Forget the Moral Outrage: Just Restore the Mortgage Markets 43 comments
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Exactly 13 months ago, I shared my very pessimistic views in an article entitled: Ben Bernanke's Initiation: Flashback to 1987. I conveyed a few of my concerns, including an untested Fed Chairman, an upcoming presidential election that would necessarily lead to a change, M&A activity that had surged, a high "real" interest rate, narrow credit spreads, consumer confidence beginning to roll over, low unemployment, the faltering housing market, the 5th year of a bull market and the eroding value of the dollar. I concluded (emphasis added):
My advice (take it for what it is worth): Steer clear of banks and brokers, Fannie (FNM) and Freddie (FRE) and any company that needs to access capital (many REITS). Yes, these things are down a lot, but they can go down a lot more as this credit crunch evolves. I am not sure how it will end, but, like the infamous Chrysler bail-out that culminated the failed presidency of Jimmy Carter, I expect that President Bush will have to deal with the government take-over of Fannie Mae and Freddie Mac.
I don't always get it right, and, especially in this case, I became more constructive earlier this year (and remain so) a bit early. In fact, I purchased some FNM in the 20s earlier this year when I mistakenly assumed that their brighter future (higher market share) would come to pass, neglecting to envision that the fallacy of "implicit guaranty" would become unraveled beforehand (more below). I was sucked in by my view of them as "part of the solution". As I type, the details aren't yet fully known, but it is apparent that the Treasury will imminently announce a plan to "finalize its GSE back-stop". It appears that FNM and FRE will enter conservatorship, implying government control of their operations. It also appears that the government will take an active role, including financial support, to work through the challenges.
It is clear that the government's plan will most likely significantly dilute current shareholders. I have been following the GSEs closely my entire professional career (since 1986), and I can't tell you whether that means FNM or FRE will trade at 1 or 10 after the details become available. Even with the details, it will be tough to determine the value of the equity, but without them it is impossible. If the plan is perceived as feasible, it could ignite a massive rally in the market. If it is viewed as flawed, it could create a crisis of confidence unlike any that this country has seen in modern history. I think the former, but am prepared to deal with the latter if necessary.
Why is this such a big deal? The GSEs are the end of the proverbial line. The housing problems, which have been brewing for much longer than analysts and pundits generally seem to accept, surfaced initially with the demise of some unheard of "sub-prime" lenders. The market disregarded the significance at the time, writing off the problems to a small subset of the market. As 2007 progressed, the depth of the problems became more obvious, and we have now seen the actual or virtual elimination of all of the major players who had a significant touch on the mortgage finance market. Originator Countrywide (conforming and jumbo), investor/market-maker Bear, Stearns, guarantor of non-agency mortgages ABK and MBI, Alt-A/non-conforming specialist IndyMac, and, of course, the big daddies (or is it mamas?), Fannie and Freddie. If we can address these issues and get the mortgage market functioning more normally, we can move on. If not, the downward spiral will continue.
The GSEs ARE the mortgage market. The long partnership between government and the private sector has enabled a transformation in the financial world. In the olden days, if you wanted a mortgage, you went to your local bank. That bank would hold the mortgage as an investment. The "implicit guaranty" has allowed the mortgage market to standardize, where banks now originate loans per standards and the assets can then be pooled and sold either to banks or other types of investors.
The GSEs retained a significant portfolio of mortgage investments as well. For borrowers, the end result has been lower interest rates than would have been available otherwise. The cost? Absolutely nothing - until now. The government used its "implicit guaranty" to enable lower rates by removing credit risk. By partnering and not having an "explicit guaranty", it avoided reflecting this in its balance sheet or its "income statement" - the annual budget. Now that the whole scheme has become unraveled and the government can't afford to stiff banks and foreign entities, everyone wants to point fingers and express moral outrage. The simple analysis is actually the correct one - the government failed in its regulatory oversight.
I have been almost amused by the cries of outrage and the pleas that the "taxpayer" shouldn't shoulder the burden of fixing this problem. Very few of these folks have complained about the relationship between the GSEs and government over the past few decades, but suddenly they find it wrong that this was the system. While they don't want to "pay" for it, they simultaneously fail to credit it for keeping mortgage rates lower than they might have been otherwise. They also don't seem to mind that they are allowed to deduct mortgage interest (subsidized by renters) or to exempt capital gains from their taxable income when they sell their homes.
