Trickle Up Bailout?

October 1, 2008 7:16 PM

Jonathan Koppell and William Goetzmann on why Congress should let Wall Street hang for a bit and use the $700 billion to directly refinance homowners' bad mortgages. Fire away, mefites!

Notable points:

"Implementation could follow the example of the Home Owners' Loan Corp., which in the 1930s issued new mortgages to a quarter of American homeowners. The government could offer to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent. No credit scores, no questions asked; just pay off the principal of the existing mortgage with a government check."

"All this could be done through the Federal Housing Administration, with the help of Fannie Mae and Freddie Mac, which have the infrastructure to implement this plan rapidly. An equity participation structure would prevent thousands of foreclosed homes from being dumped on a strained housing market and would allow prices to reach a new equilibrium that is based on realistic demand for houses rather than on easy money or impending foreclosures. "

(from today's WSJ)

posted by puckish (84 comments total)

Mike Moore has a similar idea...

but the bastards in DC will bail out their friends, wait and see....
posted by HuronBob at 7:22 PM on October 1, 2008

Warren Buffet on tv a very short time ago and interviewed by Charlie Rose. B. said that the magnitude of the problem --no credit--is so immense at this point that only federal govt intervening can work and that without it, all would crumble. In passing he noted that people like him under the last few years (ie, ush) paid hardly anything while those cleaning his office paid a lot (percentage of income) and that the wealthy ought to be doing much more. there have been any number of pundits telling us that this or that would solve the problem, and of course we worry about those who created the mess (top down) asking us (bottom) to fix their problem.
The latest irony: the senate was able to pass the bailout because they gave more tax breaks that we must pick up on top of the tax money we have to pour in now...
posted by Postroad at 7:22 PM on October 1, 2008

Buffett has been saying that we should tax him more for years now. Can we please tax him more, for crying out loud? I mean, forget the other rich people, I know Bush would veto any widespread changes, but let's just up the rate for Buffett. (We've already blown through the fourth and fifth amendments — don't tell me now we're going to get hung up on the bills-of-attainder clause.)
posted by enn at 7:29 PM on October 1, 2008

Warren Buffet on tv a very short time ago and interviewed by Charlie Rose. B. said that the magnitude of the problem --no credit--is so immense at this point that only federal govt intervening can work and that without it, all would crumble.

Yes. But buying a few assets at inflated prices does not fix this.

What this does -- inflates the price of assets on the books of everyone else. They can't sell those, because the market won't pay that. So, we just end up giving 700B to Paulson's friends, and we're still in a credit crunch.

The correct answer: Take over these failed banks. Sell the bad assets at true market prices -- whatever they'll bear. Relaunch them, with new management, with bad assets gone. Then, with solid books, they can make loans, and the credit crisis abates.

What this bailout does? Spend 700B, leaves banks unable to loan, but "solvent." They do nothing. We end up like Japan in the 1990s.

We need Sweden, 1991, not Japan 1988.
posted by eriko at 7:51 PM on October 1, 2008 [5 favorites]

Sen. Bernie Sanders: Don't Make Working People Bail Out Wall Street
posted by homunculus at 7:51 PM on October 1, 2008

but the bastards in DC will bail out their friends, wait and see....

The same logic that says we shouldn't bail out a bunch of wankers who made stupid decisions and ruined their companies would seem to me to be the same logic that would suggest we shouldn't bail out people who stupidly purchased houses at absurd prices with mortgages they couldn't afford to service. Especially the people who have negative-geared multiple investment properties.

But perhaps that's just me.
posted by rodgerd at 7:57 PM on October 1, 2008 [4 favorites]

I'll actually go one step further, rodgerd, and say that the concentrated wealth in the hands of the thieves on top could actually be put to good use via investments, charities, etc. The only thing the McMansion douchebags at the bottom know how to invest in is a house 50 miles away from their workplace and a gigantic SUV to get them to and from it.
posted by GooseOnTheLoose at 8:21 PM on October 1, 2008

Umm... while I believe something has to be done to help all of those people who were mis-sold those terrible loans, I'm not convinced that just paying the loans off fixes the current crisis.

The securities based on those loans were priced based on theoretical returns that could only be met if the loan was paid off at a higher than usual interest rate and a default rate that turned out to be entirely fictional. If you pay off the loans, the default rate problem is fixed but that interest is never going to be paid and the securities will still be worth considerably less than the banks paid for them. So it seems to me that it's at least an over-simplification to say that the resulting securities "would be as good as U.S. Treasuries" as this article does.
posted by pascal at 8:24 PM on October 1, 2008 [1 favorite]

Why don0t they just give each US citizen $2M and leave it at that?
posted by signal at 8:29 PM on October 1, 2008

Stop The Housing Bailout .com, worth looking at. The site makes, imho, some excellent points.

"A bailout shifts the risks of falling market prices from financially secure banks to the American taxpayer. As a result, either taxes or the federal deficit will skyrocket! This is a government handout that we simply cannot afford and, moreover, it is wrong!"

"The sole remaining hope of fiscal sanity lies with the House of Representatives. This is your last chance: Contact your Representatives or be silenced in favor of greasy, shameless, pork-barrel political handouts!!! "

"It should come as no surprise that, come November, I will vote against any Senator or Representative (in my state/district) who votes for the bailout. Period. End of story.

Here is a list of the Senators up for re-election and their currently known stance on the bailout [Contact us with any updates!]. Every single Representative's term is up this year [Here is a spreadsheet of the entire Congress]. YOU DECIDE who you want to support!" (scroll to the right to see bailout stance)

"The Paulson plan fails because it does not stop mistrust between banks or mistrust by depositors. All it does is throw $700 billion in taxpayer money down a black hole."

Fax Title: Scrap The Paulson Plan, Instead Try This (scroll halfway down the page for the suggested content of the fax)

Obama/Biden and McCain are all pro bailout.
posted by nickyskye at 8:34 PM on October 1, 2008

Tsc. You guys still insist that this "bailout" bill is about the so-called "fat cats". You're missing the point.

If you actually RTFB, you'd see this on the actual bill passed on senate:

SEC. 503. EXEMPTION FROM EXCISE TAX FOR CERTAIN WOODEN ARROWS DESIGNED FOR USE BY CHILDREN.

SEE? CHILDREN!

Won't someone think of the CHILDREN ('s wooden arrows)???
posted by qvantamon at 8:35 PM on October 1, 2008 [2 favorites]

The sole remaining hope of fiscal sanity lies with the House of Representatives.

Lord help us all.
posted by malocchio at 8:45 PM on October 1, 2008 [3 favorites]

FUCKIN' A! WE WANT W.P.A! (repeat)

(for clarity, I belive the New Deal never went far enough, and strongly believe in the importance of imposing ballot-based brakes on economic growth)
posted by mwhybark at 9:01 PM on October 1, 2008

Why don0t they just give each US citizen $2M and leave it at that?

Because that would cost $600 TRILLION dollars, as in, a thousand times as much.

Anyway, the "Paulson plan" is dead, gone, vanished. The only similarity between what was passed in the senate (400 pages) and Paulson's plan is the pricetag.

Rather then just giving money to wallstreet, the government will get warrants for shares in the companies, so that if they end up turning a profit while the acquired assets don't end up being worth more then what was paid, then the government will get a piece of that profit.

Guaranteeing everyone's mortgage would still transfer all the money to wallstreet. It would have the exact same effect as buying the mortgages from wallstreet directly, in fact it would be even worse. The companies would end up getting full face value for the distressed assets, and even under the craptacular Paulson plan, the government would be able to buy distressed assets at a discount and (theoretically) turn a profit. The new deal passed by the senate would allow for even more recoupment by the government (or "taxpayers")

To sum up: Refinancing people's mortgages would transfer more money to wallstreet and reduce the ability for the government to recoup the money.

What the government should do is simply take controlling interest in distressed banks by buying new shares, diluting existing shareholders, and using that new capital to ensure loans are made, thus alleviating the credit crunch. This is a model that has been used in lots of different countries facing similar problems, and has worked pretty well. It wouldn't reward existing shareholders and execs, and it would fix the actual problem directly.
posted by delmoi at 9:07 PM on October 1, 2008 [3 favorites]

If this went through, I'd be pissed I worked my ass off and did everything right and got a 6.125% fixed 30 year mortgage in 2005, because I knew the ARMs and subprime loans readily available to me at the time were total and complete bullshit.

