OK, so the market fell 777 points, dove like a jumbo jet that ran out of fuel. Clearly Wall Street didn't like the news that Congress had demurred on the $700 million bailout package.
But what was to like about the plan in the first place? OK, if you are holding some funky real-estate based derivative assets that you cannot figure out how to price, then sure, you were looking forward to having a naive $700 billion buyer in the market to pay way too much for these assets. But how was that going to stabilize the markets, and more importantly get the US economy and financial markets moving the right way?
There are so many problems with this plan that it is hard to enumerate them all, but lets start with a problem that Bill Gross at PIMCO hit on: Who is making the decision of which assets to buy, and who is determining the appropriate / fair price? I got news for you, neither Paulson nor Bernanke have any clue how to price these assets. Bill Gross was recommending a price of roughly 65% of face value, but what about the derivative assets that do not have a face value? And why is 65% a magic number?
Is it possible that our government could purchase $700 billion in assets that are worth materially less? Is it a possibility that after our government purchases these securities that our markets will still drift downward? The answers are yes and yes.
A downward market absorbs capital. Lots of it. It creates a vortex that sucks everything in its path into the abyss. Just ask TPG. Those smart fellows learned a $1.7 billion lesson about the sharpness of a falling knife. Sure, $700 billion is a whole lot more than TPG threw into the pit, but arguably TPG threw their dough in a much shallower hole. We have no idea how big the entire real estate related market pit is, and certainly no conclusive evidence that $700 billion will plug it.
A smarter idea would be to stop, take a step back and review what put us in this predicament in the first place. Sure, there were lots of bad mortgages out there, and lots of dumb securities formed and derivatized (new word? Honk if you like it). But the problem wasn't that banks were making sub prime loans. The problem is that they stopped.
OK, take a deep breath, and stay with me on this.
Since 2001, the engine of our economy has been real estate. This has driven construction, which has driven commodities and labor. The average American was wealthier, and used his home as a blank check. New homes meant new furniture, new drapes, new paint, new dishes. Remodeled homes meant media rooms, new flat screen TVs and other electronic toys. New communities meant new shopping centers, new health clubs and preschools. And of course, new mortgages, second mortgages, and credit cards bills to finance all the purchases.
Say this with me: It was good. Very good.
So the problem wasn't the real estate lending based boom. The problem was it STOPPED.
Why did it stop? Well, thats is a complicated question, but basically, the market stopped purchasing loans because of all those scary, evil, and bad sub prime mortgages out there (we will come back to that in a second).
Who was the market? Basically Wall Street packagers, and a couple agencies you no doubt have heard a lot about, Fannie Mae and Freddie Mac. A couple of Bear Sterns hedge funds go "tits up" (to use the street's vernacular), and the market ran for the hills. Soon, all across the media we were hearing about the evils of these sub prime mortgages.
So these Wall Streeters and Agencies responded to pressure from the government and the media, and these folks stopped buying loans from banks. When they stopped buying, the banks couldn't make any more loans.
And so the real estate market ground to a halt. No more liquidity. Prices fell. People could not refinance. They were foreclosed upon. Prices fell some more. Banks were damaged and began to close. And so on. The vortex had been formed.
Wrong idea, wrong response.
Markets are based upon liquidity much more than underlying value. Value is a tenuous thing, its what the buyers agree to pay and sellers agree to receive. Its ephemeral, fleeting, and based on psyche. Primarily that psyche depends on: If I had to resell this thing, what could I get for it?
So were sub prime mortgages bad? How about so called liar's loans? In each case, a resounding "No." Really, who cares whether you leverage your home 50% or 100%, so long as you can afford the payments? If you can afford to make the payments, the fluctuation in the market prices for real estate do not really matter in the short term.
Were there problem loans? Of course there were. These were the loans that I classify as "designed to fail" loans: negative amortization, teaser rate, pick a payment, call them what you like. They all had one characteristic: The borrowers could not afford a traditional mortgage. These mortgages were relatively short term before they reset, and depended upon either 1) real estate prices increasing significantly so that the loans could be refinanced, or 2) that the buyer's cash flow would significantly increase. Or in some cases both!
Well, what happens to borrowers with negative amortization loans when prices don't go up but rather go down? Well friends, we are living it.
So what does that have to do with our $700 billion debate? The issue is this: Now that lending has ceased, and prices have dropped, piggy banks have gone dry, and the economy has faltered, will propping up the owners of these crazy derivatives make a damn difference to Joe and Jane homeowner? And by extension the economy? The answer is "NO."
A Better Idea: Take that same money, or even less, and create a new Fannie Mae or Freddie Mac to purchase MORE LOANS! We would have to call it something else; how about in honor of Bill Gross and me we call it Billie Mike. Whatever.
The point is to start buying new loans again. Lots of them. This will drive down the spread in mortgages, and create liquidity. Liquidity will support real estate prices. Construction will restart, and people will start buying furniture, etc..... you are seeing my point I think.
