Non-Recourse Loans: Positively Counterproductive

We don't know exactly what Timothy Geithner has in mind for the "Public-Private Investment Fund". But we do have a few hints. First, we know that among its purposes is that it

allows private sector buyers to determine the price for current troubled and previously illiquid assets. (pdf file)

And we also know, that on the very day Mr. Geithner offered his outline of a financial stability plan, the Federal Reserve announced its intention to expand its Term Asset-Backed Securities Lending Facility, or "TALF" to up to a trillion dollars, coincidentally the round number that Geithner suggested the "PPIF" might expand to. Hmmm. What is the TALF again?

Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral... As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets... The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the MLSA.

Does your head spin, acronym upon acronym, non-recourse, warranties, and covenants? Well, unspin it. The New York Fed is telling us, in plain and simple legalese, that it is planning to make a very generous gift to investors that participate in this program (and indirectly to the banks that sell assets to them). A non-recourse loan bundles an ordinary loan with an option to "put" the collateral back to the lender instead of paying off the loan. Sometimes this is not much of a gift: When a pawnbroker lends you half of what your Fender Stratocaster is worth, and the fact that you can surrender the guitar rather than pay off the loan is cold comfort. But if someone fronts you substantially all of what an asset is worth, and the value of that asset is uncertain and volatile, then the put option bundled into the "loan" becomes extraordinarily valuable. If the asset appreciates, you take the profits and "ka-ching!". If the asset falls in value, the lender takes the trash and eats the loss.

A near-the-money option is itself a valuable asset. Offering non-recourse loans to participants in the PPIF would directly contradict the program's goal of "allow[ing] private sector buyers to determine the price for... troubled... assets." Private sector buyers would not be pricing the assets themselves: they would be pricing a portfolio containing a troubled asset and a free, three-year put option, courtesy of the Fed. Depending on how much of the transaction the government is willing to finance, the value of the put option could represent a substantial fraction of the value of the asset being priced. This is a subsidy, that would be incorporated in the sales price of the asset and split by banks and private investors. It amounts to the government bribing investors to certify banks as more solvent than they are, by overvaluing bank assets in subsidized purchases.

John Hempton wrote a very brilliant essay on what it means for a bank to be solvent. If you haven't read it, go do. Hempton's definitions 2 and 3 of bank solvency — current accounting value (which implies mark-to-market valuation for many assets) and economic value as an ongoing enterprise — diverge because the cost of funding for investors in risky bank assets is unusually high. Under these conditions, Hempton reasonably suggests, private fund managers will be unable to bid assets up to their best estimates of "hold-to-maturity value", less a "normal" risk premium, because investors are desperately unwilling to hold anything other than government guaranteed securities. Definition 3 is a very generous view of what it means for a bank to be solvent, because it implies that the actual market risk premium is wrong, that an estimate of hold-to-maturity asset values by a reasonable analyst, even accounting for risk, would put those values above current market bids. But in evaluating bank solvency we should be generous: Since an insolvent bank must be nationalized (reorganized, received, conserved, preprivatized, whatever), we should try to avoid declaring as insolvent banks that do have positive economic value, since that would amount to a capricious expropriation of private property.

But generosity in evaluation is distinct from a generous cash gifts from taxpayers to banks and investment funds. What is required to get a generous but still accurate evaluation of bank solvency is inexpensive funding, so that analysts willing to bet on what a "toxic asset" is worth can borrow the funds they need to back their spreadsheets with shekels without giving away all the upside to nervous lenders. What is not needed, what is in fact positively counterproductive, is to give investors a special bonus in the form of a free option if they buy the asset. This guarantees that assets will not be accurately priced (they will be overpriced), and reduces analyst incentives to value assets carefully and generate reliable market prices.

I actually think having the government offer cheap, full-recourse loans on a maturity-matched basis to investors willing to bear the risk of holding currently disfavored assets is a clever idea. ("Maturity-matched" means investors don't have to worry about margin calls: as long as they get the long-term values right, they can ride out any tempests in mark-to-market prices.) We do need a market in these assets, and if it is true that funds' availability for people willing and able to bear the risk of ownership is preventing such a market from arising, then by all means, that's a "market failure" the government can correct. But the key point is that a market price is the price at which private parties are willing to bear that risk. If funds are provided non-recourse, much or all of the risk of ownership is absorbed by the lender. Any prices that result from "private" purchases by investors funded at high-leverage on a non-recourse basis are not market prices at all. Such prices would be sham prices, smoke-and-mirror prices, sneaky off-balance sheet public subsidy prices.