So dipshits that bought more house than they could afford and knew the ARMs would kick in after 1, 2, and 3 years get a better rate and a free loan? That kind of blows.
posted by mathowie at 9:13 PM on October 1, 2008 [15 favorites]

Anyway, the new senate plan, while far from ideal, is fine. There will be plenty of oversight and a new president (almost certainly Obama at this point) will put in a new treasury secretary to run the program.

Yes, the original plan was horrible, but this newest plan is very different.
posted by delmoi at 9:14 PM on October 1, 2008

So dipshits that bought more house than they could afford and knew the ARMs would kick in after 1, 2, and 3 years get a better rate and a free loan? That kind of blows.

It's called 'moral hazard' and, for some reason, it apparently doesn't exist once you're down to the individual greedy-toerag level.
posted by pompomtom at 9:18 PM on October 1, 2008 [1 favorite]

We came up with this long before that article and Michael Moore's came out.

But they never ask us about anything...no....
posted by Alexandra Kitty at 9:23 PM on October 1, 2008

That wooden arrow thing is bizarre. I wonder who paid to get it in there, and how much.
posted by grouse at 9:32 PM on October 1, 2008

...oh yeah, that said, and I'm not in the US, but if anyone wants to pay off my mortgage... you know, just go ahead.
posted by pompomtom at 9:35 PM on October 1, 2008

So dipshits that bought more house than they could afford and knew the ARMs would kick in after 1, 2, and 3 years get a better rate and a free loan?

So dipshit "professional finance people" lent these dipshits money they damn sure should have known they wouldn't get back, and now we have to bail them out to the tune of INFINITY FUCKING DOLLARS, because they are failures at life beyond any possible reckoning?

Oh, that's right. We have "warrants", so we'll get that money back. Yeah. And our next president will hire some other former failure CEO of a failure bank, so he will make sure we get our money back with those "warrants". And we certainly won't end up in a depression if we give these failures free money, because they're the richest people in the world, and they obviously are for a reason*.

*most of them were born that way
posted by dirigibleman at 10:12 PM on October 1, 2008

Matt, you and me in our millions. We're the target demographic for the next 'fiscal responsibility' snake-oil Republican or inheritor scammist party that comes down the pike. I intend to hold them off with gay-loving, anti-religionist legally-obtained firearms.
posted by mwhybark at 10:12 PM on October 1, 2008 [2 favorites]

The only similarity between what was passed in the senate (400 pages) and Paulson's plan is the pricetag.

You're right. They added another $150 billion in pork on top of it.
posted by dirigibleman at 10:13 PM on October 1, 2008

Err, you're wrong. Whatever.
posted by dirigibleman at 10:17 PM on October 1, 2008

So dipshit "professional finance people" lent these dipshits money they damn sure should have known they wouldn't get back

Bollocks. They bundled up the dodgy debt and punted it on so some other dipshits. That's at least half the problem.
posted by pompomtom at 10:25 PM on October 1, 2008

>It's called 'moral hazard' and, for some reason, it apparently doesn't exist once you're down to the individual greedy-toerag level.

I haven't really taken a side in this debate yet, but as far as the moral hazard problem goes, if we paid the homeowners off instead of the finance guys, wouldn't they make sure that the homeowners could never do that to them again? If they think that we'd choose to bail the homeowners out instead of the financial institutions, the institutions will be a bit more careful about which kinds of loans they offer.

Yes, homeowners wouldn't learn as hard a lesson as they should, but this money's got to go somewhere and I think the financial sector has a measure of power the homeowners don't.

I know just a tad more than fuck-all about economics, so I'd love to hear more of this debate.
posted by Grimp0teuthis at 10:31 PM on October 1, 2008

if we paid the homeowners off instead of the finance guys, wouldn't they

Sorry, that ambiguous "they" is supposed to refer to the finance guys.
posted by Grimp0teuthis at 10:35 PM on October 1, 2008

Rather then just giving money to wallstreet, the government will get warrants for shares in the companies, so that if they end up turning a profit while the acquired assets don't end up being worth more then what was paid, then the government will get a piece of that profit.

I once knew a con man who sold misrepresented grade coins and he used to say, "they can get their money back if they hang on to them for awhile" and then he'd laugh and say "in about a hundred years."
posted by Bitter soylent at 1:53 AM on October 2, 2008

Delmoi: This is a model that has been used in lots of different countries facing similar problems, and has worked pretty well.

What countries? Also, is this voting equity or not? It still doesn't seem similar to the Swedish plan.
posted by benzenedream at 2:01 AM on October 2, 2008

So dipshits that bought more house than they could afford and knew the ARMs would kick in after 1, 2, and 3 years get a better rate and a free loan? That kind of blows.

And about the fucking geniuses around here who told people that under almost no circumstances should they purchase a house. What about those people, who knew all this bullshit was coming and made the decision to keep renting because we recognized the bubble when it was being inflated? Do we get a free house? After renting for years and sacrificing our chance for ludicrously low rates?

No? Then fuck you mortgage holders looking for a bailout. And fuck you assholes that encouraged them.
posted by Civil_Disobedient at 2:31 AM on October 2, 2008 [5 favorites]

Well, without the gratuitous use of the word Belgium, I sort of agree with C_D.

We can't bail out the mortgage holders if, as part of that bailout, we attempt to hold prices up. This, of course, screws those who have reasonable loans that are current.

The core problem is the housing bubble. By and large, you will not be able to sell your house today for the price you could have sold it for two years ago. That speculative equity is gone -- and any plan based on supporting that speculative equity is also gone.

There's no good answer. We can let them default, this just deflates housing prices more, which puts more people underwater, which means more defaults are possible. We can support, but now we have an artificially inflated asset that won't bear market price, should something else happen. We can try to cushion the fall, but then we're screwing those who didn't go down that path.

And while there is a great deal of fault with the lenders, there's fault with the borrowers. Either you were assuming you could sell the house in three years at a profit -- in which case, you were an investor, not a homeowner -- or you bought a house you couldn't afford, because you didn't clearly look at the loan terms. In this latter case, I am sorry, but fundamentally, you're on the hook.

Bailing out the loans themselves means that banks will make them again. They were made whole, why wouldn't they.

In the end, bubbles collapse. They hurt when they do so.

There's no way to avoid the pain. But there are sure ways to extend it.

Like the Paulson plan.
posted by eriko at 2:54 AM on October 2, 2008 [1 favorite]

Ok, I think it's worthwhile to review what's happened and how we've gotten to where we are, before commenting on the efficacy of this or any other proposal. Also, there is some misunderstandings regarding how CDOs work in this and other threads that I'd like to try to clear up as well.

Much - I'm not sure if all, but without a doubt, a significant part - of the current difficulties financial institutions are facing relate solely to a lack of credit.

LIBOR is still trading at very high levels; troubling, as LIBOR reflects the interest rate that banks charge each other for short term (i.e., overnight) loans.

These funding constraints were further strained yesterday as trades reflecting month end / quarter end activity were clearing; very few counterparties are willing to lend for terms longer than overnight.

While the news in The States isn't much better, yesterday here in Europe we saw banks and other financial institutions depositing a record 173B Euros with the ECB in overnight loans. Accepting lower rates from the ECB rather than somewhat (and in some cases markedly) higher rates offered by private counterparties (again) brings to mind that Mark Twain quote "I'm more concerned with return OF my money than return ON my money".

But how did financial firms get into this mess? Where does all the fear, the systemic risks originate?

Well, I've previously mentioned FAS 157, an accounting standard that was intended to strengthen banks balance sheets by insuring certain assets - e.g., Level 3 - were marked to market not model.

Why is this distinction causing problems? Well, once we started marking CDOs and other Structured Products to market we found that some of these assets were worth perhaps $0.20 on the dollar. In other words, for reasons that were more related to business and credit cycles than the underlying assets themselves (e.g., CDOs containing individual mortgages), we found that the value of the structured products was wildly overstated.

A key concept to grasp here is that balance sheets must balance; that is, assets must EQUAL liabilities.

