Why The Paulson Plan Won’t Work 25 comments
David Bailey
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Make no mistake, something must be done and quickly. Let’s admit this is largely about WaMu (WM), which may be just days away from bankruptcy. We here in the Pacific Northwest appreciate the attention and the plan put forward by Secretary Paulson might even succeed in saving WaMu for as much as a year. However, I believe that banks like WaMu cannot be rewarded for creating huge pools of mortgages that were economically, if not legally fraudulent. I have been in favor of all the bailout efforts up until now, but the Paulson Plan might be the worst approach possible.
Not only will it reward misdeeds, the Paulson Plan will fail to save the very financial market it hopes to save. I can actually explain why with a single Wikipedia page.
Honestly.
To spend just a moment on Secretary Paulson himself, while some apparently view him as a born-again socialist, I think that up until now Henry Paulson has been acting as an investment banker with America his client. He hasn’t liked the moves we were insisting on - extending emergency credit to financial institutions – but if America was going to do it, investment banker Paulson was going to see that America, his client, got plenty of equity for our risk. With his latest plan, however, a cynical person might suggest that Mr. Paulson is treating the banks as his client and America like a "customer" - the lowest form of life for in the investment banking world. A cynical person might suggest that Paulson is simply "jamming bonds" down America’s throats. Actually a non-cynical person might suggest the same thing, because it's true.
As you may know, arguably the largest financial market in the world has crashed. No, you didn't read it in a headline when it happened. No, nobody in the government told you that it happened. The level of denial and disbelief has been astounding. But in historical terms it is 1930 and the market has already crashed. You can see the crash start August 9th, 2007 in a chart of the LIBOR interest rate many know all too well:
click to enlarge images
The market , obviously, was the market for American mortgages and mortgage-backed securities. Contrary to the irresponsible reporting that prevails in all but the financial press, selling mortgages is NOT a new practice, of course. It is many decades old. It helped get us out of the Depression. It is completely essential to our financial system. But right now, banks cannot sell their mortgages into a crashed market.
Thus, the Paulson Plan's simple premise is for the American government to start buying these mortgages, putting on them - they hope - a rational price where a crashed market has failed to. It seems reasonable. It would even work and I would support it wholeheartedly and shout down the critics if the problem in the secondary mortgage market was simply a lack of liquidity. But I fear the problem is deeper and different and must be addressed with different means.
The real problem is that banks (and other originators of RMBS) acted like scummy used car salesmen. They brought investors onto their used car lot of mortgages and made their crooked pitch:
"This one? Oh, this one's a beauty. It's a $500K mortgage on a house assessed at $510K, which we made to a guy who makes $125K a year. Oh, and I will throw in an insurance policy on it that's worth $400K. Wanna buy it?"
And people bought.
But it turned out that the loan above was actually a $500K mortgage on a (then) $400K house with its assessment inflated by $110K made to a guy who...well, we really have no idea what he makes, but it's probably more like $45K. And that insurance policy? Yeah, turns out that was actually worth $0K - nothing. Hence, we the citizens now own 80% of AIG (AIG). Oh, and that house isn't even worth $400K any more, it's worth more like $300K and dropping.
So the market for these loans quite naturally dried up. They were phony junk passed off as safe investments.
The banks were selling were Lemon Loans. And if you don't think "Lemon Loan" is strong enough and think something like "felony fraud" would be more appropriate, me too. I choose "Lemon Loan" to connect all this to a theory for which some guys got the 2001 Nobel prize in economics. Henry Paulson seems to have forgotten about it. Maybe he wasn’t in class that day.
The Nobel-prize-winning theory is called "The Market For Lemons" and if you follow the link to that single Wikipedia page I promised you, you will see that the Nobel was for a paper which revealed why markets crash when they become filled with bad merchandise passed off as good merchandise. Of course we all know this through common sense, but you don't get Nobel prizes for common sense.
For comparison, let's use another little no-regulation nightmare and yet another market predictably destroyed by fraud: How many of you would buy powdered milk from China right now?
I'm sure China produces many tons of perfectly good powdered milk that would be healthful for anyone to drink. However, it has been revealed in the last few months that they have also been producing fraudulent powdered milk that has proven toxic to some children who drank it. If you are in the market for powdered milk you are not, I predict, going to spend the valuable money in your wallet on something with very uncertain value - Chinese powdered milk - something that might even be toxic. Likewise, America produces and can produce trillions of dollars of sound mortgages that would be wise investments for anyone to buy and own. However, it has been revealed in the last few months that we have also been producing fraudulent mortgages that have proven toxic to the balance sheets of some institutions who bought them.
Would you buy Chinese powdered milk simply because you read that Chinese government had started to buy it? I think not. Therefore, it is my belief that people in the secondary mortgage market are not going to start buying American mortgages simply because the American government starts buying them. I think people are going to wait for proof that these mortgages are not toxic to their balance sheets before they put down cold cash. If we give buyers good information and sound guarantees, they may come back and buy. If we don't, I fear they will not.