We are all tired of the lies, Mr. Geithner. By all means, let nationalization be a last resort, and do all you can to offer liquidity to private parties willing to take both the upside and downside of speculating in questionable paper. But if you keep nationalizing the downside and privatizing the upside, it will not be very long at all before the public concludes that stress tests and market prices are just a sleight-of-hand for Davos man while he picks our pockets, again. Act fairly, and you may end up nationalizing the worst few of the larger banks. Keep up the games, and we will insist that you nationalize them all. It is getting hard to believe that there is a banker in the land who has not already robbed us. Eventually we will tire of drawing fine distinctions.

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Afterthought: There's another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give 'em a ticker symbol, and put 'em on an exchange. I know it's out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

Comments

[CautiousInv...:]

Nice analysis of a policy response to artificially maximize the value of troubled assets at the expense of the taxpayer. It is speculated hedge funds will avail themselves of this opportunity.

As a note of interest, a number of states, including Arizona, California and Florida, have non recourse mortgage note statutes that limit borrower liability and limit attempts to secure deficiency judgements.

It's a horrible pattern and to encourage responsible behaviour, I hope all loans modified under the recently announced housing initiative will become recourse.

Feb 22 08:14 AM

[t-bird:]

Non recourse only fosters more of the same behavior that got us into this morass...

Feb 22 11:06 AM

[user344210:]

Excellent laying out of the issues involved in the various program designs. My one quibble is that the title is not sufficiently cynical of the motivations of the program designers. For them, non-recourse loans are fantastically productive. For the rest of us, you are correct that they amount to a potentially huge subsidy to exactly the wrong type of person/institutions.

Feb 22 11:08 AM

[AllStreets:]

Excellent article, once again exposing the fancy financial engineering going on out of general publicview to use taxpayers' resources to save banks and mortgage investors while doing virtually nothing at all to save the owners of the underlying assets, the homeowners, who are not only going to stay stuck paying their underwater mortgages to their rescued lenders, but also pay the ultimate tax and inflation bill.

It's beyond strange that almost the entire focus of government regulators is on saving banks and investors. Surely it must be obvious to most of those supposedly knowledgeable financial mavens that the way to bail out homeowners, lenders and investors all at once is to bail out homeowners first, then lenders and invstors are automatically bailed out. If you only bail out lenders and investors and leave homeowners stuck in underwater mortgages (about 25% of all homeowners at last count) that leaves the underlying assets in impaired condition for all parties. It's a prescription to leave the economy in a state of collapse for many years. There will be countless foreclosures, short sales and bankruptcies as homeowners give up and walk away from their mortgages.

So, how do you bail out homeowners? Pretty much the same way proposed to bail out lenders and investors, with non-recourse loans from the federal government that aren't secured by the underwater properties. Take, say 60% of the drop in value of each home, and pay off that much of the mortgage and split that amount into two equal loans, one to the homeowner and one two the lender, from the federal government at 3% fixed rate for 30-years. Presto, the lender is not only whole, but liquid, the homeowner is not underwater, the pain is shared equally, the value of mortgage securities is automatically restored, and the taxpayer has an earning asset instead of a giveway that adds to the deficit. For complete details of the plan, The AllStreets Bailout Plan please see www.themortgagenews.in....

What's really amazing is that the bailout czars and lawmakers apparently aren't very good at analyzing numbers. CNN Money recently tallied all the government bailout loan programs, loan guarantees, and direct spending and it totalled $10 trillion, which, I believe, didn't even count some of the additional lending, such as the $200 billion expansion of Fed or Treasury lending to Fannie and Freddie in the mortgage bailout plan announced February 18 by Treasury. Well, total residential mortgage debt in the U.S. is $12.2 trillion per "Freddie Mac Update, January 2009." So, the $10 plus trillion of government bailout commitments could pay off at least 82% of all residential mortgage debt. What a bailout that would be!