So as the value of the assets held on the balance sheet had to be written down (i.e., these Structured Products were worth less), the liability side of the balance sheet held constant (or changed, but not as much). The exact sentence I wrote last January describing this process was "... large portions of the balance sheets at many institutions are being sharply marked down. ".

Net result - well, as we all agree that assets must EQUAL liabilities, therefore if assets shrink then either 1) liabilities must shrink as well, or 2) assets must increase.

Option one is achieve by paying down liabilities. We all know that's difficult to do if we haven't got the cash.

Option two is most effectively achieved by raising capital, thus the wave of takeovers, direct infusions of cash (Warren Buffett) into faltering business entities and share offerings we've seen to date. Option two also seems to be what the Senate Bill is trying to achieve (although personally I wouldn't accept this unless the public gets common stock, 51% ownership to boot, with FULL voting rights, not warrants(lots of ways for firms to get all sneaky with warrants), not preferred shares (debt/equity hybrid, makes no sense to hold this class) -- but that's just my personal viewpoint).

Another driver of stress at financial institutions is what's known as regulatory capital; in other words, the amount of money that must be set aside to support instruments held on the balance sheet. These capital charges are calculated as a result of nominal not market value of the asset in question.

For example, if we've got a loan worth $40M, the regulators require us to set aside capital based on $40M, not the market value of this loan - which in these times might only be $10M. As you can see, this is another, rather significant drainer of capital and causing financial institutions much stress. Any bank that is able to attract funds needs to retain these funds for regulatory capital purposes, as well as to shore up their balance sheet.

Seems like banks and other financial institutions are getting whacked from (at least) two different directions.

So while the Koppell / Goetzmann proposal on the surface appears to offer a solution, it seems they ignore the underlying problem - a lack of liquidity in the interbank markets, driven, to no small extent, by financial institutions hoarding cash, cash which is needed for the purposes just described.

And what about FASB 157 in all of this? Well yesterday it was announced that the SEC has been granted authority to relax FAS 157.

It will be interesting to see just how much of 157 they pull out of current accounting standards, and how they go about this process - totally curtail FAS 157, mark to market in some cases or for some assets, or even mark to matrix.

My personal favourite is a mark to matrix (aka "pricing matrix"), which is a relatively older methodology, and something we do for many different assets e.g., ill liquid bonds. Essentially what we do is find "proxies", instruments that are liquid that we can use to infer prices of other, less liquid securities. Given a few observed prices we can interpolate missing prices, prices we can't easily observe in the market. This is easy to understand (you're all experts now, by the way), transparent and easy to implement.

More or less, pricing matrices represent the middle ground between market to model (purely theoretical pricing) and market to market (the real world).

The markets are volatile enough, and I don't think we'd gain much by swinging back and forth, FROM market to model TO mark to market BACK TO market to model and then?

When stepping back from the abyss I prefer to take baby steps.

----

A general note about CDOs - Collateralised Debt Obligations - to help correct some misunderstandings in this and other threads.

When we structure and price these products we build upon many assumptions, one of which is Default Rate, or the frequency at which home owners are expected to default on their loans.

We use a default rate of 40% which seems reasonable as the highest default rate ever observed in The United States was almost 50% in 1933, as described by Pennington-Cross & Yezer (2000) in "The Federal Housing Administration in The New Millennium " [.pdf]. This metric is further corroborated by The Annual Report of the Federal Home Loan Bank Board, in particular the fourth through seventh issues covering years 1936 through 1939.

So CDOs are priced assuming 40% default, a number which is by no means pulled from the air, but based upon worst case scenarios (whether or not we'll see worse this time around is yet to be seen).

In terms obligors of paying off their loans before maturity - this is called "prepayment risk", and yes, we do structure this risk factor into our models as well.

Key concepts here, noting that behaviour differs according to the type of mortgage held, fixed or floating.

• Fixed rate - folks will only pay off a loan when interest rates fall. If you've got thirty year debt financed at 5% fixed, you simply do not pay off your mortgage if and when rates spike to 7%. On the other hand, if rates fall to 3% then you do indeed payoff your debt (clearly hypothetical numbers).
• Floating rate - if you've financed ten year floating the situation is reversed. That is, you won't prepay if rates drop as your mortgage payment actually goes declines as well. If rates increase you definitely repay.

For either of these scenarios, repayment is synonymous as remortgaging, as from the lenders point of view the events are identical (you paid off your loan).

And what exactly happens when these loans are paid off? Well, contrary to points opined earlier, there isn't any loss realised, as the loans principle was repaid. What is UNREALISED (i.e., not "lost") is the profit the financial institution was hoping to gain via interest payments across the term.

Again, this is factored into the price of the CDO when it's structured; yet another assumption built into the model, and a great deal of work goes into forecasting interest rates when these products are priced.

I hope that clarifies some misunderstandings of how these instruments really work.

I was having a pleasant chat with one of our MeFi colleagues via email and I mentioned to her that I hated to see these instruments demonised due to a lack of understanding how they work.

These derivatives have done a great deal of good, and its rather unfortunate that they played a part in this speculative bubble.
posted by Mutant at 2:57 AM on October 2, 2008 [15 favorites]

We Have the Bailout Money--We're Spending It on War
posted by adamvasco at 3:12 AM on October 2, 2008 [2 favorites]

Regarding unfairness to those homeowners who were responsible:

The article makes the point that at least this (i.e. paying the mortgages of your irresponsible neighbors) is at least preferable to the unfairness of bailing out financial institutions.

Like the administration's proposal, this plan would result in the government owning assets. But these assets would be real estate, not complex derivatives whose true value would take weeks to discern.

So, it wouldn't be a total handout to your neighbor, because your neighbor won't own all of his/her house. The government (and by extension you) would.
posted by poppo at 5:28 AM on October 2, 2008

Sen. Bernie Sanders:

Most of my constituents did not earn a $38 million bonus in 2005 or make over $100 million in total compensation in three years, as did Henry Paulson, the current secretary of the Treasury, and former CEO of Goldman Sachs.
posted by dragonsi55 at 5:33 AM on October 2, 2008

Magic Eight Ball predicts...

• Finance industry CEOs return to the trough by April for another $700B because "We did not fully recognize or understand the depth and severity of the underlying financial instability."

• Deafening, nation-wide gnashing of teeth by citizens as record, post-bailout financial industry CEO bonuses are announced.

• An immediate run on stockpiles of tar, feathers, and sturdy rope.
posted by Thorzdad at 5:40 AM on October 2, 2008 [1 favorite]

Here's an excellent, thoughtful, skeptical piece: Glenn Greenwald interviews David Cay Johnston on the current "panic mode of this impending doom" that "drowns out every meaningful question."

GG: Right. Let me ask you about that core premise. One of the questions that you posed early on, which is clearly the key question, is, and this is how you phrased it, "Are credit markets really about to seize up?" Now, I've read lots of economists who have been quite critical of the bail-out plan, and false premises, and everybody seems to agree that there is distress in the credit markets - I don't think anybody questions that. But there's a big leap required to acknowledge that to going and saying, there's going to be this massive contraction that going to cause a world-wide economic melt-down, and a return to the Great Depression. You've done some reporting on that issue about how severe the problems in the credit market are.

What are your views on that issue at the moment? Is the government claim about that exaggerated? Do we have time to craft alternative solutions, or is it as immediate and dire as the warnings suggest?

DJ: Let me deal with some pieces. First of all, there are other things the government can do to make sure that credit keeps flowing. We just have the government essentially guarantee all money market funds. Or we could rapidly expand other guarantees of banking. There are a number of steps the government can take and they haven't been taken. There will be a contraction in credit no matter what we do. Wall St. has assets that must deflate - there is no escaping that, and the pain is going to cost. And borrowing more money to pay off badly borrowed money, is a bizarre policy.

Secondly, there's a new study out by two economists with the International Monetary Fund. IMF policy. They published a study, in which they study 42 banking crises around the world over the last 37 years. And they concluded essentially this: bail-outs don't usually work; they often make things worse; and they are fundamentally a transfer of wealth from everybody to bankers and their customers. So, Congress should be saying, is there something else we can do in the short run to sort of patch this over and keep going forward? They're not asking that question. They're not even discussing that question.

