We the Cared For

Ready, Willing and Able… Not for the American Long Haul

The current economic crisis is one that has an unfortunate, effectual permanence to it. If we are successful at designing and implementing the structures that work to mitigate these asset bubbles and busts in the future, we will have sealed our own fate… and we must.  Our policy makers are flailing around grasping at a thousand ineffectual straws, sealing the promise of an even longer and more painful period than could have been. The rule of law and letting bad businesses fail, is now nothing more than a historical novelty.

We are in the midst of a fundamental downward shift in our standard of living to a very uncomfortable equilibrium. Excess credit availability, stoked by the fires of Federal Reserve policies and governments heavy hand in private markets, have fueled trillions of dollars of phantom wealth that are now in the process of being removed from the system. In our efforts to cushion the blow and in hopes of spending our way out of the problem, we are growing spending, debt and the size and scope of government far beyond our now completely disconnected, constitutional bounds.

Our desperate grasp at maintaining our standard of living, has caused us to give up our founding principles of free market capitalism, individual liberty and limited government. Yet, when it is all said and done, all we will have accomplished is the loss of these ideals because the unfortunate fact is that we are in for an extended period of readjustment that I believe  will last as long as 10-15 years. 

It goes without saying that there has been a downward revision in the wealth and balance sheets of the American people since 2006…

Housing devaluation = $6+ trillion

Equity markets devaluation = $6.9+ Trillion

Unemployed 15 Weeks and over an increase = 3.3 million

Public Debt = $11.5 Trillion or 60% of GDP by 2010

And we are still attempting to pump trillions of dollars of air into the balloon to keep it from hitting the ground. I have been repeatedly asked, “Where did all of this money go?” In simple terms, down the drain by route of a completely irresponsible administration and Congress keeping failed companies in business; banks, insurance companies, foreign banks and investors and now automotive manufacturers and suppliers … all up in a puff of smoke. So our solution becomes what has now become De rigueur; borrow more money and print more money.

Let’s suppose for a moment that housing prices stabilize in the next six months. Then what?

Willingness and Ability

To find the bottom of the housing market requires buyers who are both willing and able to buy the inventory. The willingness factor will not be an issue. In fact, the reduced prices that exist today, are already stimulating interest from buyers. If willingness were the lone factor, we would be feeling the bottom now.

The stark reality from an ability perspective is that borrowers received loans in the past, that shouldn’t have, in every credit class. That group of borrowers is out as lenders will no longer make loans to that population. There is a large segment of sub-prime group of borrowers moving forward, but they are only going to be handled by the tax payer owned and only sub-prime lender left, FHA. Popular low payment products such as Adjustable Rate Mortgages (ARMs) have now been regulated out of those advantages, wiping out another segment.

Lending will not return to pre-crisis levels, even if unemployment and the economy “normalize”. If we want to avoid this same situation in the future, banks will have to reserve for losses and own the credit risk, effectively and permanently cutting off the previous level of credit.

More borrowers are becoming less qualified by the day as jobs losses continue, real estate equity declines persist and an increased tax burden for each family foisted by this “stimulus” begins to draw on the consumer’s net cash flow. Commercial, credit card and auto loan portfolios are all in the same cycle, as tapped out consumers borrow the last of their lines to sustain living standards and credit histories and scores are destroyed for a segment of the population.

Interest rates can’t stay low forever; we are going broke trying to keep them that way. Interest rates will have to increase and we will have rampant inflation, more than likely both.  Energy prices have nowhere to go but up, and since we dropped below $4 a gallon for a gallon of gas, in the space of a mere few days, the pain was wiped from Americans ever short memories thus wiping out policy pressure like rain off the windshield. This energy tax will be with us again soon and we will all be braying that this was obvious and wondering why we haven’t done something in the last 10 years to gain energy independence.

Sound familiar?

In the period from 1990-2000, mortgage volume averaged 11.64% of GDP. From 2001-2006, the end of the mortgage boom, it averaged 25.10% of GDP. Knock that 13.46% of GDP and we knock off a very real $2 trillion per year in spending moving forward. Since the public debt is going to go as high as 62% as a percent of GDP from around 38% in the very near term, it is not difficult to see how long term and difficult the climb back to our standard of living will be for ordinary, taxpaying Americans.

All of this portends that the mortgage and housing market, minus continued and unsustainable stimulus, will be reduced to the qualified borrowers in existing homes moving up, buying second homes or refinancing existing mortgages. To that you can add the new first time home buyer population rolling in, but it doesn’t make a dent in stabilizing housing values.

Raise historically low and massively subsidized interest rates by a mere .5% and watch these currently qualified borrowers hunker down to the comfort of their existing mortgages, while at the same time more and more borrowers become “unqualified” as higher interest rates increase monthly payments they must qualify for.

The conclusion of my thoughts is that the U.S. citizen loses at every turn. Average wealth and assets values are being hammered, access to credit will continue to be denied and a mountain of debt will have to be paid back from the hard work of the current and future generations. We’re in for a permanent adjustment to our standard of living and to think any of these trillions of straws we’re grasping at will help is totally unrealistic. We’re trying to borrow our way back into prosperity and if there is anything the current crisis should make people realize, it’s that it may look like it’s working for a little while, but it’s a bit like borrowing on your credit card to make your mortgage payment; soon the credit line is maxed out, you can’t get more credit because you don’t qualify due to your level of increased indebtedness, your income hasn’t increased and next month’s mortgage payment is coming with the predictability of time.

