Wishin’ and Hopin’

After a tumultuous 2008, can 2009 be better- or worse?

Is the ride over, or have we only experienced the beginning?

It’s now obvious that the current recession is likely the worst the world has seen since the 1930’s. Not only is it far-reaching, it has exposed many follies in the financial markets. The pessimists have had a field day, projecting that the US (and UK) real estate markets will fall further. The US Treasury seems to have no clear-cut plan and keeps coming up with ideas that haven’t been fully vetted before being implemented.

Hopefully the new US administration will bring sanity to the situation.

Here are some ideas:

• Don’t continue to prop up failed industries (automakers). If they aren’t viable, let the market decide what to do with them. Consolidation, reorganization, whatever, now, is much better than putting off the inevitable.

• Speaking of putting off the inevitable, the only real solution to the mortgage situation is to recast all mortgages, not just those that are in default. The lenders made grievous errors in judgment, and they should be responsible for them. A stable mortgage market will stabilize housing. “Band-aid” approaches just push the inevitable out. But that was likely the plan anyway, to put the hard decisions into the hands of the new administration.

• Let’s have a real stimulus package. No giveaways or pork. Good uses of the money for infrastructure improvements will bring about economic health and could also accelerate the timeframe for combating global warming. There’s an opportunity-take it!
  

Reality

About time…

So, the Bush administration is considering an “orderly” auto bankruptcy

As I’ve said in previous posts, the best solution to the automakers’ situation is a “pre-packaged” Chapter 11 reorganization with Treasury money structured as “debtor in possession financing.” It’s good to see that the administration is finally recognizing that concept as the correct path, rather than giving the automakers just enough ever few months to prolong the agony. Hopefully Congress will recognize it, too.

Credit cards

The Office of Thrift Supervision (OTS) has finally come out with their new regulations on credit cards. While many in the banking industry won’t like them, they’re the right thing to do. For too long lenders specializing in credit cards have used predatory practices that were inherently unfair and “bottom fishers” have preyed on people struggling to reestablish their credit. It’s about time that things were changed. The credit card business was a healthy, profitable one for many years before the concept of greed stepped in.

If it wasn’t bad enough already…

Now, besides economic troubles, pirates, ineffectual band-aids, there’s massive fraud

Charles Ponzi was a piker

It seems almost unfathomable that the SEC was so inept at its job that they let Bernard Madoff run his scheme for decades. And, too, that his investors who continued to invest. The signs were there. The red flags are numerous. It would seem that any astute investor and competent regulator would have seen the signs. But apparently, nobody paid attention. The rule of thumb regarding possible fraudulent schemes has always been “if it’s sounds too good to be true, it probably isn’t.”

Speaking of ineffectual band-aids

The Treasury’s continued “fix du jour” plan marches on. Only $15 billion left before they have to go back to Congress for the other half of the $700 billion bailout fund. But that seems to be set aside for the automakers in a futile plan to “save the industry.” As I’ve said previously, it won’t. They will just come back for more.

But then, maybe a ray of hope

GM and Chrysler are again talking about a merger. Maybe they’ve finally realized that they’re running out of time and that the prospects for getting last minute unencumbered cash are dwindling. That’s good. The US auto industry needs a major reorganization in order to stay in business.

Automaker funding

Wrong reasons, but right result

What to do…

Though the reasons that some Republican senators gave for not supporting the administration's hand-out to the automakers smacked of partisanship and dogma, the result was a positive one. The hope is that the Treasury’s anticipated funding from TARP won’t have the same result.

While many are predicting doom and gloom if the automakers don’t get funding, the reality is that it won’t be all bad. True, some will lose their jobs, and there will be difficulties for the related suppliers, however, letting them go into bankruptcy can be a good thing.

If properly structured, Chapter 11 for GM, Ford, and Chrysler can work. Very rarely these days do large companies go into bankruptcy without a carefully worked out plan for eventually coming out. Witness the airlines in years past. Granted, there are some issues that need to be carefully worked out, but they can be.

First, the TARP money should be structured as “debtor in possession” financing. The automakers have given the tight credit markets as a reason for not considering bankruptcy. TARP funding as “debtor in possession” financing gives the Treasury a double guaranty of getting its money back first.

Second, warranties need to be protected. As part of a bankruptcy, the buying public need to get the assurance that the automakers won’t use restructuring to alleviate themselves of their obligations. Doing so will also eliminate another reason to avoid bankruptcy.

Thus, Chapter 11 filings are a viable solution. The manufacturers will be given the opportunity to shed excess capacity, rationalize their products, streamline their dealership networks, and get their labor costs in line.

Once they have started down that road, they have the real potential of being viable profitable companies. It’s quite possible that once they have eliminated their excess costs they will be potential merger candidates with each other or with more successful automakers.