And, do you see reporters on TV saying, excuse me, have you discussed other solutions to this, have you discussed if there's something short-term we could do 'till we sort this out? There's a basic question reporters should be asking. Does the Treasury Department have a list of all the banks in the country, and what they say are the face value of their illiquid assets? That would tell us real quickly if there's a problem concentrated in a handful of banks, or is it spread all over.

The critique of the journalism in this mess further down is excellent, too.
posted by mediareport at 6:01 AM on October 2, 2008 [1 favorite]

Link.
posted by mediareport at 6:02 AM on October 2, 2008

the Senate needs favorites. Pass the bill, +10 favorites? Oops. Reject it, +1,000,000 favorites? Yay.
posted by bonaldi at 6:29 AM on October 2, 2008

Mutant: So as the value of the assets held on the balance sheet had to be written down (i.e., these Structured Products were worth less), the liability side of the balance sheet held constant (or changed, but not as much). ... Net result - well, as we all agree that assets must EQUAL liabilities, therefore if assets shrink then either 1) liabilities must shrink as well, or 2) assets must increase. ... Option one is achieve by paying down liabilities. We all know that's difficult to do if we haven't got the cash.

Accounting quibble: once the assets are written down, wouldn't the corresponding liabilities have to be written down, too - that is, wouldn't shareholder equity simply drop by the same amount? Paying off current liabilities would require (1) drawing down the cash account, (2) selling of shares, thus increasing stated capital, or (3) require some debt financing, which would simply replace one liability with another. Right? Isn't the problem that once assets are written down (e.g., because of being marked to market), the companies are viewed as undercapitalized, because their capital surplus is written down at the same time?

eriko: And while there is a great deal of fault with the lenders, there's fault with the borrowers. Either you were assuming you could sell the house in three years at a profit -- in which case, you were an investor, not a homeowner -- or you bought a house you couldn't afford, because you didn't clearly look at the loan terms. In this latter case, I am sorry, but fundamentally, you're on the hook.

The fault of the borrowers is easily overstated. Following the refi boom of 2002-2003, lenders found themselves with tons of excess capacity and investors expecting outrageous origination volumes and values to continue. So lenders went looking for new markets to issue loans to. Naturally, the untapped markets were credit poor relative to the traditional borrower pools, so expanding into these markets required a loosening of credit standards. But the higher interest rates required to make them profitable also posed a problem: how to get poorer people to take out more expensive loans? Many products offered by lenders in recent years were carefully designed to entice credit-poor people to take them. And the lenders weren't very good at predicting repayment rates. I actually worked in the secondary market for two years trying to evaluate the credit quality of these new products, and historical performance measures were all but useless in predicting performance for entirely new types of products. The banks played a guessing game in setting their credit thresholds and prices, and they guessed wrong (not surprisingly, they got it wrong in the direction of their wishful thinking - toward too many originations).

News outlets often talk of "subprime" mortgages as causing the current crisis, but "prime" Option ARMs and other non-standard loan products are big contributors to the nationwide wave of foreclosures. Sure, some borrowers didn't do their "due diligence" and really figure out if, when their teaser rate expired, and their ARM rates reset, and the baseline rate went up, they would still be able to afford their payments. Absolutely true. Worse, some borrowers knew they couldn't keep their loans long-term, and simply planned to flip the house and pay off the loan (or were speculating that rates might drop, allowing a refi on better terms). These people may have no legal recourse (other than to seek legislative relief). But many borrowers experiencing difficulties now mistakenly trusted their broker or lender when they said, "We've got a loan that's perfect for you, and you've been approved! Of course you can afford it. What does the fine print say? Nothing, nothing... just the usual legal mumbo jumbo. 'Teaser rate' just means we're giving you a discount! 'Prepayment penalty' is a technical term that means you'll love this loan so much you'll never want to get rid of it!" Not surprisingly, many borrowers are claiming they were misled and misinformed by their brokers/lenders. In cases where this is true (or where a jury would find it more likely than not to be true), such borrowers could have viable legal claims against their lending agents. Most states have consumer protection laws generally applicable to unfair or deceptive trade practices, and some have lending laws specifically dealing with lending practices, that could allow them to seek legal relief from their lending agents. There's also the federal Truth in Lending Act. Not surprisingly, there have been a few class action cases filed challenging these practices. [Note: class certification in the Chevy Chase Bank case was recently overturned because the court found relief under TILA not suitable for class consideration.]

But there may be other significant contributing factors to the foreclosure crisis - namely, economic volatility for homeowners. [Warning: semi-self-link:] My co-authors and I surveyed a number of people going through foreclosure at the end of 2006 and found that nearly half of them reported that medical-related problems were a contributing cause of their foreclosure. [See link to "Get Sick, Get Out" paper at previous link.] It's not just that people took out loans that turned out to be bad deals (which they did) - it's also that large swaths of the country live on the raggedy edge, with very little padding to weather tough times. They are inadequately insured, thoroughly dependent on cars and family and employment such that even a temporary disruption can cause major economic setbacks, including foreclosure. It is true that many investors are also losing out to foreclosures - but the people losing their homes, they weren't all profligate spenders buying McMansions on their credit cards. Not to mention the renters who are often displaced when their landlord's property is foreclosed....

But the resolution of the current financial crisis is principally about credit availability for banks, financial institutions, and commercial enterprises. Guaranteeing scheduled payment on the mortgages underlying the CDOs, ARSs, and other MBS products would help the balance sheets of the financial institutions holding those assets, as they could be marked up (see Mutant's explanation of marking to market), which might encourage others to lend to them on better terms. But it would be an indirect method, difficult to implement correctly (and quickly), and might be more expensive long-term than simply infusing credit or a "Swedish-style" take-over. But I'm not sure it's a fair assessment to say that some sort of mortgage relief would simply be a windfall for "McMansion douchebags".
posted by dilettanti at 6:51 AM on October 2, 2008 [7 favorites]

at least preferable to the unfairness of bailing out financial institutions

Why is it more preferable? The two most important questions to me are:

1. Is my money safe?
2. Do I have access to money if I need it?

...in roughly that order.

If banks aren't lending to each other, that means banks aren't lending to their customers, either. That means companies aren't getting loans. Towns aren't getting loans. These are groups that actually employ people. That affects me a hell of a lot more than my neighbor's friggin' McMansion.
posted by Civil_Disobedient at 7:10 AM on October 2, 2008

But I'm not sure it's a fair assessment to say that some sort of mortgage relief would simply be a windfall for "McMansion douchebags"

Relief can be provided in a number of different ways. Extending the terms of the obligations, for instance.

large swaths of the country live on the raggedy edge, with very little padding to weather tough times

Those living fast and loose on the raggedy edge don't deserve a break any more than those living cautious and timid on the raggedy edge. If you want to talk about reforming the medical insurance racket, fine. If you'd like to talk about low-income rentals, fine. But nobody deserves a house. Sorry.
posted by Civil_Disobedient at 7:18 AM on October 2, 2008

Mutant, could I suggest that you actively campaign to appear as a regular guest on various business news channels and seek to testify before the house and senate on this topic. YOu present a strong and cogently argued case on these topics.

Now some questions. Isn't the net effect of this government plan very similar to the role that a specialist would play, meaning that they would act as a deep pocket contraparty to ensure markets in illiquid securities? Would it make sense to ensure in this plan that the government just would take the other side in transactions as opposed to just buying inventory. Wouldn't this also serve to provide a level of price transparency to the this market? Wouldn't this be a good thing for the banks that continue to hold positions in the CDO marketplace? Don't equity specialists make a fair amount of money? At least before spreads narrowed with penny pricing.
posted by sfts2 at 8:19 AM on October 2, 2008

Why is it more preferable? The two most important questions to me are:
Is my money safe?
Do I have access to money if I need it?
...in roughly that order.


Well, assuming that the proposal in the article and the proposal on the table at the House satisfy both of those, which is preferable?

I was only paraphrasing the article, btw.
posted by poppo at 8:38 AM on October 2, 2008

Civil_Disobedient: But nobody deserves a house. Sorry.