Before you listen to the snake oil sales folks on TV whose livings depend on selling you the great “come-back” dream and an administration that plays with taxpayer hard earned money like its monopoly money, think carefully. Stay as liquid as possible. If you have assets that have values that are declining, you should consider selling them and preserving your cash and reentering when the actual reality meets the dream for over a year. Don’t buy the desperation of their dream, preserve yours. In short… plan accordingly.

Bad Bank – Bad Consumer – Bad Stimulus – Bad Economy

Our country, our citizens and our policy makers need to begin to face reality. Nothing they have done and nothing they are preparing to do, will fix the fundamental problems plaguing our economy. For the sake of political expediency, policy makers are addressing the very real fear and panic of the people by applying chiropractic manipulations to shrink a cancerous tumor. It hasn’t worked to this point, and it’s not going to work in the future and here’s why…

Our economy faces three primary issues:

1. Getting credit flowing to businesses and consumers
2. Creating jobs to stimulate the economy
3. Stabilizing the housing market

Credit

The only way to get credit flowing to the levels policy makers and the public think we need, is to guarantee the banks against losses on new lending moving forward.

Banks will not increase credit availability regardless of how many trillions are pumped into the system, because it would be fiscally irresponsible to do so. They will make loans to businesses and consumers when they think they will be paid back.

How do they know who will pay them back, when unemployment is reaching record levels and over 466,000 new lay-offs were announced from October 2008 through the month of January 2009?

The amount of lending will not change by giving the bank’s more capital or buying bad assets from them. No matter how much capital banks have or are given, they will hoard the funds until the future looks more promising.

Stabilizing the Housing Market

Unless there is a different response, credit will continue to be restrictive, jobs will continue to be lost and housing prices will continue their decline.

A significant portion of previously qualified home buyers can’t obtain a mortgage because far fewer people now qualify with the revised guidelines and limited products available. Home values have declined so far and fast, that existing mortgages exceed the value of the property and can’t be refinanced. Banks own more and more of the homes through record foreclosures and need to liquidate these properties at severely reduced prices. Unfortunately, this will continue for the foreseeable future.

Continuing job losses means even fewer qualified borrowers with access to credit which translates to reduced home sales and a continuing decline in home values.

Creating Jobs

The government can’t create sustainable jobs. The only way to create sustainable job growth, when sales and profits are down, is to give companies more capital to work with. This should be done by letting them keep more of the money they already earn. This should not be pursued through any government loan or equity ownership; it should be stimulated through tax policy. If these bail-out and stimulus dollars are to be spent, it should be spent on creating jobs in the private markets.

We need to cut personal and corporate taxes immediately. This will leave more capital with the people who earned it and lead to sustainable job creation.

The “Bad Bank” and the New “Stimulus” Plan

As I’ve already established, relieving banks of their bad assets will not increase credit availability. It will concentrate the bad assets and provide some operating relief to the banking system, while loading it elsewhere. All of these actions resolve nothing in addressing the real problems. Leaving these assets on bank balance sheets and allowing the write-up of the values and/or reducing the capital requirements, and/or providing a federal guarantee accomplishes the same thing.

The “Bad Bank” is a Bad Idea and will solve none of the 3 top issues facing the economy.

It seems apparent to the people serious about actually stimulating the economy, that the stimulus package, as approved in the house, is quite disassociated from actual stimulus. Infrastructure spending seems to make everyone feel good, but it will take too long to ramp up. And in the end, what sustainable job growth will result when the government is out of money and/or the bridge is built and we have to put the shovels down?

If we are going to address these issues and we are going to do it with taxpayer dollars, we need to get directly to the tumor. How many of you have spent and borrowed your way into prosperity in your personal lives?

Here is a suggestion for how to do it...

1. Banks should be allowed to write up the value of their assets and/or reduce their capital requirements.
2. This one I find the most painful, since I believe the companies should be allowed to fail and these bailouts have no place in free market capitalism. However, we’re well past that point, so if we actually want to have an impact, the government should temporarily step-in and guarantee losses on new credit advances and on mortgages in particular. This would include extending credit to borrowers who are not qualified for a loan today because of their job and/or credit record, and don’t meet the more restrictive hurdles created by market conditions with high loan-to-value ratios and high debt-to-income ratios.
3. This is where something akin to the covered bond structure would come into play using the government; take the $1-$2 trillion we are getting ready to commit for nothing, and use it as the insurance wrap on a covered bond pass-through structure. This scheme sells the bonds collateralized by the loan (i.e., mortgages) to private investors bringing private capital back into the banking system. Normalized losses would be allocated to the bank and to investors; excess losses would be covered by the government. You can find extensive coverage on covered bonds at the "Covered Bond Investor".

This outright government guarantee is the only way credit will get flowing to a more un-rational level again. The structure can be debated, but excess losses will have to be picked up by the tax-payer if we want to get things moving.

The bottom line is that it doesn’t take this complex patchwork of ineffective policies that just flush trillions in tax money down the drain. A government guarantee of losses to the banks will stimulate lending, significant reductions in corporate and personal taxes in combination with credit access will stimulate jobs and housing can be stabilized... eventually.

Back to the Future: Banking and the Nations Housing Policy

The banking system is a wreck. Credit is not flowing. Trillions of public dollars have been used and are at risk with no planning and no oversight. Governments attempts to leap frog the constitution and fix the “Too-Big-to-Fail “ problem with tax dollars have created entities twice as large as the ones they said they were “fixing”. Foreclosures are at record highs, housing prices continue to decline and there is no end in sight at this point.

