Long the Financials? Solving the Mortgage Problems Will Help

Speculative investing in financials in this economic environment may be a sign of poor judgment. On the other hand, suppose one invests in financials and then someone comes up with an idea that will turn around their free fall overnight. Suddenly it doesn't seem like a bad investment after all.

I am long Citigroup (C). I do not believe it will go under and think that in the long run it will recover. It has been at this level before and has gone on to prosper. Also, one must look at the current investors and their political influence. Prince Walid bin Talal is not renowned for losing money. His influence could carry significant weight with American regulators and officials, since Saudi Arabia is likely a significant purchaser of U.S. treasury bonds. Sovereign wealth funds from the Middle East have also invested in C, and would be "miffed" if it went under.

I regard the probability of C being fully nationalized and liquidated as low. However, the common equity shares, now heavily diluted, may not reflect much gain for years unless there is a catalyst. One such catalyst would be some kind of financial solution that dramatically increased the value of leveraged assets that C controls either directly or through derivatives.

Derivatives haven't gotten the amount of press they deserve, particularly since much of the trading is done in unregulated markets, but it is worth noting that the Bank for International Settlements (www.bis.org; drill down through statistics, derivatives, table 19) last year had over $600 trillion in derivatives. A recent Bloomberg article alleges that JPMorgan (JPM) had over $87 trillion in derivatives last year. I imagine that C has its fair share of these instruments as well.

Derivatives and leverage are so complex, particularly in a multinational firm, that efforts at regulation without day to day oversight on a massive scale would appear to be futile. C will probably continue its business practices as usual, in my view, regardless of the large percentage ownership of common equity by the U.S. government. The current CFO of C gives the impression in television interviews of being both highly qualified and well informed. Consequently, I predict that derivatives and other occasionally risky investments will remain a part of the C portfolio.

This is actually good news, because it means that C would be a prime candidate for huge advances in stock price, if something happened to increase the putative value of their "toxic" assets. Mark to market accounting is nothing short of smoke and mirrors for illiquid assets. If there is no genuine market for farm land, that doesn't mean that the land can't grow crops and earn money. It just means that few people want to be farmers. Plans for one or more exchanges to begin trading exotic financial instruments in a liquid manner appear to be moving slowly, and it is not clear yet how successful this regulated market would be, as compared with the "shadow market."

I have both an altruistic and personal interest in coming up with -- and welcoming from others -- ideas which would improve the economy, and which more specifically would dramatically improve bank balance sheets. Such concepts might even yield a significant positive outcome in the economic situation, and proposals gaining political traction could drive bank stocks prices higher rapidly. For those of us long in C or other financials, that would be a fruitful development.

It puzzles me that the current economic downturn hasn't been solved already. The causes and their interaction, while long ignored, are not mysterious. The solutions should not be mysterious, either. We have many smart people in government, commercial and academic circles. Plus, there is no shortage of economic meltdowns throughout history in other countries to learn from.

The remainder of this article gives some suggestions. But first, a recap of how we got here.

Many banks and financial institutions stopped being mortgage holders and became mortgage brokers, selling their loans to Fannie Mae and Freddie Mac. The loans were then securitized, packaged and sold to investors. So far, so good.

Meanwhile, foreign countries recycled dollars into our treasuries, keeping our interest rates artificially low and the value of the dollar artificially high, despite our huge trade deficit. This allowed exporting countries to piggyback on our economic growth. It also allowed these foreign interests to gain great influence and control over our financial and political destiny, but that's another story.

Because of the artificially low interest rate for treasury bonds, the mortgage backed securities (MBS) offered attractive yields. These securities were rated "optimistically" by ratings agencies, allowing investors to obtain credit default swaps (insurance by a different name) against default. The resulting "good as gold," insured securities were then used by investors as collateral to borrow money to buy more of them on leverage. Among those who bought on leverage may have been the very institutions that initially sold the mortgages to Fannie and Freddie. Talk about making money coming and going! This description is greatly oversimplified and not all-inclusive, but it gives a gist.