I searched the entire FPP and thread, and was unable to find anyone suggesting that people going through foreclosures deserved their house. Did I miss something? Any intervention will effectively amount to aid to a large class of people who don't deserve the help. Of course, it looks like whatever we do, and perhaps more so if we do nothing, lots of people who don't deserve it will be hurt by this crisis. The fundamental questions are public policy questions: what outcomes are we looking to secure, how much are we willing to pay for them, who will we askrequire to bear the costs. I would like to see the financial crisis contained a bit, to protect my economic well-being from serious impairment - and yours, too, as it happens. Preventing future similar crises will evidently require some form of regulatory oversight to protect against rapid devaluation of financial assets. But it seems like this crisis is likely to have some serious spill-over effects if we don't do something.

I don't think paying off distressed mortgages and letting the homeowners off entirely is an optimal solution, but it does at least have some merits that the current bailout proposal lacks - unlike the large financial institutions, the class of potential homebuyers, and consumers generally, face serious collective action problems, and would be unlikely to coordinate efforts in the future to secure another bailout. That is, consumers can't game the system or bet on bailouts quite the way the large players in the financial market can and do. Also, the income redistribution goes in a direction that turns my stomach less.

I do support housing assistance generally, but I'd like to see it come in the form of a targeted but comprehensive, deliberate policy designed to help the poor enjoy some housing security (not necessarily to get the middle-class McMansions). Other, narrower relief might simply involve helping families in foreclosure transition to more affordable housing - but this wouldn't do anything for the current credit crisis at all, unless it was perhaps packaged with some sort of plan that slows the actual foreclosures - temporary mortgage assistance to allow sales at non-fire-sale values, maybe. I also think that (until recently, at any rate) homeowners put too much of their wealth into their homes - which is not surprising, as the tax code strongly encourages this. We have a strong national policy that favors overconsumption of housing, and as a side-effect, we have a large number of households with all of their eggs in one, non-diversified asset basket.

All I was trying to say in my earlier post is that there are systematic, situational factors (pressures from management to keep originations up, tax policies encouraging overconsumption of housing, asymmetric information between lenders and borrowers, lack of controls on extending credit, lack of safety net and economic volatility facing borrowers, etc.) that was conducive to people to take out loans they couldn't ultimately afford. Simply blaming the borrowers fails to account for those situational factors, and bailing out the banks while leaving those factors untouched won't do much to avoid future similar crises.
posted by dilettanti at 9:01 AM on October 2, 2008

If you want to talk about reforming the medical insurance racket, fine. If you'd like to talk about low-income rentals, fine. But nobody deserves a house. Sorry.

Civil_Disobedient: You do understand that there are still many, many rural areas in the US where rental options are severely limited, right? Where the best you can hope for is a trailer on a small plot of land if you're on a restricted budget? And moving to urban centers isn't an option for these people either because, believe me, if you can't even afford a trailer on a quarter acre in some unincorporated part of Florida, you're not even in the same league much less the ballpark as someone who might consider a move to Manhattan.

Also, it's not just about low-income homeowners losing their homes, it's also about the further erosion of credit at the bottom of the income ladder, which no matter how you might feel about credit-driven consumption on principle, ultimately means less consumer spending--which means continuing economic shrinkage, fewer jobs, and less prosperity all around.
posted by saulgoodman at 9:06 AM on October 2, 2008

responsibility and fairness

Neither borrowers nor lenders "deserve" a bailout. All relief is based on practical advantages and/or the threat that lenders will continue to not lend. But there should be some steps we can do that help while not letting people or businesses off the hook for their bad decisions, and if carefully targeted it should help spread the pain manageably:

1) End foreclosure fees by processors who don't own the mortgage; they make the incentives all wrong.
2) End prepayment penalties. They are fundamentally predatory.
3) Consider a government program to refinance ARMs with extreme teaser rates and other junky "creative" loans:
-- a) limit it to first houses and people with incomes below a low threshold (to weed out speculators and McMansion grabbers)
-- b) Govt. pays off initial loan at a discount reflecting the junkiness of these types of loans. So lenders share the cost but gain certainty.
posted by msalt at 9:29 AM on October 2, 2008

So dipshits that bought more house than they could afford and knew the ARMs would kick in after 1, 2, and 3 years get a better rate and a free loan? That kind of blows.

Yes, but under my "balanced bailout" plan, they'd have to paint their houses hunter orange and leave them that way until the bank and the government were repaid in full. There's your moral hazard, beyotches! And the orange houses would serve as a nice full-scale histogram of bad loans by neighborhood.

Vote nicwolff! Paint 'em orange!
posted by nicwolff at 9:52 AM on October 2, 2008 [1 favorite]

not preferred shares (debt/equity hybrid, makes no sense to hold this class)

Mutant, can you explain this more? Buffett's deals are for preferred shares + matching warrants (right?) and I was wondering why the Fed wouldn't want that. Thanks.
posted by nicwolff at 9:54 AM on October 2, 2008

Nobel Laureate Joseph Stiglitz: Bail Out Wall Street Now, Change Terms Later
posted by homunculus at 10:18 AM on October 2, 2008

Can I nominate Mutant for MeFite most likely to have helped the community figure out WTF has been going on?
posted by infini at 10:21 AM on October 2, 2008

Mutant: thanks for the great response about default rates and prepayment. However, I had heard somewhere else (namely the This American Life "Giant Pool Of Money" documentary, which talked to many in the mortgage securitization industry) that one of the problems with these securities was that the default rate had been underestimated based on analysis of historical data that failed to take into account sliding lending standards. The presumed default rate mentioned there was much lower than 40%, more like 10%. So why might they have said that?
posted by pascal at 10:33 AM on October 2, 2008

homunculous,

I've thought that this makes sense from the beginning, you can not only change terms later (some problems involved with this, but so what) but also change regulatory framework, etc.

...but then congressfolk don't get to pontificate on TV and engage in their favorite sports, demagoguery and political grandstanding.
posted by sfts2 at 10:41 AM on October 2, 2008

You do understand that there are still many, many rural areas in the US where rental options are severely limited, right?

Rural areas aren't where the housing market went nuts. I used to live in Nebraska, and out there people will tell you they're land rich and cash poor I have just as little sympathy for those complaining about the cost of gas who choose to live 100 miles away from their job. But you're right in one respect: these people don't have any other real options. So do we try and support a structure that's falling in on itself?

I think we need to fundamentally re-evaluate a lot of the feudalistic notions we hold so dear to our hearts if this country hopes to sustain itself, particularly the notion of property and ownership.

If the government wants to purchase $700 billion of foreclosed/near foreclosure property and turn it into low-income housing, I'd happily sign my name to that.

Vote nicwolff! Paint 'em orange!

Brilliant!
posted by Civil_Disobedient at 10:49 AM on October 2, 2008

homunculus, this may sound far out but i read an astropolitical newsletter where they point out that current planetary alignments say its mercury retrograde, a time when contracts that are signed are almost guaranteed to be up for renegotiation later. fascinating to see the diverse viewpoints seemingly begin to align
posted by infini at 10:50 AM on October 2, 2008

Following up my previous comment, here's the relevant part of the documentary:

Mike Francis: All the data that we had to review, to look at, on loans in production that were years old, was positive. They performed very well. All those factors, when you look at the pieces and parts. A 90% NINA loan from 3 years ago is performing amazingly well. Has a little bit of risk. Instead of defaulting 1.5% of the time it defaults at 3.5% of the time. That’s not so bad. If I’m an investor buying that, if I get a little bit of return, I’m fine.

Adam Davidson: Wait Alex. I want to step in for a moment because this is a very important piece of tape. A big part of this story, of this whole crisis, is that a lot of really smart people, people who knew better, fooled themselves with this data. It was the triumph of data over common sense. Can you play that tape again?

Mike Francis: All the data that we had to review to look at, on loans in production, that were years old, was positive.

Adam Davidson: As we now know, they were using the wrong data. They looked at the recent history of mortgages and saw that foreclosure rate is generally below 2 percent. So they figured, absolute worst-case scenario, the foreclosure rate may go to 8 or 10 or 12 percent. But the problem with is there were all these new kinds of mortgages, given out to people who never would have gotten them before. So the historical data was irrelevant. Some mortgage pools, today, are expected to go beyond 50 percent foreclosure rates.