The banking system, the banking model, as we have known it for the past two decades, is dead and the lack of careful thought given to how we address the problems, before we spend public money at an unprecedented pace, is nowhere to be found. Only now are there a few ideas from a few individuals and biased constituencies coming to the surface. We can put a man on the moon with billions in public funds because we assemble teams of very smart people to work the issues, but we can’t seem to muster the management discipline to work this problem.

The Fundamental Issue

The very heart of our problems today is asset securitization, the synthetic securities created from them, and the use of these uncollateralized synthetics in “hedging” (add gambling) risk. The final large layer of plaque in the arteries is the use of these mechanisms by government created behemoths like Fannie Mae, Freddie Mac and Ginnie Mae. These public policy driven and government supported entities exponentially increased the risk and finally the heart attack to the patient.

The primary reason these structures have seized the heart beat of the patient is that the lenders making the loans passed along the risk to others and took fees. Since they didn’t own the risk and wanted to increase their fee income, they loosened credit standards and made loans to people who shouldn’t have received them.

Since this many bad loans had never been in the system before, investors working off of old assumptions and with assurances from the credit rating agencies bought them up as fast as they could. This brought trillions of dollars into the mortgage market making even more loans available, driving lenders to make even riskier loans, with more exotic products, driving up home values and increasing investor appetites.

A great deal of this money came from outside the United States, it had an upward leveraging effect on our economy. We didn’t have to produce all of the capital to fuel consumer spending. It also meant that the banking system never put away the reserves to cushion the system against losses, because these were passed along to others.

This created massive excess credit availability, and inflated home values, and everything else… for decades.  Credit expands economies. It increases purchasing power, fuels business creation and jobs, stimulates the inflation in the values of almost everything, and it has gone on for a long time. This is why all of the money being pumped into the system is not having an effect. The balloon is deflating and will continue to until we arrive at a systemic solution that ties the risks back to the lenders (as it once was). When we know what that solution is, we may then calculate the bottom and the massive costs it will take to arrive there.

The bottom line to all of this is that the standard of living and the steady increases in the standards of living are on a permanent slide back to the equilibrium of rational credit availability within the system.

Solutions

These solutions recognize the fact that we have already socialized the banking system; however, we need to find our way back. This restructuring has, and will require public investment with the goal of moving us back to accountability in the credit markets and banking as quickly as possible.

Public Finance Agency

The first solution I would propose is to recognize the reality that we can’t seem to extract government from housing policy. To that end, I would propose breaking the system into two parts. The first would be to create a single Public Finance Agency entity that would be owned by the government and lend or provide guarantees to borrowers who would not qualify for mortgages from the private system (more on that later). Unlike Fannie, Freddie and Ginnie (FHA), this entity would originate, own and guarantee these mortgages. Fannie, Freddie and Ginnie assets would be transferred here and those entities effectively cease operations. This will segregate and make completely transparent the public cost of our nations housing policy.

The Private Banking System

My second proposal pertains to the private banking system, it requires a number of changes. The first of which is to establish an asset size limitation to mitigate risk concentration and the “Too-Big-To-Fail” problem we have just doubled down on. We need smaller banks that are more manageable. You will trip over the examples of the risks associated with expansive management and risk controls in our global information age economy. One rogue or misguided trader has put many a firm out of business, let alone the capital that has been squandered by just plain poor management. Poor management will always exist but I think the reader will agree that managing the expanse of a $1 trillion bank enterprise is far more difficult than a $10 billion dollar bank. This addresses the risk and control issue, as well as the massive concentration risk we have created today. Large loans needed in the market would be syndicated.

Second, and this is painful because it recognizes the “fundamental problem”, but it is reality… we need to bring back the ownership of risk and loss to the lender making the loan. This means shelving the asset securitization in its current form. When the bank books the loan, it should own the loan. These loans represent collateral that the bank may borrow against in the form of bonds (this is the basics of the covered bond structure). Additionally, banks may be allowed to sell whole loans or pools to other banks regulated within the banking system. This means other lenders, who would have to reserve for the loss on their balance sheets, would require a high degree of due diligence from what are hopefully trained underwriters rather the rating agency structure we now have. The bonds would have to be rated by a rating system and I’ll cover that further along.

Third, all third party originations would require 100% underwriting by the lending institution staff whether the loans are bought on a flow (one by each) basis or in pools.

Fourth, one rating agency would be responsible for rating the company only. A second entity would bear the responsibility for rating the underlying collateral (mortgages) only. Neither rating entity would be allowed to have any other relationship with the banks. The collateral rating entity would be paid fairly up front and then receive stepped payments over time based upon the performance of the collateral. Obviously, provision will have to be made for the quality of the servicing, but that is certainly manageable.

Fifth, the loans made by the private banking system would only be allowed using criteria that exceeded that used by the Public Finance Agency. This should keep a counterbalance in place in the form of constructive tension as these criteria are regulated by a body consisting of representatives from both sides of the equation.

Sixth, as the holder of billions in toxic assets now, and at the conclusion of this restructuring, the Federal Reserve would go back to its normal operations and charter restrictions pre-crisis. Hopefully, they will to do less meddling than they did previously.

This hardly covers it all and the devil is always in the details; however, rather than just point out the problems I thought I would offer a few solutions from my experience and without a constituent interest.