No matter how one looks at it, we are in this as a society. For whatever reason, home ownership has been viewed as "good". The mortgage deduction, the capital gains break and the GSE model all share this goal. The poor regulation of these entities has left them facing highly uncertain future cashflows.
No one knows how much of a hit the GSEs will take on their portfolios and their guarantees. As a result, no one is in a rush to lend them money. It is very possible that the losses will be far less than many expect, or they could be greater. It really depends upon what happens to housing prices. The worse it gets, the worse it gets. Pretty simple. What is clear, though, is that the recent lack of mortgage credit available isn't helping the situation. Clearly, we need to get the GSEs through this period of tough access to capital, which is what I think the plan is all about. Mortgage rates have increased over the past year - this isn't helping!
For those who think that the common equity holders should be "wiped out", I question that sentiment. As one can see, there aren't too many equity holders who haven't already been de facto wiped out. FNM hadn't done anything for seven years until it started to plunge last year, and it's value is a mere fraction of what it was even 15 years ago. If the plan is so punitive to shareholders that it doesn't allow them any participation in the future of the company, I believe that the government will never be able to partner with the private sector. How else are we going to get a better Post Office?
click to enlarge
Yes, there have been a lot of people over the years who profited greatly from this partnership, perhaps even some current executives. Directing anger towards the shareholders, though, makes little sense. There isn't a single political party to blame - they both are culpable. Alan Greenspan deserves some of the blame as well. One can have a debate about whether or not it ever made sense to have this scheme of the federal government subsidizing housing (yet again) by avoiding the proper on balance sheet accounting, but that won't fix the current problems.
We have two giant, historically mismanaged and underregulated, vital lynchpins to our economy. We need to get them capital in the least costly and quickest fashion that we can, reestablish a normal mortgage market and then deal with a longer-term vision. For those who don't won't to do this but still want to deduct their mortgage interest, you are hypocrites. Forget about the capital gains benefit, as that ain't happening. I can assure you that without restoration of the mortgage market, we will have falling home prices, job loss and an even bigger mess to address. On the other hand, by addressing the issue, we may be setting in place the path for an economic recovery.
Disclosure: Long FNM
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This article has 43 comments:
This is the best reason why this is no good (bailout)!
This interview has to be seen by all "tax payers" we are going to pay while many have lined their pockets on this. It was a candy store for "candy bandits".
Let the Brokers pay, Let the Brokerage Houses pay. I do not want too.
Let Fannie, Freddie Fail: Jim Rogers
Fannie Mae and Freddie Mac should not be saved if they go bankrupt, and economic stimulus packages do more harm to economies in the long run than good in the short term, Jim Rogers, CEO of Rogers Holdings, told CNBC Friday.Last Update: Fri. Aug. 29 2008 | 08 09 00
www.cnbc.com/id/158402...
Its just my opinion but I don't think - and never did - it was a question of "should" or not. I always looked at it as a consequence of what needs to be done. Like a lion hunting its prey; there is no malice involved or moral judgement, the lion does what it needs to survive. As you wrote, "We need to get them capital in the least costly and quickest fashion that we can, reestablish a normal mortgage market and then deal with a longer-term vision." If they can do that w/o wiping out current shareholder, they will. If they can't....
I can see a scenario, for example, where a reverse split is done (1:20) and then the government kicks in $5 billion and raises another $5 billion with the issuance of new shares at $10/share (an arbitrary figure but based on the number of shares outstanding, the new capital structure, etc.). Current shareholders would lose a lot - though not everything - but FNM and FRE would be in better shape and I think confidence would improve.
I agree that shareholders are not to blame for this mess. I didn't blame them for Enron or Worldcom either. But they are suffering like any investor would when the company invested in turns out to be a disaster. Of course, until we know the details of the plan, its just speculation how current shareholders will fare. Still, I'm betting not very well based on statements Paulson as made in the past, what media sources have been reporting, as well as some legislators. In other words, in spite of the lack of details, multiple sources are saying it doesn't look good for current shareholders and so that's what I believe at this moment.
The greediest of all, though, were the Democrats and Republicans. The status quo, which is what keeps them in power, was nothing but helped by the easy money policies. The regulators for which they were responsible failed. People who actually knew the GSEs were always aware of the chink in the armor, but it was always a game of confidence in how and when the government would honor its commitment. I believe it is disgraceful to end this charade by trying to accuse FNM and FRE for causing the problem. The government should be honest in assessing its own culpability.