Full transcript here.
posted by pascal at 10:54 AM on October 2, 2008

Rural areas aren't where the housing market went nuts.

Well, the housing markets in rural parts of Florida definitely went nuts (and in Florida, newly relaxed regulations under Jeb Bush's administration allowed loans to be originated for the first time by thousands of unlicensed loan originators, of which more than 5,000 were later found to be individuals with major felony convictions in their histories, on charges ranging from interstate cocaine trafficking to money laundering).

My grandparent's house on 2 1/2 acres in Bayou George, FL, which sold in 1998 for around 89,000, is now appraised at over $300,000, and that's even taking the current slowdown into account. So the markets presumably got pretty over-heated even there.
posted by saulgoodman at 11:23 AM on October 2, 2008 [1 favorite]

Delmoi: This is a model that has been used in lots of different countries facing similar problems, and has worked pretty well.

What countries? Also, is this voting equity or not? It still doesn't seem similar to the Swedish plan.

The "this" in that sentence referred to Swedish style nationalizations, which is what I would have preferred, rather then the current plan being voted on, which is sub-optimal, but better then nothing (IMO)
posted by delmoi at 1:09 PM on October 2, 2008

I have just as little sympathy for those complaining about the cost of gas who choose to live 100 miles away from their job.

Choose? Get your head out of Nebraska. Come to Indiana and I'll show you whole towns full of people who used to live 10 minutes from work but now commute 60-80 miles one-way because the job they used to have packed-up and left for Mexico, leaving them with little prospect but to find work anywhere, even if it means driving over 100 miles a day for a job that pays half of what the old one did.
posted by Thorzdad at 2:28 PM on October 2, 2008 [1 favorite]

Housing prices need to come down, they are still too expensive. I think I believe that anything that impedes the fall of housing prices is a bad idea, it will just prolong the problem. Housing got way to expensive, people were unrealistic. Prices still have a ways to drop until median income people can afford to buy.
posted by Buck Eschaton at 4:43 PM on October 2, 2008

Come to Indiana and I'll show you whole towns full of people who used to live 10 minutes from work but now commute 60-80 miles one-way because the job they used to have packed-up and left for Mexico

Maybe those jobs wouldn't have packed up and moved to Mexico if the people in those towns didn't go shopping at fucking Wal-Mart instead of sticking to their own goddamned Main Streets. I swear to God, some of those tiny towns are filled with morons that will drive an extra 80 miles just to go the "SuperCenter" and use their 10-cent coupons to buy vast quantities of cheap schlock. But the consumer engine values quantity over quality. Big over small. Fast over slow. Cheap over durable. And we keep re-buying the same shit repackaged each year by the next poor country down the line. And we wonder why our clothes don't last as long as they used to, and why all the storefronts are closed, and why do we now have to drive 80 miles to the Wal-Mart SuperCenter to get our eyes checked by the SuperOptimologist when we used to be able to just walk to the eye doctor's? And why is it that when you get there, the eye doctor is the same guy who you used to go to in town, only now he's working for half as much salary and has to pay for his own insurance?
posted by Civil_Disobedient at 5:09 PM on October 2, 2008

You know what, Civil_Disobedient, you're right. It's all stupid people's fault. Oh well, guess we better just heap some more righteous scorn on them and then the rest of our problems will just solve themselves.
posted by saulgoodman at 6:23 PM on October 2, 2008

I understand that the mortgages are not the only problem, and I understand that helping home owners may not fix the problem, but can anyone explain why helping Wall St. solves the problem? Why should real money cover Wall St.'s imaginary derivatives money?

I'll give you one far simpler solution : The FDIC has taken over many failed banks already. So there are numerous stable financial institutions theoretically capable of borrowing money form the Federal Reserve and lending it to real businesses who need money for payroll, etc. So no depression! Sure maybe those federal banks need more employees, fine rehire some bankers they just fired. Or order some NSA mathematicians to report for work at these FDIC held banks.

I just don't see any reason why we can't keep the economy afloat without paying off trillions in bad derivatives. Japan recession was caused by not letting the failures fail, no?
posted by jeffburdges at 7:20 PM on October 2, 2008

the problem, jeffburdges, is that if a bank is forced to draw money from the federal reserve, it's already in trouble. and all banks have to be able to cover the deposits of their account holders first--banks can't just go lending more money when they're already in such bad shape they need federal reserve money to cover their existing obligations. FDIC insurance is to secure account holder deposits from potential losses, not to allow banks to lend and engage in other activities that might put more of their operating capital at risk.
posted by saulgoodman at 7:40 PM on October 2, 2008

Don't forget that you can always donate $20 or $50 to the opponents of senators on this list, telling both them and the recipient opponent why. You've got plenty of choices from either party.
posted by jeffburdges at 7:46 PM on October 2, 2008

You completely missed my point, saulgoodman. Yes, I'm well aware that FDIC insurance doesn't let banks keep lending their depositors capital, fine.

But banks do make money when they loan money they borrow from the federal reserve, just not as much as their when they loan their own assets. So our only real concern is that borrowing banks don't make enough to cover their operational costs. Well, we're already handing significant operational costs of those banks that failed already. If they need more mathematically inclined people, then we can either rehire the laid off people, or use quasi-military personnel already on the federal payroll.

I'm not asking to lend out FDIC insured deposits. I'm asking that the Fed simply step over the derivatives addicted middle man, lending directly to real enterprises that require operating capital.
posted by jeffburdges at 8:00 PM on October 2, 2008

and all banks have to be able to cover the deposits of their account holders first

I don't believe this is the case. Banks wouldn't work if they had to be able to cover their deposits. That's why we (used to?) have minimum liquidity levels. If the minimum liquidity level were 100%, there'd be no point being a bank (also: credit creation and monetarism will require a rethink).

Feel free to slag me off with whatever it is that I'm missing... because I must be missing something here...
posted by pompomtom at 8:43 PM on October 2, 2008

dilettanti -- "Isn't the problem that once assets are written down (e.g., because of being marked to market), the companies are viewed as undercapitalized, because their capital surplus is written down at the same time?"

Absolutely correct in terms of the three alternatives available to institutions as assets are written down. But I'm not so sure that this is completely a perception problem, as the banks still have to maintain regulatory capital, which is a function of nominal of the asset, not market.

Clearly there is a perception of undercapitalisation but also a reality that what cash remains (after drawdown or other activities) must be devoted to shoring up the balance sheet. And all the while assets are continuing to decline in value, therefore cash is withheld from the intrabank lending markets, contributing to the overall liquidity problem.

And this liquidity problem is growing. The Commercial Paper market is beginning to show signs of stress, with many non financial firms now unable to obtain short term funds.



sfts2 -- "... could I suggest that you actively campaign to appear as a regular guest on various business news channels and seek to testify ..."

Ha here's the rub - Anybody who has encountered me at a meetup will attest that I don't have a television face nor do I have a radio voice. Clearly I'm a mess. My DNA is defective, for gosh sakes! Nice thought, but that's not gonna work.

"Now some questions. Isn't the net effect of this government plan very similar to the role that a specialist would play, meaning that they would act as a deep pocket contraparty to ensure markets in illiquid securities? Would it make sense to ensure in this plan that the government just would take the other side in transactions as opposed to just buying inventory. Wouldn't this also serve to provide a level of price transparency to the this market? Wouldn't this be a good thing for the banks that continue to hold positions in the CDO marketplace? Don't equity specialists make a fair amount of money? At least before spreads narrowed with penny pricing."

Ah great questions. Wow I do agree that this plan seems like it should - implicitly at least - correct the intrabank liquidity issue, while eliminating the need to relax / remove FASB 157, mark to market, no less. But I'm not sure I totally agree with their premise:

"The financial crisis is a liquidity crisis, yes, but it is ultimately a product of homeowner failures to pay."

Default rates have by no means, across the board, rocketed so high that structured products are only worth maybe 20% of their issue price; in fact we're currently seeing a nationwide default rate of about 6.5% (disclaimer: this is a blended number, cutting across both geographic and demographic axis - I do believe that some regions are seeing default rates approaching 30%, and the subprime sector is seeing similar levels).