I've estimated that the AllStreeets Bailout Plan would involve no more than $4.8 trillion in loans to consumers and their lenders, of which $1.9 trillion would go to pay off rsidential mortgage debt, 15% of it. The balance would be used for fair acces to the same loans for those adult citizens who don't have mortgages or don't own properties, and would be used at consumer discretion to pay off credit card debt, fund a business, as second mortagage money to buy a property, or as a personal loan. All of the $4.8 trillion would replace all of the above mentioned $10 plus trillion, since all of the problems that was supposed to solve would be solved the The AllStreets Bailout Plan. It would also restore housing values to a significant extent, and the stock market, especially bank stocks.

Feb 22 11:27 AM

[AllStreets:]

CORRECTION: I meant to say that the government loans to consumers and lenders would be full recourse, but not secured by the homeowners' properties, except those loans used to purchase properties. In this manner most homeowners are made free once again to refinance or sell their property without a short sale, and the lenders' mortgages are made whole. I should also note that under the AllStreets Bailout Plan, the payment on a paid down mortgage would be reduced based on the lower principal, the original interest rate, and the time remaining on the mortgage, so overall debt payments by consumers who still have mortgages would be reduced.

Feb 22 11:45 AM

[Paul Wilkinson:]

Very nice analysis, and a wonderful afterthought. I wonder how the afterthought might be converted into forethought. If the government won't get behind it, is there a holder of ABS, CDOs, or whatchamahaveyous who might be willing to step up and let someone dissect their proprietary information into a format that would support exchange trading? Is there an exchange that would be willing to be the host? If the quality of the underlying data is even marginally adequate, it should be nothing more than a plumbing problem to expose it to the market, since there should be enough data to ensure that errors cause aggregate instruments to revert toward the mean. The government could be the plumber, but that reminds me of the old Reagan joke:

A Russian wants to buy a car. The dealer tells him it will take a long time and that he will put his name on a list and he should come back in 20 years. The man says, "Do I pick it up in the morning or in the afternoon?" The dealer asks, "What's the difference 20 years from now?" The Russian says, "Because the plumber is scheduled to come that morning."

If we rely on the government, we may be waiting 20 years for the ABS, CDO, or whatchamahaveyous plumber to get here. Who might step up to make freedom and capitalism work now?

Feb 22 11:49 AM

[John Lounsbury:]

Steve Waldman - - -

Another great article. Many have talked about socialism for the powerful and capitalism for the weak. You have discussed another example.

AllStreets - - -

Very interesting discussion. I would ask you what your plan would do for the retiree who has worked his entire life, paid off his mortgage, and now has 30-50% of his net worth tied up in house equity. Let's say he has $200K in his home value (current market value). Two years ago he had a $300K home (same house). His other life savings have been conservatively invested. Two years ago total (non-home) investment value was $300K and today it is $280K.

It turns out that the riskiest investment this person made in his lifetime was his home, down 33%, while the rest of his life savings are down less than 7%. Will your plan "bail out" my retiree? Will he get a $60K loan for 30 years at 3%?

AllStreets, I'm not sure that I can endorse much of your plan. It seems to me that there must be a more efficient way to use my (taxpayer) dollars, but I have not taken the time to work all the way through your proposal. Therefore, I will merely remain in doubt and not in opposition.

If you have thoughts on my example individual (above), I would appreciate it. I have a major concern in all this financial "rescue" effort, that we are rewarding some with bad behavior and punishing some with good behavior.

Feb 22 12:57 PM

[irondoor91:]

John Lounsberry:

Let's deconstruct your scenario. Your retiree's home was "worth" $300,000 two years ago. Though what he thought it was worth 2 years ago has nothing to do with the present, let's look at the situation anyway. If we assume that he bought the house 30 years ago and enjoyed 5% annual compound appreciation, he paid $69,413 for it in 1977. If it is now worth only $200,000, his annualized gain was 3.59%, or roughly the annual inflation rate. He has enjoyed appreciation while having the benefits and control of ownership. His house is paid off. It is a residence, not an investment and he has a roof over his head as long as he lives and doesn't screw up the rest of his retirement funds.

Many retirees had a stock portfolio that was 50% higher a year ago. They could have sold at any time, but now they want bailed out? Give us all a break!

