Subprime: We Have Nothing to Fear But Forbearance

"Let them fail; let everybody fail! I made my fortune when I had nothing to start with, by myself and my own ideas. Let other people do the same thing. If I lose everything in the collapse of our financial structure, I will start in at the beginning and build it up again." Henry Ford, February 11, 1933

The quotation above refers to an important but little known fact about the Great Depression, namely the role of Henry Ford in forcing Washington to address the issue of bank insolvency. The great inventor hated "the banksters" and was no less concerned about the safety of his money than today's subprime shocked investors. Not only did he reject President Herbert Hoover's eleventh hour appeal to provide additional loans to support Detroit's insolvent banks, but he threatened to "take his boys" into town that Tuesday following Lincoln's birthday and withdraw some $60 million in cash deposits.

Hearing of Ford's threat, Michigan Governor William A. Comstock declared a week long bank holiday, beginning the process that would see nearly every bank in the US closed just prior to the inauguration of President Franklin Delano Roosevelt in March. In some cases, banks would remain closed for months. Yet in a very ironic way, Ford's mean spirited and supremely selfish stance forced Washington to deal with the problem head on, closing all commercial banks and forcing them to meet a solvency test before being allowed to re-open.

Fast forward to the present day and consider the temporizing and lack of leadership coming from the Bush Administration. It should be apparent to all by this time that Treasury Secretary Hank Paulson's first two proposals to address the subprime crisis, call them "MLEC" and "Forbearance," have the very same object: revive the now moribund market for complex structured assets, the chief area of activity by Wall Street for the past decade or more. Paulson's former employer, Goldman Sachs (NYSE:GS), has benefited enormously from the structured asset fiasco, both long and short.

"What is the next 'new thing' for Wall Street to hock?," asked one reader of The Institutional Risk Analyst. "Securitization and the corresponding three-letter alphabet soup is now a four letter word in most people's book. We've had the nifty-fifty, conglomerates, de-regulation, LBO's, privatization, .com mania, hedge funds and now mortgage securitization. We need a new money machine..."

Sad to say, Humpty Dumpty cannot be reassembled, no matter what Paulson or other government officials may say or do, at least not unless and until investors are convinced that the bad news is behind us. Markets are waiting for tangible corrective action in the form of asset sales and write-downs, one reason why we focused last week on Wells Fargo & Co. (NYSE:WFC) and that institution's decision to bite the bullet and write down 3% of total loans in a single quarter.

Of interest, WFC's ratio of loans held to maturity vs loans marked for sale shifted dramatically over the past several quarters, evidence of the death throes of the structured asset racket. In Q3 2005, loans marked for sale equaled $46.7 billion or 15% of total loans, while in Q3 2007 loans available for sale were just $30 billion or 8% of total loans. Over the same period, income from securitization has dropped from 11% of total income to just 6%. And OREO, short for "other real estate owned," has risen from $158 million in Q3 2005 to almost $900 million as of Q3 2007.

Click here to see a chart of WFC's total loans, loans marked for sale and loans held for inventory since Q3 2005.

Perhaps more significant, WFC's total loans and leases have risen more than 10% in the past six months, this after remaining essentially flat for the previous two years. Indeed, looking at the sharp move in the Economic Capital numbers of the largest banks in Q3 of 2007 (See IRA News -- Economic Capital for Q3 2007 ), it seems fair to conclude that the collapse of the securitization assembly line is causing many banks to make significant balance sheet adjustments, additions mostly. With the ability of banks to sell assets now sharply curtailed, balance sheet management -- and restraint -- is back in vogue.

The solution to the subprime crisis has nothing to do with the level of interest rates set by the Federal Open Market Committee. We note with approval the efforts by Citigroup (NYSE:C) to shed assets in that bank's off balance sheet funds, apparently some $15 billion so far. But the real question going forward for C, WFC and many other banks which have been dependent upon loan securitization, both for fees and to free up balance sheet capacity, is how to reconfigure their operations for a market where originating and selling assets to investors is not the primary objective.

The inability of banks to originate and sell loans and other assets implies a vast reduction in the supply of credit available to the US economy, an outcome which must surely be unacceptable to both political parties. Trading volume in structured assets is nonexistent and volume in other OTC products such as credit default swaps is likewise facing a sustained drought. One would think that eventually we're going to see Paulson, Fed Chairman Ben Bernanke and SEC Chairman Chris Cox on national TV telling the Street to take the pain, clear the decks and get on with the cleanup process. But do Paulson and his peers have the guts to do the right thing?

The biggest threat facing the markets today is inaction by public officials who are reluctant to force all of the major banks (and their Buy Side clients) to recognize reality. As our friend Alex Pollock at American Enterprise Institute likes to say, "the loss has already occurred, but it has yet to be recognized." If Secretary Paulson and others in positions of leadership in Washington and on Wall Street want to fix the subprime crisis and restore investor confidence, then the solution must start with a comprehensive, mandatory write down of all illiquid complex structured assets held by every bank, dealer and fund.

Only when investors are convinced that the rot has been cut out of the financial system and that banking institutions are honestly disclosing their full liabilities will the global capital markets start to clear and recover in terms of liquidity. The result will be some bank failures and fund insolvencies, but the next day the markets will start to rebound. As in the dark days of the Great Depression, the more our leaders in Washington try to restore the status quo ante, the larger will be the scope of the financial crisis and the longer it will take to truly restore investor confidence.

Comments

[Reinko]

It is not only the banking sector that has to clean up it's act (and they will take many months to do just that), it is the entire debt structure in the US economy/households.

When you add up all the debt you arrive at at least fifty trillion of debt hanging over the US economy and if you take a reasonable level of interest, lets say 5% you see that interest is 'just' 2.5 trillion US$ a year.

Since 2.5 trillion is over the combined profits of the entire US economy we see why the political leaders keep their ugly mouthes shut: At the moment they tell the truth, they are dead meat...

[rc whalen]

Agreed. The predictions of authors like (The Two Income Trap, Warren & Tyagi 2003) have definitely been validated. The deflation in the US economy over the next several years could be far more severe than the agriculture-led deflation of the 1930s. All of the mechanisms we have in place to avoid a repeat of that experience are inadequate to the present task.

[jack kreg]

Why do the lenders have to take all the heat? The borrowers should be assigning equity to the lenders in return for lower rates or principal reductions. Maybe, the homeowner becomes a renter and the lender becomes a landlord. But a transaction needs to occur, not a confiscation.

[kurt walter]

Start the real estate auctions... supply and demand should rule. ... crazy loan interest rates and ignorant fiscal fools caused the bubble. ..the music has stopped. ... time for a big downward adjustment in real estate prices. If I buy a house with 20% down, rent the house out and can get a postive cash flow every month, then the real estate value is right. If not, it is overpriced ...