I would greatly appreciate any and all ideas readers may wish to share theirs.

Too Big to Fail - The Fourth Branch of Government

There is, and should be, a significant amount of consternation over the size, speed and impact (or lack thereof) of the actions taken by the Federal Reserve, the Treasury and Congress to address the credit crisis, now sans economic crisis. The significance of the unintended consequences of these actions should not be underestimated.

I will only be addressing the immediately obvious consequences to the banking system however the reader may translate these same issues to the other industries participating in the governments’ largesse.

The first of these unintended consequences is the lack of impact that pumping almost $3 trillion dollars into the banking system has had on making credit more available. The second is what we have created by saving all of the institutions under the banner of “Too Big to Fail”. Policy makers have rushed to the public trough to address the “Too Big to Fail” companies and in typical governmental fashion have created ever larger institutions that we may now consider the “Fourth Branch”.

This Fourth Branch consists of now massive financial institutions that are completely privately held, yet fully backed by the U.S. taxpayer. If you thought the “Quasi Governmental” agency models of Fannie Mae and Freddie Mac were a problem, you ain’t seen nothing yet. That tragic policy has been leapfrogged by the Fourth Branch.

The omnipresent example is the banking system. I have taken two points of observation from the FDIC Statistics on Depository Institutions. The first is 12/31/2006, which is a date prior to the recognition of the credit crisis, and 9/30/2008 the last quarter the bank data is available within the eye of the storm. Consider the following:

• There are 255 fewer commercial banks
  In the Banks with Assets Greater than $1 billion category:
  • There are 509 in 2008 vs. 494 2006
  • Assets have increased by $1.9 trillion in the period
  • The total number of employees has increased 28,425
  • Total deposits have increased $1.7 trillion
  • Total unused commitments have increased $1.2 trillion

Auto Bailout Provides Cars to Over 4 Million People...

Observing our congressional leaders approach to the auto industry bailout is like watching bad reruns on Nickelodeon.  The case they are making to bailout the auto industry is exactly the same as they made for the Bear Stearns, AIG and TARP fiascos… further damage to the economy during a fragile time, incredible hardships for “Main Street” and the urgency to make it happen in a period of weeks before the economy comes crumbling down.

These efforts don’t work to help Main Street one iota and are serving only to temporarily prop up these failed business models into an unknown future. They need to be cleansed from the system. They are all playing a dangerous political game by trying to give the appearance of fiscal propriety through hearings and a show of toughness, when the end result is obvious for all to see. The auto industry will get their money and they will be back at the trough in very short order as already seen on our TV pilot show AIG.

Please spare us the theatrics Congress.

The solution I would propose is one that would help Main Street, auto dealerships, suppliers and the failed auto companies, if we are to use tax payer dollars to fall another rung into socialism:

Let’s take the $35 BILLION and put a $12,000 car credit directly into tax payer hands. It would work like this; create a lottery for people under a certain earnings level, at least $15,000/year with a maximum of $65,000/year (they still have to have the ability to pay car insurance, title, registration etc.). The winning lottery winners would receive a $12,000 dollar American Car Purchase Certificate that may be used to purchase an automobile from any American car maker dealership.

People would get cars, dealers would make sales, auto industry suppliers would sell products and the not so BIG 3 would have revenue to continue operations. The auto makers are going to fail. Their business models are not sustainable and will not be “turned around” for at least 4-5 years, even if they began immediately. They will likely need an additional $20-$30 BILLION along the way. It took AIG just two short months to go from $85 BILLION to $150 BILLION in taxpayer money.

Since $34 BILLION is the initial installment (already up from the $24 BILLION request a few short weeks ago), let’s go ahead and round up to $50 BILLION (this will be viewed as a pittance to give them when we look back 12 months from now). At that level, the lottery would put $12,000 American Car Purchase Certificates directly into the hands of 4,166,667 consumers.

That’s what I’d call a stimulus package that helps those in need (the tax payers). Why continue to inch our way into socialism in order to save bad business models, when we could just go for broke as innovative, proud, former capitalist and try a new twist on the formula… start at the bottom and let it trickle up.

Credit Crisis: We're Getting What We Deserve

Before reading this article, please look back at three previous posts here for added context Stay the Course on Denying the Bailout, A Massive Government Bailout by any Other Name, and The Real Reason You are about to Bailout Wall Street.

We’re in the books for $3 trillion dollars now to little or no effect and rather than extend this post with a list, there is an excellent run down in an article by David Goldman on CNNMoney.

This is getting very difficult to talk about, as it has taken on the feeling of a very bad and painful joke.

The hedge fund managers sat up in front of congress yesterday and testified that they had nothing to with the financial crisis and are not asking for any money from the TARP coffers. They stated, they would also agree to some regulation, as long as it is not too transparent. In other words, they realize not agreeing to something in this environment would look suspicious, so an obfuscating “yes” serves the purpose.  They also agree with Paulson’s switch from buying troubled assets through the TARP program (as originally sold) and recommend his new plan to have capital injected into the banking system in the form of debt and equity.

Of course they would. These funds are buying distressed assets from these banks today at ridiculously discounted prices, as low as 20 cents on the dollar for delinquent loans and at the high end 60-65 cents on the dollar for performing loans. The bank then takes the write-down on the loss and trots on over to TARP for a capital injection to make up the difference. The hedge funds make a killing working these loans out and the banks are no worse off (.60 from Hedge Fund + .40 from TARP = $1).