Apparently not all of the pirates are in Somalia

There are others in Detroit, too

Ransom

Now the Big 3 US automakers are preaching doom and gloom for the economy if they aren’t bailed out. To hear them (and their congressional apologists) tell it, if we don’t give them the money that they are asking for, they will bring down the country. That’s no better than the pirates of Somalia demanding ransoms for ships and crews they have captured. They have been termed terrorists. Maybe the automakers are, also.

Appeasement

The official policy of the US government is not to give in to terrorists’ demands for ransoms for kidnapped victims, as the money doesn’t guarantee release and just encourages them to do it again. Economists have stated that the amounts the automakers are asking for are just the tip of the iceberg and that they will come back again and again. The problem is that they are failed businesses that failed to learn from their mistakes. In a capitalist system like ours, firms that fail to control costs or respond to the marketplace either disappear or are restructured (often by liquidation or consolidation) into profitable enterprises. Market forces should be allowed to work in this case. They aren’t “too big to fail.” Either consolidation will happen or they will be forced to make the hard decisions that they so far have not been able to make.

Buying time

Does it make sense to loan money to the Big Three automakers?

61% of those who participated in a poll this week by CNN/Opinion Research Corp. didn’t think so.

The real question is: Would the money that GM, Ford, and Chrysler are requesting make a real difference? The answer is likely no. it will just delay the inevitable. The automakers have come up with the plans that Congress demanded as a precursor to getting funds, but they are in reality “too little, too late.” the companies’ problems are deep seated, and many of their proposals should have been implemented long ago. All three have too many brands, too many dealers, and aren’t efficient manufacturers. Throwing money at them won’t solve the problem.

GM’s CEO said that bankruptcy wasn't an option. Actually it is. Only if they can renegotiate legacy costs, recast their debt, eliminate redundant product lines, and reorganize their distribution systems can they become profitable. They, and the UAW know that, but don’t want to take the bitter pill. They need to.

Recession

I could have told you that before…

The National Bureau of Economic Research released a report today stating that the US has been in a recession for the past year. I would think that most people already knew that, but it’s “nice” that there’s now an official proclamation.

So, what does that really mean?

Not much, other than those of us who have said for months that we were in a recession are vindicated. A hollow victory, as it doesn't really change anything. However, since the recession is now official, maybe the politicians will take it more seriously. The Treasury has been making a lot of stabs at correcting the situation, but they seem more like the “solution du jour” than real plans. They, Congress, and their equivalents in the other major economic powers, need to come up with real solutions to the problems, and that includes real international cooperation, not just “feel good” pronouncements.

Too big to fail?

Are they really?

Failing

The “Big Three” US automakers are trying to convince Congress and the American taxpayers that they are too big and important to the US economy to be allowed to fail. But are they? And if they do, what are the real ramifications? The truth is, they already have.

Presently, they are asking for $25 billion dollars, money that was conceptually set aside for an R&D infusion to develop new vehicles that would be better suited to today’s market, realities of fuel supplies, and environmental concerns. However, that money would have better been offered a few years back so that they would now have the vehicles that the markets want, rather than SUVs and trucks. Of course, they wouldn't have had interest back then, seeing he profits to be made by building bigger, so that’s a moot point. If that money were given to them, now, it would be sucked down the drain like that rest of their remaining capital, and they would return to the trough within a year, still without progress on new vehicles.

So, what to do?

Let them go into Chapter 11. It won't be the economic disaster that the automakers and their unions predict. Of course, some jobs will be lost in the short term, but when (or if) they emerge from bankruptcy, if done right, they will be more competitive in the market and their remaining employees will have more job security.

Solutions

The US automakers are bloated dinosaurs, still working under business plans put together many decades ago, when they truly were the engines of the US economy. Things have changed, but they haven’t. They have too many brands, overlapping models that mean that each company competes not just with other automakers, but also with themselves. This was fine back when GM, Ford, Chrysler, AMC (remember them?), etc. had the entire market. But those times are long gone. Consumers have more choices, and have voted with their feet. In order to survive, GM, Ford, and Chrysler have to reorganize or die. It’s just that simple.

Ideas

Does GM really need all of those brands? Does it really need two truck brands selling the same product with slight cosmetic differences? Does it really need to have Chevrolet, Buick, Pontiac and Cadillac? Toyota and Nissan have two main brands- Toyota/Lexus and Nissan/Infiniti. GM could be successful with just Chevrolet and Cadillac. Does Ford really need the Mercury brand? Chrysler sells the same SUVs as Chryslers, Jeeps, and Dodges. And they sell their minivans as both Chryslers and Dodges. They could easily have Chrysler sell cars, Jeep SUVs, and Dodge trucks.

Why all of this redundancy? Too many dealerships left over from decades past. They should be consolidated, along with the brands that they carry. The dealers, along with the manufacturers, would become more profitable.