Regardless, the liquidity problem has been in place and festering for well over one year; in June 2007, for example, during the height of the Bear Stearns fund blow up folks were questioning the "true" value of CDOs once marked to market:

"Some CDOs are so rarely traded that their owners can't tell whether they are worth 50 cents or 90 cents on the dollar, said Scott Simon, who owns CDOs among his $200 billion of mortgage-and asset-backed bond investments at Newport Beach, California-based Pacific Investment Management Co."

So I'm not convinced this would resolve the underlying issue - banks balance sheets are shrinking, and as they collapse, as dilettanti pointed out cash must be used for purposes other than lending to other institutions.



nicwolff -- "Mutant, can you explain this more? Buffett's deals are for preferred shares + matching warrants (right?) and I was wondering why the Fed wouldn't want that. Thanks."

I don't know why The Fed isn't pushing for warrants in addition to their equity. That would, at least in my view, mitigate some of the downsides to holding preferred shares.

But a little more detail. Preferred shares differ in many ways from common stock (which most of us own, by the way), but most importantly:

• Place in the Corporate Hierarchy - in the event of a bankruptcy, preferred shares will be paid off ahead of common stock, but after debt (i.e., bond holders). On the downside, holding preferred shares is still holding equity, and NOT bonds (which are safer)
• Voting - generally preferred shares are non-voting and thus have no say in how the business is run (i.e., can't vote for or against corporate officers, actions, etc). On the flip side, sometimes preferred gains enhanced rights - but as these are almost always due to extraordinary events (e.g., failure to pay dividends, a hostile takeover), its not clear if this is a plus or a minus
• Dividend -- because holders of preferred shares have given up voting rights they are almost always compensated by dividend that is much higher than that paid to common ("ordinary") shares. On the downside, this dividend is generally expressed a percentage of par - e.g., 5%, 7%, etc., and thus is fixed

While this list is NOT inclusive, it would seem fair to ask under what circumstances it is beneficial to own preferred shares; well, many corporations find it optimal to hold this class of equity, largely (if not exclusively) due to tax considerations.

In general, it doesn't make sense for individuals to own preferred. If you need the security of high dividend, debt (i.e., purchasing a bond) is a better alternative, for many reasons not least of which is debt holders get paid before equity (aka shares) in the case of a bankruptcy.

So I'm really, really not sure the government should own preferred either. If we're injecting funds into financial institutions then we only do so in return for 51% of common, voting shares. That gives government (the public) effective control over the institution and we can replace non performing management, if necessary. Later, should the firms perform well they can engage in the "usual" market mechanisms - share buybacks - to reduce government control of, or interest in, their institutions.

I tend to look at it this way; they need the money. They want the money. We got the money. The public is in a very, very strong negotiating position, especially so as the general sentiment is (was?) against these actions. The public should dictate the terms, but at the same time make it a win / win. There is nothing inherently wrong (that I'm aware of, anyone please chime in) with the public taking 51% of common stock in return for their investment. Yes, existing equity gets diluted (finance speak for anyone currently holding shares is screwed, as the value of their shares plunges by at least 50% because of the new shares printed and given to the government). So those are the terms: are we doing a deal or what?

I guess it all comes down to I'm not convinced the cash for preferred is win / win. Getting non voting, preferred, without (as you've pointed out) warrants, well, it seems to me like The Street is getting the upper hand, on some level.



infini you're too kind. Shedding light on this mess is a team effort on Metafilter, so I certainly can't take any credit for what collectively a lot of us have achieved. Lots of great comments in this and in fact all threads. And besides you guys probably already know this - I just love talking finance so it's a right proper pleasure to comment in these threads, and an absolute privilege to post FPPs on the topic.



Thanks for the transcript pascal ; I haven't seen the show myself but know that many people on Metafilter watched & referenced it.

Ok, the difference in default rate arises because they are discussing a specific deal - one called Monterrey - and I described industry best practice.

Now Monterrey was brought to market by a firm called Dynamic Credit Partners, and while the market for CDOs is largely unregulated many eyes do indeed watch these deals.

For instance, Nomura Securities featured it in their deal pipeline and Fitch rated it, so lots of folks were aware of what these guys were up to.

I've read the transcript a couple of times and I didn't see any notes that they were structuring this CDO for a 10% default rate - did I (possibly) miss it?

In any case, Monterrey was what's called an "HG ABS" deal, or "High Quality Asset Backed Security" CDO, one that was pitched to very, very conservative investors. The entire subsector of the Structured Product universe saw explosive growth - the best (free) reference I can find cites

"The U.S. high-grade ABS CDO sector has grown exponentially in recent years - to roughly $40 billion year-to-date from about $42 billion in all of 2005, and some $5 billion two years earlier - primarily due to demand on behalf of some investors for "safer," higher-rated portfolio assets."

Considering the growth, it seem the sector (HG ABS) was effectively a bubble within a bubble (Credit Derivatives), so I'm not excusing but it wouldn't surprise me if these guys didn't use a far more conservative default rate. There are without a doubt deals out there that didn't price at 40% default, just as there are deals that did indeed price at more conservative default rates.

But a question I'd ask would be who purchased Monterrey and what due diligence did they apply?

CDOs aren't sold by word of mouth only. Just to give you folks an idea of some of the paperwork that goes into a deal, I've posted the term sheet for a real CDO deal here.

Lots of warning and disclaimers, and if an Institutional Investor decides to purchase, there is even more paperwork to be reviewed before funds change hands. And the folks that purchase these products have their own quants & models that are supposed to verify the claims of the people who are bringing this deal to market. Claims that are backed up by (supposedly independent) third parties.

So it seems if the Monterrey deal cited by NPR was indeed structured along a 10% default rate (I'd still like to see this) then either the folks purchasing this product knew and accepted the risk, or completely overlooked it.

In terms what Monterrey was composed of - this wasn't a secret and in fact would be fully disclosed on term sheet.
posted by Mutant at 2:36 AM on October 3, 2008

perhaps as you say, Mutant, but imho, when a thread gets too confusing for me, not having a proper finance background, and then along comes one of your lucid comments (probably the result of your pleasure in the topic) everything seems to become clearer for me. so, there ;p
posted by infini at 6:07 AM on October 3, 2008

You completely missed my point, saulgoodman. Yes, I'm well aware that FDIC insurance doesn't let banks keep lending their depositors capital, fine.

Honest, I didn't mean to...

I'm not asking to lend out FDIC insured deposits. I'm asking that the Fed simply step over the derivatives addicted middle man, lending directly to real enterprises that require operating capital.

Ah, now I see. Sort of. (Or maybe I'm just getting confused at this point.)
posted by saulgoodman at 6:58 AM on October 3, 2008

So there were two people, Alice and Bob, in the market for a house. Alice said, I can't afford this, prices are too high. I'll rent until the market comes down. Bob bought the house anyway. 5 years later, Bob will be losing the house to foreclosure.

Meanwhile with prices off this year, let's suppose Alice would like to buy. It would be a good thing for the housing market and the sensical way out of the mess for the country, that "soft landing" so to say. However, there's a problem with that: no credit! How does Alice get a mortgage when banks aren't lending and the housing market could continue to collapse?

Shall we bail out the banks and help Alice buy a house? No! Let's bail out Bob! Bob bought something he couldn't afford, so let's pitch in and help by using Alice's tax dollars.

Looking back, Bob used his dollars to buy land. He'll get to keep that. Alice kept her dollars. They are getting killed by other currencies and hard goods like gold and oil. So by taking Alice's dollars to give to Bob, we not only help Bob directly at Alice's expense, but we help keep home prices up. That makes it harder for Alice and her weak dollars to buy. Not only that, but we didn't address the credit crunch. Alice's bank doesn't get any help so Alice is not getting a mortgage anyway.

What should have Alice done with her dollars? She should have bought gold bricks and barrels of oil, sure, but lets look at other more typical choices. Bonds? No way, they are backed by overpriced collateral, and inflation is an issue, not to mention the defaulting that's already occurred. Stocks? The value's getting wiped out by the market this month, and this alternative plan is designed to help Bob, *not* Wall Street. So that's a loser too. Treasure bonds? A good move for this summer, but overall, remember that it was low interest rates and the flooding of the market with dollars that caused this issue. Have T-bills even kept up with inflation and the weakening of the dollar?

