3 Key Steps to Fix This Fiasco

I was speaking to a standing-room-only crowd at a North Carolina investing conference recently when a sharply worded question soared over the group from a gentleman seated in the back row – and who was clearly agitated by my analysis of the whole bailout plan situation.

“How would you have handled it differently, Mr. Smarty-Pants?” he asked, in a challenging voice.

What I’m about to say is academic because – when it comes to the bailout plan – “Bernanke, Paulson & Co.” has already made up its mind.

I believe Paulson actually missed a historic opportunity to remove U.S. taxpayers from further financial troubles rather than lump more debt on them, just as I believe Bernanke missed several opportunities earlier this year.

By appointing the Federal Housing Finance Authority [FHFA] as a conservator, U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. has essentially assigned the FHFA to be the legal guardian of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). And that’s good, since conservatorships are typically established when a company can’t take care of itself and is considered incapable of handling its own affairs.

In this instance, both Fannie and Freddie qualify as not only being incapable, but perhaps even criminal as well, after hemorrhaging capital over the past 12 months. And this situation was even more complicated than it initially appeared, since there were global implications. As Money Morning detailed in a special report, it was pressure from foreign bondholders that finally forced the U.S. government’s hand.

Unfortunately, conservators can rarely do anything more than keep the lights on. As the term implies, they’re intended to “conserve” assets and property, until they can return the entity to solvency.

So, despite Paulson’s fancy plans and the $200 billion capital infusion he’s lined up, he may have handed hollow authority to an agency that cannot, for all intents and purposes, assign, strip, liquidate or materially alter how either Fannie or Freddie operates. Nor can conservators typically take possession of assets, which is a critically important distinction in this instance.

On the other hand, receivers are typically entrusted by the courts, or secured creditors, specifically to take possession of troubled assets and to dispose of them in a timely manner, and in such a way that they maximize returns to the secured creditors. And in the case of a public company, that duty theoretically extends to the company’s shareholders, as well.

In that sense, rather than placing an emphasis on continued operations as a conservatorship, a receivership emphasizes a return on capital and the cessation of operations.

In my opinion, that’s what’s really needed here.

Were I running the show, I would have assigned the FHFA (or brought in some true bailout specialists) to act more as receivers than as conservators. With that accomplished, I would have taken three key steps:

• First, instead of making a $200 billion down payment on the mother of all mortgages, I would have charged the receiver with immediately separating “good” debt from “bad” debt.
• Second, I would have ordered the receiver to weed out and repudiate flawed contracts.
• And, third, I would have searched for a way to sell Fannie and Freddie common and preferred shares in such a way that it would minimize taxpayer losses, rather than make them potentially unlimited as Paulson’s done.

Apparently, FHFA Director James B. Lockhart III does have the discretion to place Fannie and Freddie into receivership if he determines that’s the move that’s required, but the eventual dissolution could only take place by Congressional Act. That makes such an outcome highly unlikely, to say the least, given how much “pork barreling” has historically been linked to the two companies and to the financial industry in general. Despite the fact that liquidation – rather than keeping the lights on – is exactly what’s needed in my opinion.

I find it terribly sad that Paulson is going to throw $200 billion, or more, of taxpayer money into a black hole that’s already consumed billions. Especially when he’s publicly admitted that regulators don’t know enough about the complex financial derivatives and off-balance-sheet investment vehicles that have forced the bailouts of some of the world’s largest banks, forcing the U.S. Federal Reserve and U.S. Treasury Department to travel deep into uncharted waters.

It would seem that cutting our losses short is a far more productive option, especially when it minimizes potential taxpayer losses from the “unknown.”

It would also appear that Paulson has opted for the easy way out by socializing losses and allowing gains to remain private. Some will say that’s the way it’s always worked and that I’m naïve for thinking that it could somehow be different this time. Perhaps that’s the case. But I also believe this country’s financial situation cannot be stabilized by stopgap measures and half-baked bailout plans.

Nor do I think that running up even more debt in the face of the unknown is the direction to travel. I need only point out that the initial Office of Management and Budget estimates for the Iraqi war were a mere $50 billion.

I believe that Paulson could have been a hero by engineering a true workout that maximizes any remaining shareholder value. Instead, he’s structured $200 billion, or more, in preferred stock, and warrants that may never be paid back and that are effectively worthless unless Fannie and Freddie return to profitability.

And with the broad-based bailout he proposed a week ago – and that Congress is now sculpting into another shape – he’s effectively added another $700 billion to the U.S. bailout tab. In short, we’re talking about a flawed “fix-it” plan that’s going to cost you and I nearly $1 trillion.

Adding insult to injury, the relatively few individuals who engineered this whole mess with implicit government support are apparently going to be allowed to ride into the sunset with their saddlebags packed full of taxpayer money. Or at least with the millions of dollars they reap from their “golden parachute” corporate-severance packages. Either way, they’re not going to suffer like the U.S. taxpayer will. And that suffering will last for a long, long time.

Original post

Comments

[Al-USA:]

There is only 1 key step, nationalize it... And then throw the bums responsible in jail... Might take another Congress to do that however - the one that will replace the current one which will likely be voted out of office come November.

Nothing is certain, but what is certain is that I and many of my peers, for years an apolitical group, have had it... And we find ourselves with lots of company. Letting the politicians know our views was not enough, so, out with the old, in with the new.

2008 Sep 28 12:21 PM

[Diane Ritter:]

You are absolutely right. We need to flood Congress with one simple message - "If you vote for this bill, I will vote against you in November. And I will lobby all of my friends, and neighbors, and family members to do the same."

