Milton Recht

How Flash Orders Work

www.reddit.com/r/Econo...

sh33ple claims credit for diagram on reddit.

Will Congress Try to Dictate Better Market Outcomes with Regulation?

For some reason, Barney Frank is overly protective of Fannie Mae and Freddie Mac. He was instrumental as chair of the House Financial Services Committee, in preventing direct oversight by Treasury of these two GSE's in 2003. Greenspan and many others at the time testified that the GSE's needed stronger oversight. In 2003 and prior, many in and outside of government recognized that the GSE's had become too big and were reaching beyond their housing mandate by directly investing in mortgages to increase their size, income, and executive bonuses instead of facilitating home ownership by guaranteeing the mortgages.

Frank was also very protective and supportive of Frank Raines, the Fannie Mae CEO who resigned due to accounting irregularities to increase Fannie Mae's income and his bonuses. See the March 31, 2005, The Washington Post article, "Study of Fannie Mae Cites 'Perverse' Executive-Pay Policy." www.washingtonpost.com...

Any product, including securitized mortgages, relies on a sufficient supply and a sufficient demand for it to be successful in the marketplace. The GSE's in 2000 through 2007 were major purchasers of securitized mortgages of all types and the GSE's purchases of securitized mortgages in the years leading up to the financial crisis are a contributing factor to the housing bubble and banking crisis.

The GSE's had the ability to borrow in the market at rates significantly below those of other mortgage buyers due to the implicit government backing of the GSE's. Without GSE purchases, the originators of the securitized mortgages products would have found it much more difficult to find a sufficient number of buyers for all the mortgage securities that they could produce.. Without sufficient buyers, prices of the mortgage products would have had to decrease, which increases the yield, to attract more buyers into the marketplace. Mortgage originator profits would have declined because of the lower prices, which would have forced some originators out of the business. Additionally, the remaining producers would have had to increase the cost to borrowers through higher interest rates or points to remain profitable, which also would have had the effect of decreasing the number of borrowers and the number of mortgages originated.

While not the sole cause of our current financial malaise, Barney Frank certainly is an important contributor to the banking crisis.

New Cars, Mortgages, and Race

Alternative causes for higher minority mortgage defaults exist and data needs adjustment to make NY Times' claim statistically valid.

Minorities' percentages of home ownership were increasing so have greater percentage of minorities with mortgages and with higher remaining principal balances as percentage of home value and in dollars than in non-minority group.

Unemployment, loss of income, and uninsured medical expenses are also primary causes of mortgage defaults. Minorities have higher unemployment rates during this recession and are more likely not to have health insurance. Also, maybe more likely to work in jobs where hours are cut backed in recession and their weekly wages have declined.

Need to compare minorities against similar group. Need to adjust non-minority default rate for lower unemployment, lower mortgage balances and lower unexpected medical expense costs.

When two groups are balanced, default rate will most likely be the same, which is why just about every time Fed researchers look at problem they do not find a minority, mortgage discrimination problem.

Higher mortgage foreclosures are not as much due to a subprime problem as it is due to other social and economic factors.

Mark to Market: Why Not Bend the Rules on a Temporary Basis?

You are assuming the government wants a simple solution. This is the administration that does not want to waste a crisis. Until stronger Federal regulation of financial services is achieved, until GM is resolved and until the budget is passed, the banking crisis will linger.

In Defense of Mark to Market

"After all, if I repeatedly lend you $100 and the market has now determined that for each of those loans I'm only likely to get back $50, how do my operations have "continued viability"?"

I agree with your statement if the bank had no other future sources of income or loans, but banks with viable businesses do. All banks, even very good ones, write off some of their loans. All banks have made $100 loans that they only get $50 back or even less. However, most banks have other loans and sources of income to make up for the loss and to provide a reasonable return to their investors. Most banks today hold US Treasury bonds with very low interest rates that could be lent out as loans at a higher interest rate.

Every company has flops, but hopefully, it makes enough from other places or future business to be profitable in the long term. A balance sheet is a snapshot of a point in time. It does not include future business. In your example, suppose the bank made some $100 loans and got back only $50 on each of those loans. Suppose the bank learns its lesson, stops making those loans, and finds a different lending or bank service opportunity that is profitable over the next several years. The bank can get back to its starting place and recoup its losses by relending the $50 and redeploying cash and low yielding securities as loans. Sure it might be a bad past investment, but should the bank be closed?