So how can we be sure that the same mistakes are not made? First, no neg am loans. They cannot be sold into pools. Also, require that borrowers sign a statement acknowledging the risk. Further, require that lenders segregate their portfolios so that they disclose exactly how many of their loans are this toxic waste. Perhaps require 100% capital against negative am loans that are more than 50% loan to value.
Also, on the intermediary side, its time to require much more capital against derivatives. How much? and won't this damage liquidity? Well, I don't know how much, that's a subject for a different blog. And certainly it will diminish liquidity. But remember the 1990s when Alan Greenspan developed the concept of "soft landing." Soft landings are ok. Hard stops are not. If liquidity is a bit less than 2005, that's ok. We just can't have the hard stop of 2008.
So there you have it - a simple, elegant, and aptly named (Billie Mike) solution to our economic woes. Messiers Bernanke and Paulson, you're welcome and you know where to reach me.
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14 comments:
Wasn't the ARM adjustment the trigger? Like you said, it only matters if you can pay your mortgage, but all of sudden people couldn't. -Bill
You've got to be kidding. Saying that the engine of world economic growth rests on real estate is quite a stretch. Real estate values drove a tiny portion of the economy, specifically those industries tied to real estate values. What you've described here is an economy that looks like an upside-down pyramid with mountains of credit-created value balancing on a thin housing stock.
You know, liquidity is more important than real value in a Ponzi scheme, which can extend it's life indefinitely as long as new parties keep subscribing. But at some point the weight of the world then teeters on nothing more than the credibility of the Ponzi schemer's BS.
Poli: If real estate hasn't been the driver of the economy since 2001, what has? Have we seen expansion of productivity? An increase in the workforce? Expanded sector spending?
No, no, and no.
Conversely, what have we seen since the real estate meltdown? Retraction, reduction of consumer spending, markets spiraling downward.
There was definitely some tulip bulb stuff going on with the financing and packaging of loans, but stopping is never a good thing. Adjusting, maybe even (gasp!) regulating. But hard stops to a major economic component is always bad.
Thanks for reading, Mike
I like your insight into the deeper cause of the problem. This is not an angle I have heard in the news. I also like your proposed solution “Billie Mike” better than the $7B bailout because it is not a bill, full of pork fat and ear marks, but a solution that is focused on just the mortgage problem. Of course we know who would pay for it ... us, but how much would it cost?
I would also like to hear your opinion on what is going to happen next?
Seriously? Are you making the argument that the problem with the bubble was that we stopped inflating it?
If that’s the case, I think that the problem with the Hindenburg was that it didn’t have enough Hydrogen!
When the party is over there is always a price to pay, the only question is how big the tab will be and if we can put together an installment plan.
Ronen: I love your analogy, and wish I had used it first. The problem with the Hindenburg wasn't that it flew, but how it landed. Same is true of the real estate financing market. Just like with the Hinderburg, soft landings are better.
Markets Mike -
Just because Greenspan decided to drive the economy by recapitalizing the housing market doesn't mean it was a good idea. The result we are seeing was inevitable. How can you maintain that liquidity creates value?
I suggest you read Michael Kinsley's essay in Time Mag's Oct 6 issue where he explains this Ponzi scheme in layman's terms.
With all due respect, there's no economic justification for your proposal. Real estate prices ultimately must revert to fundamental value, which is the equivalent rental cash flow. Liquidity only facilitates the discovery of those values. Juicing liquidity only prolongs the Ponzi scheme.
BTW, if you expanded the hydrogen in the Hindenburg without limit it wouldn't need to crash to earth. It would just explode in mid-air. Then it would crash. Really.
Poli: I am not debating whether home prices were too high. What I am saying is eliminating liquidity is always bad. Very bad. You can reduce liquidity, but when it is eliminated markets crash and companies fail. This is what happened in 1990-91 (a discussion for another post on the blog) and this is what is happening now.
If prices housing prices were too high (and I am not sure too many folks would disagree) what is the correct price? Where is the bottom? When do prices pick back up? How do we move to a place where prices can stabilize and move up from there?
For the market to stabilize and move forward we need liquidity.
Hey Mike:
Interesting point of view. I’m not a financial wizard by any stretch of the imagination, but a comment about the Hindenberg caught my eye.
Indulge a metaphor here.
The Hindenberg existed because it was a smoother and more luxurious way to fly than in the planes of the time. What killed the people on Hindenberg was not how it landed, but rather the explosive hydrogen inside the dirigible. When it exploded, the fireball toasted them. Had it been filled with much more expensive to produce and basically inert helium, they would have fallen a few tens of meters and may or may not have lived. But we wouldn’t be remembering the Hindenberg today if that had happened.