I am libertarian to my core - it is the framework I use to address all government/citizen interaction. I also despise hypocrisy. So, I struggle with resolving this issue. We can debate whether or not government should EVER have intervened in the mortgage market 70 years ago and increasingly over time, but the fact is that they are involved. If we want to make it to the point where we can debate the optimal involvement in the future, we have to make it to the future. Quickly restoring the mortgage markets, which this plan will attempt to do, is of vital national importance. The failure to do so will lead to a further collapse in home prices.
Just as would happen with an investment in any other company in this situation, the shareholders would watch their investment go to zero. Should we as a government move to shore up the GSE's until things turn around? Absolutely.... we have to. Should the shareholders be protected? No. They own shares in an insolvent company.
To bailout the GSE's is pathetic in the sense that they were allowed to dig themselves into this hole to begin with. Given the perpetuity of human greed, I believe that BEFORE any bailouts take place, the rules of the game need to be rewritten. Significant oversight and firm restrictions must be in place to insure that this does not happen again. If that means that fewer people buy homes, then so be it.
So, if we must restore the mortgage market, then we must. But we also must realize that the rules of the game have to change significantly.
How will taking over the GSE's stimulate the housing market? There is still no liquidity. Banks still have bloated mortgage portfolio's and still need to recover huge losses. Upside down homeowners have stopped throwing good money after bad and are now living rent free for the next 12 months, so the losses are still growing more than anyone thinks.
Like any businesses, any losses are passed on to the consumers. They are borrowing at 2.5% and lending at 6.5% conventional & 7.5% jumbo as it is. Median property values are based more on local income than anything else, so if income isn't going up to offset diminishing buying power caused by increased rates, how will property values recover? Most of the troubled markets home values are based on ARMS with 4.5% interest. A 2% increase means less buying power which in turn means lower property values. Decreased liquidity means fewer qualified buyers which also means lower market prices.
Taking over the GSE's has the same market saving effect as having the Titanic play happy music as the ship sinks. Day trade the run up next week, but don't be fooled by the music and don't buy any financial long. Game over.
It is plain that whilst there is plenty of blame to go around, unless some of the originators of these ponzi schemes are held to account, we are asking for another mess.
Far from being allowed to scarper with fat bonuses, prosecutions should be brought for gross negligence, and in many cases false accounting.
This is a massive transfer of funds from the middle classes to the wealthy.
Hopefully Obama will level this, with large increases in taxes for them.
All that has happened from the ridiculously low effective tax rates the rich pay is that they put their money into bubble after bubble, which are then 'too big to be let collapse'.
Therefore the money needs stopping at source.
Over the past decade the rich have increased their income hugely - in fact they have looted just about all of the increase of productivity for the whole of society - does anyone seriously think that they have improved their performance?
This author doesn't get it. It's the lack of moral and ethical standards that has gotten us into this mess. We are in this as a society? Well, we should all bite the bullet and suffer the consequences of not keeping our eye on the crooked politicians and bankers.
The government involvement in "saving" the GSE's is ridiculous. Are we saving the GSE's or preserving the wealth of those who have vested interests in the banking and financial industry? The GSE's should be allowed to fail in this so called "free market" and let the chips fall were they may.
If this were allowed to happen, the ensuing pain would create a well deserved and well needed moral outrage within our society. Maybe then, we would insist on serious investigations into the fraudulent behavior of the bankers, mortgage companies, rating agencies and brokers.
This will be the largest government bailout since the Great Depression orchestrated by the Republican neo-con men.
Let's not forget the lesson: It applies to all politicians and political parties on the left, right and in the center.
Watch what they do and ignore what they say.
It should be the basis of all investing also: Look for fundamental economic and financial causes and structures and ignore ideologies.
It is, after all, the advice of Warren Buffet.
And this above all: Don't drink the cool aide.
A reasonable person can see that a financial disaster may be just around the corner. These bailouts and guarantees are nothing but a bandaid to help prop up a failing financial system--a system based on uncontrolled borrowing made possible by printing more and more fiat currency.
The model is terribly flawed. The mounting debt, both public and private, is no longer sustainable. It is like an individual who needs to borrow from one credit card to make monthly payments on other credit cards which are over the limit. Eventually, one runs out of credit and defaults. "Capitalization", a euphemism for unfettered borrowing, is just sending us down a one way street to failure.