Mind you, the bank hasn’t given credit to one new borrower in this shell game, but the hedge funds are now inserted into a very profitable and non-transparent transaction.  Unfortunately, there is no requirement to disclose these sales to the public. If the treasury injects equity, the bank may use the funds for any purpose and the use of taxpayer’s money is not monitored in any way whatsoever.

How convenient.

These are very smart people making another killing at the expense of the taxpayer under Paulson’s congressionally approved Ghillie Suit.

More to come as consumer loans and credit cards make their way through over the next 12 months.

I am going to highlight a few facts that portend a very sorry future for the economy over the 3-5 years. I’m going to do this in direct violation of O’Reilly’s fatherly admonition to a guest night before last to quit talking this way because we’re “scaring the people”.

In short, the first of the bailout measures were peddled to the American people as a bailout for Main Street; however, it’s a bailout for Wall Street that is now racing down the path as a bailout for any part or piece of private industry.

• AIG gets a loan for $85 billion on September 16. In less than a month, the financial wizards are back to get an additional $37.8 billion loan. On October 31, AIG heads over to the window for yet another $20.9 billion, all after this was sold as a wonderful investment and profitable transaction to the taxpayers. It’s all now being restructured to include money from the TARP bailout funds into a $150 billion package.  $85 +  $37.8 + $20.9 = $143.7 billion dollars to AIG.

• TARP is also going to be used for non-banks, which has absolutely nothing to do with Main Street’s credit access. It means, we have moved from convincing the public that public funds are needed to be sure they get credit, to propping up private enterprise in the name of saving jobs.

• American Express is now in the banking system and has access to the Federal Reserve’s coffers and TARP.

• CIT has applied to be in the banking system for the same.

• A second economic stimulus package is on the table to the tune of $150 billion.

• The auto industry, which is failing for reasons that will not change for at least the next two years, are at the trough for their first installment of $25 billion.

• The guarantee made by everyone involved that the TARP program had to be entirely transparent to the public, since the money is coming from the tax payers was thrown out in the first few weeks of its approval. The public is fighting to get information from the Treasury and the Federal Reserve on what and how much is going where.

• $200 billion to prop up Fannie and Freddie and asking for more.

• Credit is no more available than it was before TARP (because it can’t be).

This $3 trillion dollars doesn’t just appear out of thin air. It is “printed” and it is borrowed by the treasury with interest and principle due at some point in the future. The $3 trillion is where we are so far and unless someone calls the ball and says enough is enough, we are on our way to doubling this number. This money has to be paid back and it will happen in the form of higher taxes, higher inflation and reduced standards of living for a very long time.

The answer to the avoidance of future problems is to restrict leverage, mandate that lenders own the credit risk on the loans they make, and ban the use of leveraged-non-collateralized-synthetic assets in the banking system. We need to let private business fail now. It is going to be very painful, but we will feel the pain no matter what we do. 

Hopefully, this is getting through to the public by now. We are throwing Trillions of dollars at a problem that is going to end up with the same result, whether we throw all of this bad money after bad, or not. We are just buying a postponement of judgment day.

The American people have let themselves be duped by Secretary Paulson, Ben Bernanke, Congress and the Administration. Congress gets somewhat of a pass, because if you listen to their hearings and questions, they are completely uneducated, ill-prepared and clueless about the banking and financial system. Paulson and Bernanke are taking care of their friends and the system that has provided their current and future wealth.

Companies that make the wrong decisions, bad decisions, or that even just have poor timing and bad luck, have to be allowed to fail. It is not the role of government to run or own businesses and prop up their choice of winners and losers as if we’re in some sort of free market, socialistic lottery.

The government “picks” Bear Stearns, AIG and now the auto industry to prop up and allows Lehman and others to fail. The government decides to nationalize Fannie and Freddie, wiping out the equity holders which included banks who had major investments in the stock and debt of these companies. We now have to inject more money into both.

Out of fear, the American people have abandoned the fundamental principles that our country was founded on. We have allowed ourselves to go so far down the path of socialism, that it is difficult to see how we will find our way back to our constitutional roots.

We can find our way back to our cherished values, but it will take the great will of the people which has not been shown yet. Hopefully, the truth is now self evident and the people, at great economic cost and sacrifice to themselves, will win back freedom, democracy and limited government.

Rating Agencies on the Hot Seat

The ratings agencies were the latest attendees in the congressional parade of shame today so I thought I would provide readers with some background on why these ratings are so important and the role they play in the markets.

The following is a lift from my upcoming book "From Your Wallets to Their Pockets"...

Why are Ratings Downgrades a Problem?

The problem with ratings downgrades is that they have a tremendous rippling effect throughout the financial, public, and private sectors. Ratings downgrades reflect the fact that the security is riskier than the initial rating suggested and the current market value is lower. This means the initial return expectation is now lower and the possibility exists of loss of the investor’s principal and interest.

The broad spectrum of investors in these securities includes employee pension funds, insurance companies, other banks and financial institutions, municipalities (such the county in which you live and work), private investors, major corporations, other governments, and other governments’ financial institutions, to name a few.

Investors

Investors in these now-riskier securities face two issues. First, they were expecting a profit on their investment. Second, the current value of those investments is reflected in their financial statements on their balance sheets.