2008 Sep 28 01:50 PM

[HiThere:]

Burning Down the House
www.youtube.com/watch?...

2008 Sep 28 02:06 PM

[Urbane Gori...:]

In a way, the heckler at the back of the room has a point... What should have been done is just a case of 'flogging a dead horse. ' What we need is to move forward in the most sensible fashion.

Maybe the holdouts are correct. Perhaps we should slow down and think things through. I really am concerned when Bush's cronies start flapping wildly and scream that we have to make an instant decision. Look where it got us in Iraq.

I haven't heard of any other reasonable approaches to the problem, but it might be best to see what other ideas float to the top of this cesspool before blindly signing our children's future away.

For example..(and this is just one piece of excrement that has floated up from the depths of my mind....) :

In 2007 there were 1,285,873 properties that had foreclosures begun against them according to Realtytrack. (The number of foreclosure actions was actually higher, but I'm presuming that there were 2nd and 3rd mortgages involved. )

The average home value has been variously reported at around $230,000. I'm presuming (.. a big guess here ) a loan value of $200,000 per foreclosed home.

$700 Billion divided by $200,000 = 3,500,000 possible purchases.

If Paulson is correct and the cause of our downturn is home foreclosures ( and I feel this is just more Bushie spin... The cause of the financial problem is uncontrolled lending practices.. ) then maybe we should tackle the root problem. Buy the homes directly.

We could also implement other refinements. Perhaps, we make deals with the lenders and the property owners. The owners lose their equity and the lenders have to accept 'market value'. In other words. The careless buyers suffer and the banks suffer too. Nothing like spreading the pain around.

So why would the banks go for it? Three reasons (1) It closes out their problem with real cash right now, and (2) it eliminates the problems involved in fixup, management, legal fees and delay associated costs, and (3) it relieves them of the anxiety of watching their repo drop in price even as they are trying to sell.

So, what do we do with Federally owned properties. Well, we already have agencies that are designed to handle issues such as these. In California, we have the Cal-Vet repoed homes for example. Or perhaps we could begin placing them in the hands of larger rental agencies for the normal 7% fee. Maybe, a Federally processed 'lease to own', where the homes go to people that can actually afford to buy if given an opportunity. How about bundling them and selling them to overseas investors. Think of the job growth that this will generate.

If my numbers are close, I can see the $700 Billion going towards last years foreclosures as well as this years. And those nasty old banks aren't just given uncontrolled volumes of money. Just look back at the war in Iraq. It's worse than owning a boat... We just keep throwing money in that pit... I see this bailout as being the first pitch in many innings.

jegan ;-)

2008 Sep 28 02:11 PM

[Purl Gurl:]

User comments with frustration, "...then throw the bums responsible in jail...."

No! No! Wall Street has this Monopoly card up its sleeve:

www.purlgurl.net/aue/b...

Okpulot Taha
Choctaw Nation

2008 Sep 28 02:39 PM

[Humblemaster:]

In looking at historic home price increases since 1940, we have averaged about about a 15% increase in asset value per decade through 2000, but a whopping 60% increase in yrs. 2000 - 2008. If we have some 48 trillion of valuation out there in US homes, and even if 10% of that is already gone, aren't we due for another 35% correction before this bubble comes historically in line? this is theoretically 16 Trillion. What kind of GDP do we need going forward to mitigate that? This seems to me to be a crisis of unimaginable proportions. 700B may not make a dent.
Please, input from more knowlegable people?

2008 Sep 28 04:45 PM

[Crocodilian:]

Your proposed solutions are really quite trivial, and not consistent with the realities of the problem

"I would have charged the receiver with immediately separating “good” debt from “bad” debt."

Immediately? How is this going to be "immediately?" Do you have any sense of the scale of the problem? Since we're kicking out the old team, how long do you think its going to take for a new team to have even a general understanding of what they've got? The people who _made_ the loans didn't understand what they've got. Texas Pacific Group, the very smartest of the private equity groups, did intensive due diligence on one bank, WaMu, just six months ago-- and got it completely wrong.

And you're asserting that someone else, employed by the Feds, is going to be able to understand what's good and what's bad-- immediately?


"Second, I would have ordered the receiver to weed out and repudiate flawed contracts."

Uh huh. This is one of those things which "sounds good" but isn't realistic. We are speaking of hundred of thousands of mortgages, documented with millions of pieces of paper. At a practical level, getting a true understanding of these mortgages is a matter of years, not "snap your fingers and it happens". The time frame of your proposed action doesn't match the time available

" I would have searched for a way to sell Fannie and Freddie common and preferred shares in such a way that it would minimize taxpayer losses,"

And I'll "search for a way" to turn lead into gold-- let's see who comes up with an answer first.

Seriously, if you're going to write a piece like this, which claims to have some better idea, you really ought to actually _have_ some idea . . . you can't claim that "search[ing] for a way" qualifies as anything other than a speculation

2008 Sep 28 06:17 PM

[raising4dau...:]

This all goes back to the "War on Poverty." In our attempt to help the poor by getting them into homes, we've made a handful of crooks wealthy and the rest of us as poor as the folks we wanted to help.

Fifty years of failed attempts to help blacks has impoverished us for generations and will probably put one of them in the White House. How ironic.

2008 Sep 28 08:25 PM

[User 272189:]

It is a good topic. Fiasco is a more strongly worded title. It is very useful to everybody. Thanks for Keith Fitz-Gerald. He told very nice.
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2008 Sep 29 01:55 AM