As housing prices topped and creative mortgage defaults increased beyond projected levels, it turned out that some credit default swaps came from counter parties without sufficient capital to guarantee payment for the defaults. Like mythical garage shop hurricane insurers in Florida, the counter parties were happy to take money and pay lavish salaries to their executives, but weren't against going bankrupt if the bad times came. I accuse no one of wrongdoing, but if it smells like old fish, maybe it is old fish.

Therefore, the "good as gold" mortgage backed securities, purchased "on margin" at perhaps 30 to 1, started to diminish in value, because they weren't reliably insured. Indeed some of them probably didn't come with credit default swaps attached, anyway. Since there was no ready market for the securities, yet regulations required a "mark to market" valuation, financial chaos began to ensue.

As resets in creative mortgages continued, defaults increased; "flippers" found that their business model of increasing home prices was unsound. Housing prices diminished further. Unemployment resulted. Bailouts were needed. Industries faltered. The problem became multi-faceted. And so here we are.

It is too late for a single, elegant approach to jump start the economy. A condition that has become multi-faceted requires a comprehensive set of solutions, with multiple actions taken simultaneously. We can't take it one step at a time, because it would be like pushing on a balloon full of water. If we push in one spot, a bulge comes out elsewhere. To prop up a house of cards in a wind, we need to prop up many cards simultaneously, not one at a time.

Most of the following suggestions require little additional federal funding, compared to what has already been spent, and may have greater effectiveness. They may also have flaws, but perhaps readers could correct those deficiencies or offer better alternatives.

As a high priority among other tasks, it is crucial to mitigate the increasing rate of foreclosure as soon as possible. Despite the fact that many of the creative mortgages have already reset, there are many more resets still to come. The economy may be destabilized by the leveraged impact of these remaining resets. To avoid this, we must find a way to stop the defaults and increase the value of the MBS.

The amount of leverage is so high that even several governments collectively cannot afford to buy all the toxic mortgages and just write them off. Some other approach is needed. So far, our bailout money has been treating the symptoms, not the cause, and I believe that much of it has either been spent on bonuses for some of the very people who caused the problems, or else hoarded and not put into the credit markets. It is only when defaults end and MBS values increase that bank balance sheets will improve rapidly, and that should be the goal. Suspension of mark to market accounting would also be helpful, but it wouldn't represent a genuine improvement in asset values.

We need to offer both lenders and borrowers a uniform, overarching deal: take it or leave it, one solution across the board, no negotiation, no telephone banks, no fuss, sign here and we're done. Those who don't take it can go into normal foreclosure. The proposed suggestion is a variant of "shared appreciation," a concept mentioned by a congressman on March 3, during questions to the Secretary of the Treasury at hearings before the House Ways and Means Committee. Clarification is required about tax consequences of shared appreciation, but that should not be a show stopper. In any case, my suggestion involves equity sharing, not simply appreciation sharing, and equity sharing is better understood in terms of tax consequences.

Suppose we have lenders refinance the creative mortgages into 30 year fixed rate 5% standard plans, which is a reasonable rate of return. Borrowers could elect to continue paying the amount they paid before, and any difference between that "teaser rate" payment and the new, fixed rate payment would accrue to the lender as an equity interest in the property. If the borrower chose to pay at the new rate, then this would simply be a regular mortgage.

For example, suppose a teaser rate monthly payment of $1,500 was made on a $565,000 home. The payment on the 30 year fixed rate 5% loan might be about $3,000 per month. The lender would continue to receive $1,500, an amount affordable to the borrower, but would get a 50% equity interest in the house. If the lender equity interest qualified as rental property, there could be additional tax benefits to the lender from depreciation, which the tax code might be changed to accelerate.