With regard to the expectation of profit on the investment, the investor relied on the initial risk/reward analysis, which has now proven to be flawed. Now the investor is receiving a rate of return far lower than another investment of similar (or perhaps now more or less) risk would pay.

Loss of the investment means more than just the bonds becoming worthless. Those who invested in them have lost not only the profit they expected to earn but also the money (the principal amount) they used to purchase the investment.

Then there’s the matter of the balance sheet. As these securities decline in value, they must be marked-to-market, or written down to their current value in the market. Not only does this write-down lower the value of the company that made this bad investment but, in many cases, these changes are so significant that the company cannot stay in compliance with its own operating charters or regulatory requirements.

Consider, for example, Bank XYZ. Bank XYZ has invested $1 billion in these securities and has an adequate capital ratio as required to stay in business. The securities in which they invested are then downgraded and the marked-to-market value is now only $500 million. This $500 million loss in value reduces Bank XYZ’s capital level to an inadequately capitalized condition that must be rectified immediately. Bank XYZ has a few options to raise this additional required capital:

• sell more stock, which raises equity capital and dilutes the existing shareholders’ equity;

• borrow the money, which involves paying interest at a higher rate, since the loan to the bank is now to a “riskier” organization;

• sell part of the business, losing more control and diluting current owners’ equity;

• sell off other higher-performing assets to get the balances down to the bank’s new level of capital; or

• sell the downgraded securities at a significant loss… if there are any buyers!

All of these options are extremely costly and sometimes making decisions like these put companies out of business.

Public municipalities can find themselves in similar predicaments. I happen to reside in Orange County, California, so even if I weren’t in this business, I can honestly say I have firsthand knowledge of how this works. My fellow taxpayers (and my family and I) in Orange County are still paying for the county’s bankruptcy due to a different financial debacle in December 1994.

Let’s say that, as part of investment plan for cash on the balance sheet, Orange County purchased subprime mortgage-backed bonds or CDOs and that these bonds defaulted or were downgraded. This would effect the county in two ways. First, the county would have lost taxpayer dollars from its operating budget and, unless cash was in abundance, it would have to make up the loss from somewhere else. Second, if the amount of the loss was significant enough, it would result in the county’s own credit rating being downgraded. Since the county borrows money in the form of bonds, its ratings downgrade would require it (readers are encouraged to interpret that “it” as “we taxpayers”) to pay higher rates of interest for that borrowed money.

The recent, unprecedented actions by the Federal Reserve Bank have this same effect. The bailout of Bear Stearns included the Fed taking almost $30 billion of these types of securities (funded and managed securities) onto its books. Bear Sterns is not a member of the Federal Reserve System and any further loss (and, as the Fed kindly points out, “profits”) will be at the taxpayers’ expense or gain. JPMorgan Chase picked up a competitor and its good business assets at an astoundingly low price at the Fed’s behest, and the Fed took on the worst of it to make the deal happen.

The Fed’s new Term Auction Facility expands, for the first time, the collateral that may be used to borrow money from the Fed. Now, the Fed allows poorer performing security, including mortgage-backed securities, to be used as collateral. No need to give us your Mercedes as collateral; we’ll be happy with that beat-up old Pinto. Another shining example of privatizing profits and socializing losses.

Government Bailout: Not Giving Credit, Where Credit is Due

The reason the banks aren’t starting to lend yet is because they are now risk averse, regardless of how much money is being pumped into the system.

The U.S. taxpayer is propping up bank balance sheets through the Federal Reserve and we’ll be taking bad assets out soon with the bailout money.

Yet the credit isn’t flowing…

While you were sold in the weeks leading up to the approval that credit for Main Street was what this is all about, the fact is that it just props up the system and the players and does not increase credit availability.

Credit is extended through the use of underwriting criteria. The basics are intent and ability and in the case of asset based lending (mortgages, commercial property etc.) aspects of the asset itself. Does the borrower show the intent to pay (credit history), the ability to pay (income, cash-flow) and if an asset is involved; does the asset represent the right type of security, at an appropriate value, on which to make the loan.

We are now in a situation where all three of these evaluations are suspect but for the highest tier of credit quality and borrowers with significant assets. Declining asset values, business contraction, restrictive credit and higher unemployment all serve to increase the risk in making loans to the lower tiers even though they may be good credit risks.  

Until the banks are forced to lend, through mandated underwriting guidelines or regulatory force and assessment, the money will not make its way through to borrowers.

How is that for a conundrum?

Since the government has intervened and the American tax payer is being forced to hand over a trillion dollars (in this first installment),  the only way to get it back to the purported people who need it,” Main Street”, is for government to force the banks to do it. 

This is a vicious circle.

The Federal Reserves Balance Sheet

Before the bailouts “TARP” program has even been implemented, the Federal Reserve Bank has been pumping money into the system to very little effect for borrowers. The Fed has almost doubled the size of its balance sheet since January of this year:

 

The Fed does this by selling U.S. Treasury Bills (taxpayer debt). The newly borrowed money is then put into the banking system. The idea here is that the banks, now gorged with new capital, will circulate this money back into the economy through lending and other banking activities.

It hasn’t worked yet. It’s not going to work while the banks are still trying to boost their capital levels from massive overleveraging and also deal with unquantifiable levels of default in every area of lending.  

Credit will not flow by just pushing the money into the banks and hoping the system goes back to business as usual. Our government made the case that the tax payer has no choice in the matter and that unless we spend this money, “Main Street” won’t get credit. “Main Street” isn’t going to get that credit unless they force the system to do it.