If there is a real solution to our financial problems, I would certainly like to hear it. It seems to me that the system needs to wash out the corruption before it can be viable again.
This plan is likely to ultimately not cost the government anything. They will get paid handsomely on their investments and won't lose a penny before the Preferred gets wiped out. It certainly, if it works, will cost less than status quo and then a later bail-out. The key to watch is the borrowing costs of the GSEs tomorrow. If the spreads don't come in, we have a big problem.
When you say "subsidized by renters," let us not forget that landlords who own rental property deduct mortgage interest, as well. And that deduction potentially benefits renters. So I don't see where renters are subsidizing homeowners.
By Christopher Swann and Pimm Fox
Sept. 7 (Bloomberg) -- William Poole, former president of the Federal Reserve Bank of St. Louis, said taxpayers may face a $300 billion bill to revive Fannie Mae and Freddie Mac, the mortgage giants being taken over by the Federal government.
``I would not be surprised if their total losses aggregate about 5 percent of their obligations'' of about $6 trillion, Poole said today in an interview on Bloomberg Radio. ``Five percent does not seem to me to be an outrageous guess.''
Poole welcomed the decision to put the companies into conservatorship by the Federal Housing Finance Agency, calling it preferable to action by the Federal Reserve. He said financial fallout from Fannie and Freddie was likely to be a long-term drain on the Treasury.
``It's extremely healthy that it's now the Congress and the Treasury and not the Federal Reserve putting funds in,'' he said. ``It's not the purpose of a central bank to put funds in to save or bail out failing companies.''
Treasury Secretary Henry Paulson said today he would replace the chief executives of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac and eliminate their dividends. The Treasury will purchase up to $100 billion of senior-preferred stock in each company as needed to maintain a positive net worth.
The Treasury said it would reduce the portfolios of both companies by 10 percent a year starting in 2010. ``I think that's a good way to go, and I just hope that the government can complete that course,'' Poole said.
By the way, here is something I posted in response to another string of comments:
This plan is good in terms of accomplishing the objectives of stabilizing the market and buying time to get out of this mess (and time will fix this mess).
For those of you who can't read apparently, the government hasn't assumed the debt. In fact, it has capped its exposure at what I believe is WAY above a level necessary to sustain the GSEs. As I wrote on Seeking Alpha, the bailout of FNM and FRE is how this bear market was going to end (yes, I was calling it a bear market over a year ago). For those of you who like to invest with mirrors, go ahead and try to find some big negative here. You will be able to sell your stocks higher tomorrow, at least on the open, as a MAJOR overhang on the market is being lifted.
As far as the value of FNM and FRE goes, one can never tell where a stock will trade when such a cataclysmic event occurs. The dilution was greater than I expected, and the mandated asset reductions (which will take until 2020 to accomplish) greatly diminish the value of the stock. My initial calculations (and this assumes that the warrants have an exercise price of 1-3) is that the stock is worth about $9 or $10 a share in 2013. If one discounts it back at 16% per year, that works out to about $4 per share. Can it trade at 1? I hope so - I am a buyer. Can it trade at 8? I hope so, I am a seller.
Keep in mind that the equity wasn't wiped out for a lot of reasons, not the least of which is that the government could make an absolute fortune on this deal. Politically, it will look very bad if the stock surges - the massive dilution pretty much limits that possibility. The government has to "sound" as punitive as possible (and they were punitive). So, my best guess is that the range tomorrow is 3-6, while the rest of the market soars incredibly and justifiably.
"Justifyably"? Ha.
You do realize that by coming into Fraudy and Phony The Government has just declared all preferred issues "impossible" for any financial company from here on out, yes?
You do realize that this means that the door is SLAMMED SHUT for anyone else who needs money, yes?
You do realize that there are a lot of banks - investment and commercial - that are so far underwater you need Heliox at that depth, yes?
Now how does this all work out again?
Oh, and let's not forget - in January of 2009, there will be a new Treasury Secretary - who can reverse everything that was just done with the stroke of a pen!
You want to buy financials - or the broad market - tomorrow?
Uh, I don't think so.
More to the point, you've noticed Treasury yields tonight, yes? There goes half of the "benefit" from spreads tightening. Already. In the overnight hours.
Oops.