I propose the following solution: Have the government pay off all single-family ower-occupied mortgage debt. The banks would then have no toxic assets on the books and they are free to lend again. Homeowners would have no mortgage debt, increasing their cash flow significantly and instantly improving their balance sheets. Homeowners would also have no mortgage interest deduction, thereby increasing their income tax bills to both the state and federal governments.

Banks could then make new decisions on lending under newly stringent guidelines. New mortgages could be full recourse. Money could flow from home refinancings or equity lines. The economy and the markets would quickly recover.

We might as well do it this way, since Congress is going to piss the money away anyhow. The problem is that homeowners have no lobbyists representing their interests.

Feb 22 02:12 PM

[John Lounsbury:]

irondoor91 - - -

Well thought out comment. I have one objection. All of this will be done with taxpayer money. My retiree will be paying taxes but getting none of the benefit, simply because he was prudent. The dollars will go to the imprudent.

Let me try another scenario: The same retiree with the same very conservatively invested savings. When he retired in 2005 he sold his paid-for house for a net of $300K. He then went to a "better climate" and bought a new home for $300K. If he took a $250K mortgage and put $250K in CDs, he would get a bail out under some of these proposals. If he paid $300K cash he would not.

The person who took the most conservative route (no mortgage) ends up paying for the person who mortgaged. Is this right?

I don't think there is any one "right" solution or wrong "solution". If the government makes efforts to "prop up" home prices, it will be doomed to failure because it will merely delay (and maybe deepen) the price decline. If government action is taken to smooth some economic and social dislocations on the way to the bottom, maybe they can work, or maybe not. The devil will be in the details. What I don't want to have is a wealth transfer from some people who have worked for years to accumulate a net worth of a few hundred thousand dollars (or less) to those who ill-advisedly took on several hundred thousand in debt that they can not service. In this regard, I'm with Rick Santelli.

Feb 22 03:25 PM

[henarl:]

John Lounsbury wrote: "What I don't want to have is a wealth transfer from some people who have worked for years to accumulate a net worth of a few hundred thousand dollars to those who ill-advisedly took on several hundred thousand in debt that they cannot service."

That just about says it all!

Feb 22 05:11 PM

[dlaw:]

This is a really excellent piece. Congratulations on the clear thinking. Let's hope public policy makers are reading.

Feb 22 06:14 PM

[doctordoctor:]

agree with your observations. in addition, the fed's "delaying" tactics may only accelerate the global disintermediation. 1993, china had grossly over financed urban construction projects. instead of pussyfooting with the oversupply, they simply let the buildings sit empty, wiped out investors, and moved on. in a two year time frame, acute pain, but short lived. rest is history. dragging out this new global meltdown will only add uncertainty to the investment equation. maybe khrushchev was right after all.

Feb 22 10:35 PM

[ecliptix543:]

All the talk of bailing out homeowners and subsidizing the mortgages makes for wonderful intellectual badminton. It should go no further. If federal funds are to be used for this purpose, what of those people who do pay taxes but do not have a mortgage? Renters, those who live in a family home that has been paid off for quite some time, people who are not quite ready to buy but intend to, for instance. Are those people to reduce their future income in the form of higher taxes and inflated real estate prices should they decide to buy simply to offset a condition not of their making? I for one would be extremely pissed if such a program were initiated to force me to pay off or subsidize mortgage for houses I didn't purchase whilst maintaining inflated home prices, disallowing me from a potential purchase in the future - and most certainly not with such favourable terms as a guaranteed and retroactive federal subsidy. I'd rather the taxman just come to my door and kick me in the nuts...

Feb 23 12:18 PM

[Leftfield:]

I believe the bank bailouts of about $2 trillion so far have been about protecting bondholders. That seems to be where the money is. The Obama porkouts seem to be to begin to spread the helicopter funds further down the feeding chain; to unionized companies and soon, local/state governments and to certain homeowners.

It's not working. Our leaders are in such full smoke-and-mirrors mode that it's hard to know what they have in mind.

Mark Twain said, "I sometimes wonder whether the world is run by very smart people who are putting us on or by imbeciles who really mean it."

Feb 23 02:48 PM