Now that we’ve socialized our financial system in the name of “Main Street”, these same leaders should finish the job and force the system to get the money out to “Main Street”.

So there you have it. If you want credit to return to previous levels, the government is going to have to make them do it, with tax payer money, which will result in government controlling each of the individual banks risks and profitability. These are the same folks who did such a fine job before we had to nationalize everything.

Or we could stop now and understand that if they don’t force the banks to lend, credit will have to reach a lower, more rational level and it will be quite painful for some time to come. It's going to happen anyway.

Who was it our leaders told us we were helping again?

A Crisis in Capital for Free Market Capitalism

The two primary issues at hand for policy makers are to deal with the current crisis and to change the system moving forward to avoid repeating the problems.

In my ongoing efforts to come at this from different angles to explain why, even as the government(s) pump trillions of dollars into the system and nationalize everything, the stock market and the economy are still in for a very painful time.

The fundamental factors in all of these problems are that excess credit availability, fueled by government policy and private market greed, has over inflated the value of everything. During this period we did not put away enough money in the system (adequately reserving and capitalizing) for the increased risk (over leveraged).

In the 7 year period between 2001 and 2007, $19 trillion dollars in mortgage loans were originated. In the prior 10 year period, between 1990 and 2000, approximately $10 trillion in mortgage loans were originated. In the last 7 years we financed twice the amount of mortgages as we did in the previous decade.

 

During this same period private mortgage backed securitizations accelerated from virtually nothing to approximately $1 trillion dollars in 2006 and 2007…

 

And Fannie Mae and Freddie Mac doubled their retained and mortgage backed securities from over $2 trillion in 2001 to $4.9 trillion in 2007…

 

These mortgage backed securities were then leveraged up again as Wall Street firms created synthetic products from the underlying MBS, or collateralized debt obligations (CDO). This can be complicated so for simplification you can think of it as; the same collateral that made up one MBS was used to make another investment instrument… it was used twice. When the one loan or tranche goes bad, two different sets of investors lose their money.

On top of all of this is the additional leveraging up through the use of Credit Default Swaps (CDS) which are used for hedging purposes and significantly now, for speculation.

So what is the significance of this?

Prior to the advent of aggressive securitization by the GSEs (Fannie and Freddie), and the private Mortgage Backed Securities market, these loans had to be accounted for on lenders balance sheets. This required the banks to adequately capitalize themselves to support these balances and set aside cash reserves for the potential losses from these loans.

In the securitization model this doesn’t exist to a great extent because these loans are moved “off balance sheet” if they are treated as a “sale”. The accounting rules for these transactions are complex and contained primarily in FASB 140.

Derivatives; Credit Default Swaps (CDS)

To keep this simplified, a CDS is where one party makes insurance payments to another party (counterparties) to pay-off the credit extended in the case of default (non-payment, bankruptcy). If I am the premium paying party (Buyer) I will be paid off by the insurer (Seller) if the third party (Reference Entity) doesn’t pay off the loan, bond etc.

Basically banks and speculators are buying and selling credit insurance to each other for the performance of the bonds and companies. The problem is they are also speculating by trading in the CDS even if they don’t own or have an interest in the collateral.

The OCC’s Quarterly Report on Bank Trading and Derivatives Activities for Second Quarter puts this number at $15.5 trillion for U.S. Commercial banks. Credit Default Swaps are 99% of this number. 

The bottom line is this; we completely refinanced existing mortgages that were “on balance sheet” and adequately capitalized and reserved for in the system, with new mortgages that were primarily put into private or public securitizations, many treated “off balance sheet” in the trillions of dollars. Then we created synthetic securities on top of those. Since the same loans are used as “collateral” or are the “underlying collateral” for the synthetics, when the loans go bad multiple investments go bad, and many more investors lose their shirts.

A Simplified Example

Let’s take an over-simplified example of one mortgage loan made $200,000. The person that loaned the money, sold the loan to an investor and took their fees. The investor is now responsible for the loss. This loan is again used to sell to another investor in a derivative Wall Street product, so now there is $400,000 invested in this same $200,000 loan.

Both of these investors are concerned that the loan may go bad so they buy a credit default swap.

Other speculators wanting to make money on this loan buy credit default swaps on the loan as well betting on one side it will pay and on the other it will default. Now let’s say there is over $1.5 million invested  and bet on this one $200,000 loan and only one or two people reserved a little money to cover any loss… and it stops paying. We have a credit crisis and a crisis of capital.

The GSEs

Fannie Mae and Freddie Macs share of these mortgages may seem somewhat inconsequential on a percentage basis, in 1995 it was 35.7% and in 2007 it reached 41.4%, however in dollar terms it meant that Fannie and Freddie, meaning the U.S. tax payer  (now obvious to everyone at this point) stood behind an additional $3.6 Trillion dollars in mortgage loans. As far back as December 2004 OFHEO, Fannies regulator, rated Fannie Mae as “significantly undercapitalized”.

The table below is a combination of FDIC Statistics on Institutions and the Federal Reserves statistical release“Flows and Outstandings Second Quarter 2008” .

Observable in this data is that from the period of December 2005 to December 2007, residential mortgage loans (1-4 and multi-family) outstanding increased in total (inside the FDIC Bank group plus outside the banking system) over $8 trillion dollars. The FDIC banks loss reserves which are the reserve for all loans including credit card, auto etc. went up a mere $42 billion during the same period.

