "The Mortgage Meltdown".

Scott Pelley's piece on the 2nd Wave of Foreclosures overlooked a critical fact. The next wave of Foreclosures in 2009 Will Take Self-Employed and Smaller Businesses who have these TOXIC mortgages. In fact, ALT-A, Option ARMS, Interest-Only, the TOXIC Mortgages that are considered the "Troubled" assets in TARP were marketed to the self-employed who fell prey to them. The upcoming defaults on these risky "Toxic Mortgages" will result in an increase in foreclosures. But worse, once these small businesses fail, the resulting loss of jobs will cause millions to add to the ranks of the unemployed. Note that self-employed business owners (16.2 million according to the SBA) employ between 1-10 employees.

An NASE survey,nase.org, was the first to provide compelling evidence of small business involvement in the upcoming toxic mortgage crisis. The survey was created by Prof. Samuel D. Bornstein and Jung I. Song, CPA of BornsteinSong Consultants in Oakhurst,NJ,and was conducted by the National Association for the Self-Employed (NASE) which issued a Press Release on November 21, 2008.

According to this survey, it is estimated that 3,709,800 small business owners hold Alt-A and other toxic mortgages, and 1,279,800 are already delinquent as they have missed one to three or more monthly mortgage payments at mid-November, before the expected Resets that are scheduled to begin in 4th Quarter 2008 through 2012. These small business owners will be at-risk of payment shock and default as their monthly mortgage payments skyrocket. Small business owners were especially targeted for these Alt-A loans which required little or no documentation of income which appealed to many small business owners who previously were unable to qualify.

The resulting defaults will be the cause of the upcoming second tsunami wave of foreclosures that will dwarf the subprime crisis and will take many homeowners and small business owners.

I would be happy to discuss the implications of the NASE Survey, since I created it and NASE ran it to its national membership (250,000). See the NASE website nase.org under NASE NEWS for the Toxic Mortgage Survey.

Thank you,
Prof. Samuel D. Bornstein

2008 Dec 17 10:32 AM

[who:]

The democratic system has its drawbacks - you need to please the masses in order to get into and stay in office. Hard medicine is what is needed but instead we get more of what is caused the pain. Easy credit is what caused the mess and not more easier and cheaper credit is being prescribed.

2008 Dec 17 01:24 PM

[Xorthfred:]

Thanks for your excellent article. I agree that Paulson made the right call to stabilize the banking system with the TARP money. I also think that commercial mortgages are now sitting in the bargain bin (for those properties not in California, NY, Florida, Arizona, Nevada and Michigan). The commercial mortgage delinquency rate remains (for now) below historical averages, yet the mortgages are BEING COMPLETELY WRITTEN OFF DUE TO MARK TO MARKET ACCOUNTING!

Read it again in disbelief but it is true if you understand bank accounting. The OCC auditors like to see Reserves (write offs) as a percentage of non-performing mortgages rise during downturns in commercial real estate. mark to market accounting forces banks to reclassify performing (paying on time) mortgages to non-performing. If a bank has reserves (write offs) only 20% of nonperformings and nonperformings are rising, then the auditors want to see that percentage rise.

Example: Bank has one billion $$ of nonperformings. They have reserves of $200 million. Under mark to market accounting, some $6 billion of commercial mortgages that are current with good debt service coverage now are selling for 80 cents on the dollar based on the cds and cmos (cdo) markets. The accountants force them to take a write off to market value of $1.2 billion. Now these loans are "non-performing". "Non-performings" (even though they are current and paying) now balloon to $7 billion. Reserves now are $1.4 billion. The accountants would like to see Reserves as a percentage of non-performings at 120%. Result: another write off of $7 billion.

This scenario played out at Citicorp in the 1989-1993 time period.

2008 Dec 17 01:46 PM

[Leftfield:]

Good point about mark to market. Mark to myth doesn't appeal to me either, though. And, what about huge executive and salesforce bonuses awarded to stratospheric-income individuals on Wall St. before their system exploded? I don't recall as much fuss by above-mentioned banks as now. Maybe the trillions the government is sending will help.

2008 Dec 17 06:46 PM

[sylviechen:]

Bailout for auto? OK...

a. $5B from oil companies as investment (cars are consumers)
b. $5B from taxpayers through TARP, renewable energy, etc.
c. $5B from lending institutions.

Done

2008 Dec 17 09:32 PM