When the house is eventually sold, the lender would be senior to the borrower in terms of collection up to the full value of the original mortgage. Profit above that would split by borrower and lender, proportionally. Sale of the house at less than the full mortgage value would require agreement by both borrower and lender for the first five years. After that, either party could force a sale. If the borrower stopped making payments, the house would go into foreclosure based on the borrower's portion of the equity. If a lender needed additional cash flow in lieu of equity interest, that equity interest could be sold at a discount to any interested buyer, who would then be a "silent partner" in the house until it was sold.

The goal of all this is to allow the borrower to remain in the house, without the payment increasing. In the example, the lender continues to get a cash flow equivalent to about 2.5% on the total mortgage, which is a relatively low rate. However, by foregoing the additional 2.5%, the lender obtains a 50% equity interest in the house and in any profits from its eventual sale.

Regardless of the actual rate of return, the mortgage is now fully performing. It can be marked to market as a 2.5% bond (or more, given the equity share) with high confidence, even if the house is "underwater" in terms of assessed value, because the borrower will probably not be able to buy or rent an equivalent home as cheaply as the low payment he is currently making. This keeps people in their homes and avoids the expense of foreclosure to both borrower and lender. Perhaps this approach, or something to it, might help solve the country's mortgage problems.

The next issue is shortage of commercial credit for business loans. My understanding from talking with a local banker and watching various television commentaries leads me to conclude that credit is available for adequately collateralized loans in modest amounts. It is the larger commercial loans with greater risk that give banks pause, due to heightened economic risk in the current market environment.

A possible solution is to recharter Fannie Mae and Freddie Mac to let them buy up commercial loans, in a manner similar to what they do for mortgages. The information technology and administrative infrastructure at those institutions should not require much change, since payments on a loan, whether for a house or for commercial purposes, are similar in nature. The government could insure the commercial paper, charging banks a small origination fee (which would to towards a default insurance pool), and if the loan defaults, barring them from the purchase program for a period of time proportional to the size of the loss. The insured commercial loans could then be packaged and resold as collateralized loan obligations into the open market, where their government guaranteed yields should prove attractive to investors.

Credit card debt default is sometimes viewed as the next shoe to drop in our economic woes. We need to head off that problem before it impacts bank liquidity. Banks charge very high interest rates on credit cards because, according to them, they need the extra money to offset losses from those who default. To save banks the worry about credit card defaults -- which means they should lower interest rates for the good customers, doesn't it? -- let's recharter Fannie Mae and Freddie Mac to buy up defaulted credit card debt, if both the banks and the card holders agree in each instance.

Fannie and Freddie would pay off the amount owed to the banks, and would then schedule customer payments at more reasonable interest rates, similar to those for mortgages. Upon further default by card holders, collection would be handed over to the IRS, which would amortize the debt by adding, say, 10% of the debt due to the person's income taxes each year until the balance was paid off. Because of the increased certainty of eventual collection by the IRS, and the lower interest rates which make payments more affordable, credit card debt could be packaged and sold as collateralized (against future income tax withholding) credit card obligations. To prevent gaming and reduce risk, this approach could be limited by Fannie and Freddie to people with over $20,000 in credit card debt who were gainfully employed.

Another economic problem we face is industrial production slowdown, due to reduced consumption resulting from a combination of unemployment and reduction in asset values. Two major industries have been hard hit by the slowdown: auto sales and construction. Both industries have multiplier effects based on purchases of raw materials and parts from third parties and on large-scale employment.

It is not enough to stimulate new car sales. The government must also find a way to avoid a surge in trade-ins overwhelming the used car market and driving those prices down. For commercial car purchases, the government might modify the tax code to permit depreciation of the full amount of the purchase price the first year, with recapture if the car were sold before three years had elapsed. For private purchases, the government might change the tax laws to allow deduction of interest on car payments. To mitigate trade-ins flooding the market, the government might provide a one-time tax credit to those car owners who buy a new car but do not sell their old one for at least three years; this also stimulates the auto insurance industry, through insurance on the additional car. The benefit to the consumer is increased productivity at home with an extra car for the family.