Suppose you open a restaurant and sell hamburgers, hot dogs and steaks in an area that is predominately vegetarian. While there are some meat eaters, there are not enough customers for you to pay your rent, staff, interest and other expenses. You lose a lot of money. One day, you decide to change the restaurant's menu to vegetarian. Customers love your new food. You make lots of money and are successful. If the restaurant were a regulated bank, it would be shut down before the menu could be changed.

Loans are NOT now marked to market on a bank's balance sheet. Loan loss reserves are taken against loans based on historical and current loss experiences and are used to reduce the loans' balance sheet value. There is no market pricing or cash flow discounting of originated and kept loans. The bank determines the amount to set aside for loan loss subject to regulatory disapproval. Usually a bank reserves enough for the next couple of years expected loan losses and replenishes it as it is used. The expected losses over the next 10 -15 years are not taken all at once.

If the banks had not bought mortgage securities from other entities and instead had originated and kept their own mortgage loans, we would not be in the current mess. There would be no marked to market of the mortgages.

Changes in market prices are not just due to losses. For example, if a bank issues a 30-year, $100,000 mortgage at a fixed 5 percent and the rate for new mortgages shoots up to 10 percent after the mortgage is on the books, the old mortgage market price would be around 60 percent of its original value, $60,000. The borrower could be a great credit risk with zero chance of default and payoff the entire balance $100,000 over the life of the mortgage but because the market rate for mortgages increased, the old, low interest rate mortgage is worth less. It is worth less than the book value because it is paying less than the current market rate. However, it will payback the full $100,000. It is like buying older US Treasury bonds at discounted or premium prices because of the difference between the coupon rate on the old bonds and newly issued bonds. Discounted Treasury bonds still pay back the full principal.




On Mar 24 08:03 PM logicalthought wrote:

> Milton Recht,
>
> You write: "Mark to market and historical price valuation of a balance
> sheet provide little, if any, information about the continued viability
> of the company's operations."
>
> Your statement is completely wrong when we're talking about a company
> (i.e., a bank) whose primary business is lending money. After all,
> if I repeatedly lend you $100 and the market has now determined that
> for each of those loans I'm only likely to get back $50, how do my
> operations have "continued viability"? And yet, if we don't mark
> that balance sheet to "reality", how would we ever know about this?

In Defense of Mark to Market

The current debate about mark to market accounting is really a debate about assessing the ongoing viability of a financial company, especially a bank. Financial institutions and other companies are more than just a portfolio of their assets and liabilities. They are also businesses. Mark to market and historical price valuation of a balance sheet provide little, if any, information about the continued viability of the company's operations. Overly focusing on balance sheet values confusingly compares an institution to a closed end mutual fund.

Truthful income statements that accurately reflect revenues and expenses provide a clearer picture to the world of a company's ability to sell products at a price to cover expenses and provide a return to the owners. Income statements tell us whether a company has a successful business model. Its balance sheet does not. If businesses were only their balance sheets, every company with investors would succeed. Every restaurant would be crowded and profitable. One problem is that an income statement can distort the view of a company's earning power if gains and losses from mark to market are included.

If the bank has insufficient regulatory capital, the government can close a bank even if the bank's future business model is valid and will be profitable. The reverse is also true. A bank with a bad business plan can stay open if it has sufficient capital to satisfy the regulators.

A little over a year ago, Bear Stearns ran into funding problems. It posted collateral against its borrowings. As its collateral value diminished, Bear ran out of collateral to allow its debt to roll over. It faced a liquidity crisis. Investment banks mark to market every night. Changing mark to market methodology is not currently an investment banking industry concern and changes would not have solved Bear Stearns' collateral and liquidity problems.

Bank regulatory capital at large institutions pose two threats. Insufficient regulatory capital depresses stock prices because of the very real threat of a government takeover of the bank. It also depresses stock prices because the bank has to raise new capital and diminish the earnings available to the previous capital investors. In the current environment, mark to market has increased these threats to the continuation of the bank and to the previous investors. Naturally, these threats have caused an increase in the banking industry and in investors in the call for a change to mark to market use.