The short-bus riders are out tonight. Wait until people start to get their arms around the fact that the preferred issue market is closed, because any financial that has "creative" accounting for their "assets", as Fannie and Freddie did, is subject to having the same thing done to them.
i am a pragmatist. my philosophy is you must do what works. the home credit market simply was about to fail due to lack of liquidity. the banks can not hold the home loans on their books as their asset base is not increasing. fannie and freddie were reaching a point they could not raise capital.
i fail to see what fannie and freddie did wrong. they executed a government mandated service. this is not enron, or even chrysler. with foresight they COULD have played the game differently. there are many more experts in hindsight than foresight - and notsosmart keeps reminding us how he does not believe anyone (i concur).
but the joke is that this does not change anything. why will the market go up today?
will this increase the amount of potential buyers of real estate? no, this action by treasury only stopped a collapse of residental lending which was working but about to fail.
will it revive the economy - no. it will not trigger the homebuilders into a new round of building.
will it shore up the erosion of gdp - no. it will do little to stop the fall of home values. there are too many homes for sale that are not affordable - and we are still building 1 million homes a year.
drink your coolaid. mine will be with scotch.
"Dude, you need to cover your shorts and get a bit more balanced view. Where were you a year ago? It is NOT 1929, sorry ".
Even the phony (low) government unemployment numbers are pointing to more credit problems. As more and more people lose their jobs, there will be an increase in auto loan and credit card defaults. And even worse, commercial real estate defaults are imminent. Take a drive around your town and count the lease signs.
Chrysler was a $50M bailout; it was just a drop in the bucket compared to the exposure the taxpayer is going to incur with this GSE nonsense.
You can massage all the numbers you want to paint a rosy picture, but the bottom line is that government involvement, especially when it comes to money, is almost always disasterous for the taxpayer.
Mr. Borstein, you need to get grip on some balance yourself. You are turning a blind eye to the obvious corruption of the financial system. As I have previously posted regarding the mortgage mess, there had to be a concerted effort to hide material facts by mortgage originators, mortgage companies, rating agencies, investment bankers and brokers. This fraudulent behavior thrived in a climate of unregulated greed fostered by the neglect of our politicians many of whom received contributions from these criminals. How can we solve the current problems when the same players are still running the game?
Excellent article, good early analysis of what this all means.
Question: You make several references in your article and comments to "restoration of the mortgage market," "rstoring confidence in our mortgage market," etc. What do you consider to be a restoration of the mortgage market? A return to a time when thrifts granted mortgages and held them as investments? A return to a more recent time when practically all mortgage originators packaged them up and sold them, with entities such as FRE and FNM enabling that whole process? Something in between?
In short, what should a sound, stable, "normal" mortgage environment look like, in your opinion?
In the bigger picture, there are qualified buyers out there who are having problems getting financing due to tighter-than-normal conditions. No, I don't advocate pulse-based lending, but the market is considered very frozen right now. I believe that the plan could have a trickle-down effect that goes beyond just conforming mortgages.
I agree with what you say, but I guess I didn't make my question clear. I'm looking for a very basic snapshot of what a "normal" mortgage market should look like.
From your answer, do you see a "normal" mortgage market as including FRE and FNM (or their functional equivalents), a secondary market into which most mortgages go, mortgage bundles sold as investments themselves, and government guaranteeing (or at least lubricating) the whole process?
In other words, is "normal" what we had before this crisis started, but with explicit government-guaranteed liquidity, standards for obtaining a mortgage tightened from what they were a year ago but loosened from what they are now, and interest rates loosened (and therefore more affordable)?
My main question goes to the role of the federal government in the mortgage business. What is the proper role of FNM and FRE (or similar organizations), should they exist at all, how much should government (i.e., taxpayers) get involved in the process, and whether some or all of that function should migrate to private organizations (instead of GSEs). Prior to 1938, there was no government involvement (as we know it today) in the mortgage process. Some might argue that it worked better then.
And, if there's to be government involvement, then how much government regulation there should be? We can see now that, although it took decades to flower, unfettered greed (by both mortgage lenders and homebuyers) cannot be the standard by which mortgages are granted or denied, because it leads to situations that are not sustainable and therefore become toxic to the credit markets.
The `cart` is mortgage affordability. the horse is the ability of the majority of us to afford inflated rent payments at all, much less buy a home.
Making the mortgages more affordable will result in a bounce after which will come the REAL `recession` (similar to the ones Alan described as following the 1987 and 1998 blow-ups), in 2010, right on schedule.