No, if we bail out Bob, it means that Bob made the right choice and that Alice should have bought land too!

So we have the real estate bubble is bursting and taking down the US banking system, and the trickle up idea is to keep the bubble propped up from the inside. Well, at least it's not a "golden parachute" for Wall Street right? This idea is about blaming bankers and absolving Bob. But it's not necessarily what's good for the economy. People talk about the moral hazard of bailing out the rich, but what about Alice?

I have different idea. Rather than give the 700bln to homeowners, let's give it 700bln to those Americans who DON'T own a home but would like to buy one. That increases demand for real estate and helps solve the problem. Sounds not so bad right? How do we efficiently give 700bln to people like Alice who would like to buy a home now? It can't be a tax credit, then Bob would bitch if we gave his taxes directly to Alice (note the irony), and anyway, tax credits should be given out equally. And we also need to be sure that Alice doesn't use it to buy a big screen TV that's made overseas. Wouldn't it be simple and good just to help Alice get a mortgage? We could give the money to Alice through her bank!

Oh, wait ... sorry ...

That idea just got rejected by the US house.

Fucking assholes. Is this whole thing the end of American excellence? I don't know, but it's clear that there are a lot of populist fucktards feeling entitled and they don't have any qualms about taking from everyone and giving to themselves. Well you won't be using my tax dollars to fund someone else's home, I moved abroad. Guess what: It's a lot easier to move if you don't own a house.
posted by cotterpin at 9:03 AM on October 3, 2008

Well you won't be using my tax dollars to fund someone else's home, I moved abroad.

Good luck finding any other civilized and economically stable country in the world that doesn't use some portion of its tax revenue to fund some form of public housing or housing assistance. Because most prosperous countries in the world would, to some extent, use your tax dollars to fund someone else's home, like it or not.
posted by saulgoodman at 10:40 AM on October 3, 2008

Still, I agree with your point, cotterpin--why not make federally-backed low-interest loans more freely available?

Also, why not seize the millions of overpriced townhouse developments that popped up all over Florida during the real estate boom (the ones that are currently vacant, if not in foreclosure) and turn them into low-rent public housing? They're probably just going to end up being scrapped otherwise.
posted by saulgoodman at 10:45 AM on October 3, 2008

saulgoodman, I agree with your point as well. Getting federally backed loans is a great idea. A question though, is it quick enough? If we are short of credit right now, teetering on the edge of a catastrophe, I don't see what's wrong with going through banks.

I am not opposed to or upset with governments supporting housing. That was the reason for Fannie Mae originally, right? The FNMA, the federal national mortgage association, was it? The idea was Americans should be able to own their own home.

But bailing out foreclosed homeowers isn't saying Americans should be able to own their own home. It's saying Americans should be able to own any home they'd like, so long as they already bought it.
posted by cotterpin at 11:09 AM on October 3, 2008

Cotterpin, you're assuming that "bailing out" is a set, indivisible notion. How about specific steps that could help people with shaky mortgages:

1) Allow bankruptcy courts to restructure mortgages for individuals, the same way they do for businesses. Heck, even Sarah Palin supports that. This doesn't prop up the price of houses, it writes off the unsupportable part of the price while minimizing foreclosures. If moral hazard is a worry, limit this to first homes, or people below a certain income level, or homes below a certain value.

2) Ban foreclosure fees by any mortgage service company that does not own the loan. Right now, they ONLY make money by forcing people into foreclosure.

3) Eliminate prepayment penalties.

None of these steps props up home prices; In fact, they should help correct home values, helping Alice get her home. All of them reduce the number of troubled mortgages (helping banks).
posted by msalt at 12:30 PM on October 3, 2008

Why again don't they just hand out $2000 to every person in America? Or we could go global and hand out $100 to everyone on the planet. It could be more practical than handing over $700 billion to banks.
posted by fiercekitten at 1:17 PM on October 3, 2008

too late, bailed out
posted by infini at 1:17 PM on October 3, 2008 [1 favorite]

Allow bankruptcy courts to restructure mortgages for individuals, the same way they do for businesses. Heck, even Sarah Palin supports that.

And ... the financial industry is dead set against it. Guess who wins?
posted by mrgrimm at 2:32 PM on October 3, 2008

Guess who wins? Beggars can't be choosers.
posted by msalt at 2:39 PM on October 3, 2008

cotterpin, non sequitur much?

So there were two banks, Alice and Bob, that both make loans in the mortgage market. Alice said, I can't afford to make this loan, rates are too low and credit risk is too high. I'll exit the market until the market settles down. Bob issued the mortgage anyway. 5 years later, Bob's borrower will be losing the house to foreclosure and Bob, or the investors Bob sold the loan to, will be losing a lot of expected income.

Meanwhile with credit tighter this year, let's suppose Alice would like to issue a loan of some sort. It would be a good thing for the economy and the sensical way out of the mess for the country, that "soft landing" so to say. However, there's a problem with that: no credit-worthy borrowers! How does Alice issue a loan when the housing market could continue to collapse and all her potential borrowers have unknown risks still on their books?

Shall we bail out the borrowers, shoring up asset values, and help Alice issue a loan? No! Let's bail out Bob! Bob sold something he knew his customer couldn't afford, so let's pitch in and help by using Alice's tax dollars.

Looking back, Bob used his dollars on hookers and blow. He'll get to keep on partying. Alice kept her dollars. They are getting killed by other currencies and hard goods like gold and oil. So by taking Alice's dollars to give to Bob, we not only help Bob directly at Alice's expense, but we help keep credit controls and lending practices lax. That makes it harder for Alice and her weak dollars to issue profitable loans. Not only that, but we didn't address the foreclosure crisis or the likelihood of another credit crunch. Bob's borrower doesn't get any help, so Alice's potential customers are all still holding toxic waste, and Alice is not going to issue loans, anyway.

What should have Alice done with her dollars? She should have bought gold bricks and barrels of oil, sure, but lets look at other more typical choices. Bonds? No way, they are backed by overpriced collateral, and inflation is an issue, not to mention the defaulting that's already occurred. Stocks? The value's getting wiped out by the market this month, and this alternative plan is designed to help Bob's borrower, and Wall Street only indirectly. So that's a loser too. Treasure bonds? A good move for this summer, but overall, remember that it was low interest rates and the flooding of the market with dollars that caused this issue. Have T-bills even kept up with inflation and the weakening of the dollar?

No, if we bail out Bob, it means that Bob made the right choice and that Alice should have issued bad loans, too!

So we have the real estate bubble is bursting and taking down the US banking system, and the bank bailout idea is to reward the banks for getting us into this mess. Well, at least it's not a "golden parachute" for irresponsible McMansion douchebags, right? The bailout plan is about blaming borrowers and absolving Bob. But it's not necessarily what's good for the economy.

posted by dilettanti at 4:17 PM on October 3, 2008 [1 favorite]

I've got a Bloomberg at University, and grabbed a few minutes yesterday to look into Dynamic Credit Partners Monterrey deal.

In case anyone is curious, I've posted both the summary and agency ratings screens (the former just so you folks can see the cusip, or unique identifier as the agency screen references the cusip, not the products name).

The curious thing is this CDO is still carries fairly high ratings from both S&P and Moody's; Fitch, however, has been
downgrading the product, which started out at AAA and is now rated BB*-, this is a fair high level overview of all three ratings systems.

Of course the ratings agencies have come under criticism for their role in this entire mess, so take this as you will.
posted by Mutant at 1:23 AM on October 4, 2008 [2 favorites]

this 5 page rant from Der Spiegel criticizes everyone
posted by infini at 1:32 AM on October 4, 2008

AIG has already spent $61 billion of its $85 billion bailout loan without managing to sell off any assets yet. Moody's just downgraded its senior unsecured debt and warned it may downgrade AIG's other debt soon.
posted by msalt at 1:37 AM on October 4, 2008

Looks like we missed an excellent chance to kill our top-down, supply-side economy when we had the chance, ten more years of Reagan worship ahead.
posted by Brian B. at 10:42 AM on October 5, 2008