Mark to market debates are red herrings. The real issues are when should the government takeover a large troubled bank? How should the government deal with large troubled banks? Should we force them to raise new capital? Should the government invest in them, nationalize them, close them, merge them, etc? What do the regulators do about systemic risk?

Let us get off the mark to market obsession and deal with the real underlying issues affecting our banking system.

Mark-to-Market: Prospects for Change

Steve Forbes is correct. Banks file Call Reports and Reports of Condition and Income with their regulators. Small banks in local communities and large banks like Citibank and Bank of America file these reports. Lehman Brothers and Bear Stearns' broker dealer operations did not. Broker dealers file a different report with a different regulator. The banking regulators set the requirements for their bank reports and the numbers on these reports determine a bank's regulatory capital. FASB has no control over the numbers on these reports except to the extent that the regulators or Congress require it. FASB controls the financial reports of publicly traded entities to the extent that the SEC adopts their recommendations.

The banking regulators grant banking charters and the banks must follow regulatory rules. Some banks are owned by Holding Companies and the parent company must file holding company reports with the regulators. The holding company reports do not determine a subsidiary bank's capital. Some of these Holding Companies have shares that trade publicly. The publicly traded holding companies must obey SEC reporting rules and follow FASB.

As Steve Forbes says, the bank regulators can change the rules for the bank call reports, the bank report of condition and income and the items included or excluded from capital. The bank regulators determine the rules for computing bank capital.

Some people complain and say that it will create two sets of books for banks if the regulators do not follow FASB. There are two sets of books now. The banks currently file financial reports that deviate from FASB requirements and all publicly traded bank holding companies show different numbers for their bank subsidiaries on their regulatory reports than on their SEC reports. For example, it is common to have slightly different deposit totals on the two filings.

It is the bank regulatory reports that determine if the bank does not have sufficient capital. It is the bank regulatory reports that determine if the government should takeover a bank.

The confusion may lie in the fact that Investment Banks, as opposed to commercial banks, have used a form of fair value accounting since the 1970s. Merrill Lynch, Goldman Sachs, the former Lehman Brothers and Bear Stearns were investment banks. Even with them, SEC regulations set their broker dealer capital requirements and can deviate from FASB requirements.

All Banks Are Insolvent if You Believe They Are

On Mar 02 09:59 AM American in Paris wrote:

> It is rubbish to contend that the main reason mortgage-backed securities
> are the main reason for the depressed pricing of these assets. <br/>
>
> Given that the banks have already written down $1 trillion dollars
> worth of these assets, it seems pretty clear that it was the high
> foreclosure rates that drove the prices into the ground.
>
> Trying to make the government the culprit is typical right wing rationalization.
>
There are $11 trillion of mortgages on residential property in the US. $1 trillion represents 10 percent. In 2008, about 2.5 percent of mortgages went into foreclosure. Normally about 1 percent of mortgages default. In addition, banks and other mortgage securities holders receive the proceeds from the forced sales of the homes. The write down of $1 trillion is more than 4 years of foreclosures (with a 50 percent recovery rate in foreclosures, it is more than 8 years) and it appears more write downs will continue to occur. The write downs of mortgage securities to market values of the securities are far in excess of what would be expected if depressed house prices and foreclosures were the sole culprit of the write downs. Obviously, something has frightened the market and devalued these mortgage securities. It is unanticipated anxiety by the securities holders as to what payment they will continue to receive from mortgages. Homeowners can now avail themselves of new legal rights to decrease and delay their payments and defaulting homeowners can request that judges decrease the value of the mortgage. Government intervention into helping the homeowner has exacerbated the mortgage valuation problem in the US and contributed to the insolvency of US banks and investment banks through excessive devaluation of mortgage securities.

The government's actions did not decrease home prices but it did excessively decrease the value of the associated mortgage securities and cause a tremendous negative effect on the financial industry.

All Banks Are Insolvent if You Believe They Are

One of the logical reasons for the apparently excessive market price discounting of mortgage securities is the market anticipated the Federal government's intervention into the mortgage contract which diminished the value of the securities. The Federal banking agencies and Congress are forcing the banks to extend mortgage life, decrease the interest rate, decrease monthly payments to a lower percentage of income, and delay foreclosure proceedings. Also, there are strong indications that banks will see the principal amounts of the mortgages lowered, either through bankruptcy judges or voluntarily. All of the above factors and others cause mortgage securities to be worth significantly less than originally anticipated based on default rates and cashflow.