In terms of construction, any building activity that improves productive capacity using domestic materials and labor will provide a good stimulus. For example, expansion of the electric grid will require steel towers, heavy equipment, skilled and unskilled labor, copper for wires, fabrication of industrial transformers, cement for new roads and rights of way, etc. This seems like a worthwhile project with immediate payback. If coupled with subsidies on wind turbines, this approach could yield sustained reductions in oil imports, which would partially offset the costs of the project, as would taxes on the electricity produced.

There are several other problem areas that must be addressed concurrently, such as unemployment, tuition costs for higher education, and other areas. Suggestions for those should not be difficult to come up with.

For example, instead of standard student loans with repayment schedules, perhaps students could simply pledge to the universities or other lenders a percentage of their future gross income, say 5%, until the loan was repaid. The tax code might be modified to regard this repayment as tax free from gross income, similar to IRA contributions. The student aid should also be interest free from universities with large endowments (they can afford it). If a graduate became unemployed or took a low paying job in public service, there would be no painful financial downside, unlike the situation today with student loans where interest can continue to accrue.

This article is not meant to be all inclusive, but rather to stimulate discussion. Many talk show hosts, members of congress, and indeed the president himself, have said that new ideas are welcome. Although the financial downturn has been enormously painful -- many people have lost over half their life savings -- at least it has shaken the American public out of apathy and into involvement in the political process. Perhaps in the future we will elect competent representatives who will watch out for the interests of Main Street, not those of vested interests and lobbyists; and who will understand that free market capitalism is not a synonym for unregulated greed.

Disclosure: Author is long C and C preferred.

Comments

[Blues Gal:]

I agree with your last paragraph especially. As for your solutions, seems like the government has to be involved in every aspect of the economy!
Maybe this is what we've come to. President Obama seems to think so. Giving this much power to Washington can only bring more frustration. Look at how the government operates right now, it functions on deficit spending and can't even run a Postal Service that doesn't lose money. I'm afraid that this doesn't inspire much confidence in me.

Mar 04 09:35 AM

[romorris:]

Blues. I guess it is getting hard to tell where the government begins and ends and that is throwing you.

The US Postal Service is a business, not a part of the government. It hasn't been a part of the government for many years.

Mar 04 10:04 AM

[Blues Gal:]

The US Postal Service is a quasi-governmental agency. The President appoints 9 out of the 11 board members, they are then confirmed by the Senate. Those board members then appoint a Postmaster General and he appoints the next in command.
It is then supposed to be run as a business.

Mar 04 10:38 AM

[MattZN:]

I think you are greatly underestimating the impact of Citi's derivatives portfolio. Citi lists about 32 trillion (with a 't') in derivatives. Receivables are listed as 115 billion and payables are listed as 116 billion, AFTER netting. That is basically their risk right now. This is all in their 10-K.

(Quick definition of Netting is that it is a risk assessment. i.e. the actual derivative payables are more in the trillion dollar range, as are the receivables, but the payables and receivables associated with the SAME counter-party can be netted, since if that particular counter-party fails both sides get wiped out).

What this means is that counter-party failures can expose Citi to upwards of 230 billion of liabilities. If all their counter-parties failed all the netted receivers go poof, while the netted payables to that counter-party which Citi is still on the hook for are sold to another counter-party as an asset when Citi is liquidated).

It is unclear to me from the 10-K what Citi's situation is with regards to having to put on collateral on its derivative liabilities. Collateral requirements depend on the CDS but are often triggered by general market movement, risks related to the assets being insured, and Citi's own ratings.

This is why the U.S. government is providing a backstop on a big chunk of these securities, by the way. If they didn't then Citi would probably have to put up a LOT more collateral.

-Matt

Mar 04 08:20 PM