 

What can also be observed here is that although Tier 1 Core Capital also went up in the system by $589 billion, when you add the mortgages outside the system together with the leveraged synthetic products plus inadequately capitalized GSE’s and investment banks, you have a significant gap in loss reserves and capital in the entire system. $8 trillion dollars in additional mortgage balances and multiples of risk in the derivatives market including CDO^2 and $15 trillion in Credit Default Swaps.

Where-oh-where is the capital to support this leveraged up risk?

It's in the U.S. Treasury.

The fees to each of the participants were large, the government was pushing hard for over 20 years to democratize credit, not enough capital is set aside capital for the risk and good loans are made and bad loans are made. House prices are pumped up, businesses are expanded, jobs are added, and up we go.

Since the fix to the moral and the future financial hazard is to force adequate capitalization for risk, the availability and velocity of credit will have to return to its pre-2000 levels… and down will come everything with it until the asset prices meet the investment and spending level represented by this responsibly adjusted amount of credit in the market.

The government is trying to stem the tide through massive infusions of tax payer dollars, but if we put the appropriate safeguards in the system moving forward, it will be an artificial floor with artificial values that will meet their maker some day when there isn’t enough taxpayer dollars to make up for the difference between rational, and irrational credit availability.

It’s really not a “new” reality. It’s the reality that was always there, we’ve just run our tax paying heads smack into it as we were blown out of Alice in Wonderlands rabbit hole.

The Real Reason You are about to Bailout Wall Street

After last night’s vote on the Government’s Wall Street Bailout (a.k.a., “The Economic Rescue Plan”), I am compelled to now take the conversation to a different level. I am going to attempt to explain why this bill will make no difference in credit availability to Main Street, regardless of the repositioned marketing efforts designed to sell you otherwise.

The old way lending worked was that the bank or financial institution that made the borrower the loan, owned the loan. If you made a mortgage application to Bank of America, they analyzed your credit, approved the loan and kept the loan on their books (on balance sheet).

These were the days when you got your billing statement from the same bank that gave you the loan. The bank billed the customer, collected payments and most importantly collected on the delinquent loans. Collections include calling delinquent customers, foreclosing when they weren’t paid, selling the property and (this is key) writing off any losses (charge-off).

Since the bank owned the loan and had to take any losses from the loans they made, they had to set aside money to pay for those losses. This money that had to be set aside for losses is called “loss reserves”. These reserves had to stay in reserve and could not be used for any other purpose. The money couldn’t be used to make more loans (i.e., pay operating expenses, more loans). It was set aside to pay for potential losses.

This changed in the 1980s, as a Wall Street tool called securitizations came into play. I’m not going to go into detail on this, you can find it in my upcoming book, but the end result was that the bank that made the loan could sell the loan to private investors. The investors were now the people responsible for the losses.

As an example, let’s say a bank made five $200,000 loans for a total of $1 million dollars (5x$200,000) and their anticipated loss rate was1%. The bank would then have to set aside $10,000 ($1,000,000 x 1%) to cover those losses.

Once the loan is sold, the bank is paid for the loan and is no longer responsible for the losses. Since the bank is no longer responsible for the losses, they didn’t need to keep loss reserves for the loans they made. Using the same example, the bank makes $1 million in loans, sells the loans, collects their money from the sale and never puts anything in loss reserve.

This very fundamental difference in lending is the primary reason we are where we are today and why credit is going to be severely restricted in comparison to the last 10 years.

Let me explain.

The first issue is credit underwriting, which is the criteria the lender applies to say who gets a loan and who doesn’t. The reason so many loans were made to people who couldn’t afford them is because the lender, making the credit decision, is no longer responsible for the losses. The more loans they make and sell, the more money they collect (more profit).  It is important to note again, this model does not require the lending institution to set aside money for losses.

The game then becomes to make as many loans as possible, good or bad, which is exactly what happened. In the period between 2001–2007, $19 Trillion in mortgage loans were originated. For those that pay attention to the numbers, the reason this amount exceeds the current mortgage loans outstanding of approximately $14 trillion, is pay-downs and the large numbers of refinanced mortgages in the $19 trillion.

The second issue is that these loans are made and the loss reserves that are supposed to be set aside in the banking system do not exist. This is what the now roughly $1.5 trillion in tax payer bailout (if this ridiculous bailout bill goes through) is paying for.

The reason all of this spin telling you the “bailout” has to be approved or you, Main Street, won’t be able to get loans is completely misleading is because credit is going to be severely restrictive moving forward in comparison to the past 10-20 years, regardless of this bailout.

The only way to keep our system safe from these problems moving forward is to require lenders to set aside the appropriate loss reserves for the loans they make. The lender must be responsible for their losses. This has to happen and must be the primary demand of the public to our regulators or the problems we have now, will just continue. If the lender is again responsible for those losses, they will make better (read tighter) credit decisions. This resolves the massive moral hazard we have built into the game.

If these loss reserves have to be set aside by the lender, it means less money to lend to borrowers; less money to lend because they own the results of their decisions, and less money to lend due to loss reserves.

There are other conversations about vehicles to help resolve the problem, such as covered bonds, but none of them can get around these banking basics.

If you want to go along with the bailout of Wall Street, go ahead and line Warren Buffett and other’s pockets who are taking advantage of this situation, that’s certainly your prerogative. Don’t do it because you think it will change your ability to get credit now or in the future or actually solve the issue at hand.