So here’s the analogy. This real estate bubble was inflated with toxic financing instruments I sure don’t understand and clearly even really smart people on Wall Street misunderstood because they counted them as assets when they weren’t really that (at least not in the strict accounting sense of that word). You propose leaving toxic asset holders out in the cold and allowing homeowners in trouble (presumably) to refinance their mortgages with the government’s money. Sort of like substituting hydrogen for helium. Allow enough of this and the problem goes away because the liabilities stacked against those assets become at the very least more transparent and at the very most unwind themselves.
But isn’t the bigger problem that we are still left with an asset bubble? That this leaves us still using dirigibles instead of something a little more practical? Seems to me that if you are right – that real estate values are a huge prop of our economy – then we are more screwed than even we realize. Real value is built by productivity, not the inflation of land or real estate values. When you have an asset bubble, money chases that rather than more productive investments.
Substituting clearer government owned mortgages for toxic assets still leaves us with a bubble. So deflate the bubble. Painful as that will be, we have to deflate this bubble.
Anon:
You are absolutely right on several issues. But here is the key - we cannot link them. Here is what I mean.
You are right that my proposal replaces crazy-complicated-bubble driven derivative financing with basic mortgage pool financing - I love your helium/hydrogen analogy.
You are also right that the root of our economic problems, generally, is a lack of productivity growth since 2000. Our economy over the last 8 years has been a fragile beast. We should invest in solving that problem.
But solving one problem does not require ignoring the other.
The way to solve the real estate caused problem is not to stuff a big rag (ok, a really big $700 billion rag) down an unestimable financial hole, but to pave over and around it with a program that gets our lending banks solvent again.
We need functioning capital markets to finance the required rebuilding of our economy. And we need consumers who have homes and nest eggs to purchase in it. Letting the system crash and burn in order to "prick the bubble" is irresponsible.
Lets get the banks and home owners on track again, and let the big boys who bought the derivatives sort their own mess out.
I'm all for the "new loans" proposal, and I have a deal for you. You get the financing, and I'll get 1 million sellers in Stockton, Sacramento, Phoenix (you get the point), that are ready to sell their homes for their mortgage balance (And I'll only take 3% instead of 6% commission!). You buy the homes at $600k that are now worth $400k, and everyone is happy!
Seriously, I dont know that many families that would buy a home at "Par" that has been "impaired" by at least 30-40% or more, just because they can now get the financing and make the payment.
The real problem is not loan liquidity, its no liquidity. Banks that were short term financed (ie. levered) that now have a sinking asset on their balance sheet (Mortgages) are hoarding as much cash as possible so they dont become the next WAMU. If Banks hoard cash, they dont make ANY loans, and the economy comes to a grinding hault. Heres another problem - when Money Market Funds get redeemed (Like 2 weeks ago), short term financing for Corporations (Main Street) dries up (Money Market Funds buy the bulk of Short term Corporate financing)- Did you ever think Dell wouldn't be able to raise short term financing due to credit risk??? Its liquidity risk - and I don't see how writing more "Inflated" home loans solve the problem.
So what to do? We can do nothing, and keep the frozen markets in the ice box - Great Depression anyone?
Or we can try to clean up the pipes by buying some of the frozen assets from banks - Which is Political suicide for many Congressmen up for re-election...
Who's ready for a Cocktail?
Whiskey:
You are right. That is why my proposal works. It allows banks to make more loans and sell them on to the new mortgage company, Billie Mike. It adds to their capital base, in the form of profits from servicing fees, rather than detracts from it.
As far as corporate liquidity, well, lets fix one problem at a time. The proposal before Congress doesn't address that either.
The main issue for short term borrowers is, Don't. Its kinds like one year ARMs - great idea at 4%, but what happens when you can't refi? If home owners should do it, why should corporations?
Over reliance on short term financing has been the death of several large corporations, and I will stop here because this is certainly a subject large enough for another post. Cheers.
I guess my underlying question is - where's the buyers?
Your solution assumes there are enough gullable home buyers that are chomping at the bit to pay $600k for a home in Stockton thats worth less than $400k, if they could only get the financing.
Besides, local community banks and credit unions are still making loans to buyers that have good credit, loosening up standards to open up another wave of bad loans would only delay the inevitable.
Mike:
The Fed can provide all the liquidity it likes but none of that will prevent lenders from refusing to lend without real valued collateral underneath. The Fed has done what it can here but nobody in the private credit sector is going to keep fueling liquidity for overvalued assets.
If excess credit is pumped into a deflating asset economy it will not prevent those assets from finding their true value. The only hope would be to debase the currency so nominal prices would grow to the same level as mortgage debt. I find this a dangerous idea because debasing the currency will have much worse consequences down the road.
If the Fed tries this, we can expect a reaction on the dollar side, either with a flight to real assets that are better valued than housing or a run on exchange rates. The Fed is trying to coordinate with other central banks now to prevent this. But there is nothing that will prop up housing values and the sooner they find equilibrium based upon fundamental incomes, the better.
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