As the data on the current mortgage crisis reveals itself, it is becoming increasing clear that four states were the cause of the current banking problem. California, Nevada, Arizona and Florida account for most of the subprime, no income verification, underwater, defaulting mortgages, and foreclosures. Much of it was caused by the above average and rapid house price appreciation in these states combined with lax state regulation of mortgage bankers and originators within these states.

While in all recessions there are always calls by some of our Congressional representatives to help homeowners in foreclosure, this time around we had the US Senate and the House of Representatives controlled by individuals whose states were at the forefront of the problem. Pelosi is from California and reid is from Nevada. It was also clear during the 2008 presidential campaign that a Democrat was most likely to win the White House due to Bush's and the Republican's very high unfavorably ratings and that the Democratic winner would likely accede to a Democratic Congress on helping mortgage borrowers in trouble.

The depressed market prices for mortgage securities in early 2008, which led to the Bear Stearns collapse, were lower than many anticipated by the then actual and foreseeable cashflows on the mortgage securities. Even today, the payments are better on these mortgage securities than market prices would suggest. The disconnect between expected cashflows and market prices has caused the most problems in motivating banks to take write downs and in attempting to come up with a federal government solution.

If one uses the market prices of the mortgage securities instead of their book value then one would conclude that banks that hold them have assets that are less than liabilities and are insolvent. If one would use likely cashflow projections without government intervention then these banks are solvent.

Insolvency is the trigger for government intervention of the bank. So, the insistence by the banking regulators and the Treasury to use market prices instead of cashflow projection prices has caused the deterioration in banks' equity stock market prices and insolvency. However, Krugman and others should recognize that mortgage securities prices are excessively depressed due to the involvement of the Democratically controlled Congress and White House in coercing banks' to modify mortgage loans.

Was the Global Equities Crash Related to Obama's Election?

Incorrect link to Iowa election market press release in article. Should be tippie.uiowa.edu/news/...

Was the Global Equities Crash Related to Obama's Election?

It is not just Obama, but also the combination with Reid and Pelosi. The four states with the highest foreclosure rates, the most underwater mortgages and the most subprime and toxic mortgages are California, Nevada, Arizona and Florida. With Reid from Nevada, Pelosi from California and Arizona a neighbor, it was predictable that, with the Democrats in control, that Congress would do something to help homeowners, mostly speculators, who overextended themselves. Most of these were the mortgages securitized and held by the investment banks.

The Iowa experimental election markets are more accurate than polls in predicting US Presidential elections and predicted a Democratic win way before Obama took the lead against McCain in the polls.

tippie.uiowa.edu/news/...

The collapse of Bear Stearns, which was the forerunner of the crisis, was due to an inability of the firm to continue to fund itself because its mortgage securities had a sharp and excessive decline in value and were insufficient collateral. The loss in value of these securities was due to a much higher expectation that their actual cashflow would be much less than predicted. The banks that are holding these securities until today are finding that they are paying and not defaulting, which says that these securities should trade at a much higher price than they are. The decline in value and price of these securities, including at the time of Bear Stearns collapse, is due to an expectation that future, as opposed to current, cashflow will be modified and be less than anticipated.

In other words, the market anticipated the mortgage loan modification programs, bankruptcy cram downs, Democratic moral suasion and incentives to walk away from paying mortgages. This Democratic philosophy and programs led to the current banking crisis through excessive and unanticipated devaluation of mortgage securities. It also led to the inability of the investment banks and commercial banks to continue to fund themselves and to impair their capital base through write downs of the excessive devaluation of these securities.

Of course, a collapse in the investment banking area, in banking capital and a fear of government intervention in rewriting banking lending contracts after the fact would and did lead to the current worldwide equity markets decline and economic crisis. Especially, since worldwide governments and central banks follow each other's actions.

A Primer on Loan Modification Programs

One of the best indicators, if not the best, of a loan default is a prior loan default. So the result is not surprising and should have been expected since mortgage loan defaulters are the ones seeking modification. The result will not significantly change as the loan modification programs are tweaked to prevent redefaults unless loan modification programs include people who are not likely to default without a modification.