To be technical for a moment, I think the information in the market for American mortgages became too "asymmetric" and thus the market reached a "no-trade equilibrium." This has caused a glut in the supply of high-risk assets so huge that portfolios simply cannot absorb them and maintain a normal risk-weight – let alone a more conservative risk-weight. I think this is also affecting other liquid, high-beta equities and credits. Here's the MSCI Emerging Markets ETF (EEM):
By the technical talk I mean that nobody will buy our mortgages until we turn ourselves from risky Gordon Gecko into safe Jimmy Stewart from “It’s A Wonderful Life”. We’ve got to admit our mistakes and get the backing of our community.
I believe that the world desperately wants and needs safe American investments. If we are straight and honest with the world; if we reassure them with a next-generation financial information system; if we give them quality government guarantees; they will buy our bonds and mortgages. It will take a huge effort. Ultimately we may have to tell the truth about, and guarantee to the maximum extent possible, every non-fraudulent home mortgage in America. It sounds daunting, but only is such a project possible, it would bring monetizable value and innovation to our economy. It would allow us to survive a disaster that might otherwise destroy our way of life. It would even be cheaper than the Paulson plan.
To those who would say "let the destruction happen" - you're simply being childish and foolish. We can't let the sleaziest capitalists in our system define the value of our markets. That's not a free market. That's anarchy ruled by villains.
If we the citizens act to bring honesty, information and government-guaranteed quality to our financial system, we can survive this. The choice is ours.
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This article has 25 comments:
"To those who would say 'let the destruction happen' - you're simply being childish and foolish. We can't let the sleaziest capitalists in our system define the value of our markets. That's not a free market."
If the "sleaziest capitalists" in our economy have amassed the power, for whatever reason, to bring down this economy in a major contraction than let it begin. It will happen no or later. It will be slow or fast. It will not be "painless."
I am not childish and foolish. To make a comment like that appears to me to be along the same lines of what is going on with this rescue plan before Congress. Don't question! No opposing views! You are with us, or against us.
Passing around the contraction (bad debt) will not solve the problem. What you are seeing is nothing more or less than a game of "hot potato."
The real problem with the bailout is that buyers have not got the means to buy except under the most outlandish terms of sale. If we let Hank buy the junk and peddle it, we still need to know who can buy? Are we on the hook for financing the buyers too? Have mercy.
When I heard Paulsen tell congress that they just had to authorize a blank check and he couldnt tell them what he would do he lost my support. It is crazy to just hand over $2000 for every citizen with no true plan that you can articulate.
I think it is possible to bail out the system without a huge long term cost to taxpayers. However it is just as easy to inject money into the system which is lost forever with additional risk added on.
You bet the government needs an equity stake! My guess is the government would do best to start small by gathering investors and supporting assets they think are good buys with a passive equity stake.
If hedge fund A is willing to buy 100 with a 5% upfront government support... go for it. Get the ball rolling with investors to create interest.
Some serious dangers to avoid include using 100% government money to by huge positions from WaMu, Leh, Merrill, BAC...
Finally I suspect Paulsen has a plan for 700 billion. He just wasnt willing to reveal it. At least I hope so.
PS I still want pounds of flesh!!!
Some of you have made me fear I failed to make two important points more strongly:
First, I am in favor of a very large intervention - even to the point of creating guarantees/insurance on every non-fraudulent mortgage in America.
Second, "The Market For Lemons" suggests that government buying RMBS will NOT create a market for RMBS - because the market itself has been destroyed. The price points Paulson plans to set are simply too little information to create a basis for people to buy. This is crucial.
We must intervene, in my view. But when we intervene, we must provide much, much more information to the market about these credits or we will waste hundreds of billions. The level of fraud is - in my personal view - crippling this market.
But perhaps asymmetric information is inexorable and such scenario will be played out like it did and it does, which is just sad.
It's all Fannie and Freddie's fault - not Countrywide, not IndyMac, not WaMu, not Bear.
Incredible.
And he's not even *trying* to claim that the government will get back the taxpayer's money on these "low priced" RMBS.
1. Loans will only be made to buyers who put down 20% of the total price.
2. The buyer must qualify for the worst case interest rate change in an adjustable rate mortgage.
3. Adjustable rate mortgages must specify an interest rate ceiling.
For those who fear they may never qualify for a loan under these circumstances, I disagree. A few years of these requirements would help stabilize home prices.
Isn't this all about the incredibly overflowing froth of sleaze by rich people taking the financially illiterate class to the cleaners, reaching epic proportion, and finally coming home to roost?
James Ch 5 v 1-6 comes to mind:
'Now listen, you rich people, weep and wail because of the misery that is coming upon you. Your wealth has rotted, and moths have eaten your clothes. Your gold and silver are corroded. Their corrosion will testify against you and eat your flesh like fire. You have hoarded wealth in the last days. Look! The wages you failed to pay the workmen who mowed your fields are crying out against you. The cries of the harvesters have reached the ears of the Lord Almighty. You have lived on earth in luxury and self-indulgence. You have fattened yourselves in the day of slaughter. You have condemned and murdered innocent men, who were not opposing you.'
Yes, as painful as all of this is, I fear that it needed to happen.
However, "Somehow the banks will survive."
from 'A Prohetic Vision of the 21st Century' Rick Joyner, 1999. (a GREAT read)
Language from Section 8
Treasury Financial Bail-out Proposal
Thats the rub-
Here’s why
1 There are mortgages some of which are failing. Above them is a huge stack of transactions called derivatives.
2 Above in this sense means later. The latest transactions are at the top of the pile.
3 Risks accumulate as the piles rise. Security is dispersed. Each new participant adds his own risk, to a greater or lesser degree. (Who would have predicted the AIG risk?) The added risk cannot be removed. The new buyer cannot obtain what the seller does not have.
4 We imagine that the reverse auction should take out the weakest transactions first. These are probably the transactions near the top of the pile that have accumulated the greatest risk.
5 But that is not what will happen. It is not the transaction that matters but the player who holds it. The auction will be “won” by the weakest player. The most desperate player. The player that can not longer continue to play the game. The same transaction is valued differently. (Metaphor: One home owner sees their negative equity and quits, another with better cash flow, hangs on.)
6 Paulson does not plan to fix the problem securities, he plans to liquidate them. This is the equivalent of a fire sale. This will not make the seller stronger just (temporarily) more liquid. In many cases not liquid enough. The seller can only pass on the cash he has to those above him in the pile.
7 The people above the auction “winner” must now accept the valuation of that “winner”. The risk/loss is passed upwards until someone with deep enough pockets is found to stop the chain. The potential risk is then exchanged for certain loss.
8 There is no way for this to flow downwards.
9 Each auction is likely to increase the need (increase the desperation) of those above them in the pile. One auction creates the need to for another auction above it. The underlying mortgage (the original problem) remains unfixed.
10 This process is built on weakness. It destroys the pile without fixing the problem. It does this by accepting the valuation of the most desperate player.
11 Forcing the weakest player’s valuation on everyone above him/her guarantees the worst possible outcome.
The Leveraged Debt Industry has already died, and no-one can revive it.
Removing 'toxic paper' into one bad bank holding co would clean the closets of our nations banks and allow the trust to return to some of these institutions. Banks right now are afraid to lend to each other! Everyone is scared about what might be hiding in each other's closets.
The new plan would remove it all and infuse new 'good' capital into our system. And you can bet that NONE of the new capital will be used to fund risky investments. On top of it all, just because a loan is subprime or an ARM doesn't mean that 100% of them will default. You know, only 3% of ALL LOANS right now, are in default/foreclosure. 24% of all subprime, but subprime in the big picture isn't that much. The reality is that we could get our economy back on track within a year or two, and the bad bank holding toxic waste will eventually be able to sell the debt for what was owed or even a profit.
It CAN be revived, and it MUST. Yes, we're a capitalist country, but sometimes our over-indulgence and greed leave us no other alternative than to have our own government step in and clear the system using massive powers. It's that bad that it now requires intervention, and yes it will work.
The question is, are you more worried about pointing fingers at Wall Street versus maintaining your own livlihood?
Slick Willy said it great on Larry King recently, Americans need to start realizing that leaving a positive, progressive mark on society should be on the list of goals of every American looking to be a solid citizen.
Implicit in the Treasury proposal is this analysis:
Crises in financial markets may result from:
• Illiquidity.
• Insolvency.
• Information asymmetry.
The Treasury does not aim to address a problem of liquidity. AIG presented a problem of liquidity and it was dealt with in classic manner. The central bank acted as lender of last resort at a swingeing interest rate.
The proposal does not aim to address a problem of solvency. Lehman Brothers presented a problem of solvency and is to be liquidated in bankruptcy court.
The Treasury believes that financial markets are not functioning because lenders don’t and can’t know if borrowers are good for the money. Risk can’t be quantified.
The Treasury aims to provide information by setting a public price. In doing so it may overpay and thus inadvertently act as lender of last resort without getting interest or capitalize bankrupts without getting equity.
How is the Treasury proposal supposed to work to provide information?
Why won’t it work exactly?
Let me begin by saying I agree with the substance of your presentation and explanation concerning the causes of the present economic malaise in the United States particularly the statement ".....nobody will buy our mortgages until we turn ourselves from risky Gordon Gecko into 'safe' Jimmy Stewart from it's a Wononderful World"... I've seen that film many times and was born in 1945 and have seen and experienced many things as a citizen of this country.
Let me say this, turning from the Gordon Geckos to the Jimmy Stewarts does no good if the Thomas Mitchells in their weakness drop their hard earned savings on the floor of the bank or leave them on the counter in a newspaper so that the Gordon Geckos can snatch them when no one is looking and prosper even more in their crafty conceit!
E.Tippett
Chicago, Illinois