Labor is another problem for the “Big Three.” Their costs are such that they can’t compete. And to top it of, they are paying people not to work so that they will be available to work again when shuttered plants are reopened (like that will actually happen). Though I feel badly for the effected workers, their leaders went into collusion with their employers many yeas ago with a plan that can't survive today.

Bankruptcy

It’s the only solution. The automakers are spreading rumors that consumers would lose confidence in them if they went into chapter. Unlikely. Most of their previous customers left a long time ago an the remaining ones are their because of brand loyalty. If they haven’t moved on before now, they will stick it out. Airline passengers didn't stop flying when the major airlines reorganized, and the automakers will survive.

If we throw a TARP over everything, will it all get better?

The problem with “quick fixes” is that the ramifications aren’t necessarily apparent at the beginning

FDIC

The FDIC has finally come up with a plan for mortgages. It addresses the realities of the mortgage market and the need to clean up underwater loans for the greater good of the economy. Although some will protest that it’s a giveaway to banks and imprudent borrowers, the facts are that recasting the mortgages so that they reflect good underwriting will be better for financial markets and will help the economy. Non-performing loans will become performing again and their values can be quantified, something that has been lacking.

Treasury

The new Treasury proposals are a perfect example of flailing about. First, they were going to buy nonperforming loans from banks to give liquidity to the market. Then they changed that to capital infusions. Then they realized that they needed to put restrictions on that capital so that it would be used in a manner that would have a positive effect on the economy, rather than to give banks the money needed for acquisitions, bonuses, and dividends. Most recently, they are looking at using the money that Congress allocated to free up consumer credit.

All good things, but they are coming in dribs and drabs. It appears that they didn’t really have a plan at the beginning, and are reacting, rather than being proactive. Don’t they have people who can see ramifications?

Automaker bailouts

The US automakers, over many decades, got themselves into their current situation by ignoring market trends and being greedy. Although there is a fear that they have to be “saved” so that unemployment won’t worsen, that’s a bad solution. In decades past, the “Big Three” constituted a major share of the county’s industrial output and were too big to fail. No longer. If they can’t compete in the market, they should fail. It wouldn’t be the worst thing. In their present configurations, they have too many remnants of the days when they only competed between themselves. If they had no choice but to go into bankruptcy, they, or their successors, would have the opportunity to delete redundant products, renegotiate franchise and labor contracts, and again become competitive. They may not survive as independent entities, but how important is that, really?

Global anxiety

Yeah, that’s the ticket…

Fear

According to Roger Cohen of the New York Times, “America's moment of reckoning is global. Economic anxiety has spread far and wide, as far and as wide as the hopes vested in Obama. This moment of moral opportunity is not confined to the United States.”

While there are serious financial blunders behind the current world-wide economic problems, fear is definitely the main hindrance to recovery. Until it leaves the market, things won't measurably improve.

Opportunity

As I have said before, because the markets have beaten down “good stocks” along with bad, there are excellent opportunities to be had to invest very cheaply in well-run, profitable companies. Some investors have realized that, but more need to return to the market.

Hope

The US has a new President-elect, who sees things much differently than the current one. He have assembled an impressive team of economic advisors. Hopefully they will come up with plans that will help turn the economy around and that Congress will let those ideas have an opportunity to prove themselves.

Promising signs

But will they continue?

Has the stock market finally found its bottom?

It appears that investors have returned to the market. At least some have noticed that there are bargains available. Many very good to excellent companies have had their stock price beaten down by the market with no respect to the individual company situations. Savvy investors have noticed this and are returning to the market. Hopefully that will continue.

Mortgage reality

JP Morgan Chase has joined Bank of America’s restructuring of mortgages. In addition, the FDIC, as the owner of the successor of IndyMac Bank, is experimenting with radical restructuring. As I have said on October 8th, the only way that the toxic mortgage situation will be solved is the somewhat radical idea of doing a true “mark to market” of bad loans.

What’s happening now can be characterized as “baby steps.” What I propose goes further than what is being done on a small scale, but if implemented, would restore liquidity to financial institutions and will go a long way to unfreeze the credit markets.

All nonperforming loans should be reviewed.

Borrowers who feel that they are in danger of going into default should be invited to have their loans reviewed also.

The loans should be restructured so that the payments are in line with generally accepted underwriting guidelines.

In order to achieve this, the loans may have to have radical reductions in rate, extension of term, or a write-down of the principal balance.

While there will be cries of “giveaway,” the reality is that all of these nonperforming and potentially nonperforming loans will go into the performing category. They will have true value and liquidity will be restored.

Housing

It’s not really an industry

Ireland

Ireland is apparently the first European country to officially fall into a recession. Part of the blame for their economic troubles has been laid to not diversifying the economy and relying on builders. They are not the only country to have mistakenly seen homebuilding as a major part of their economy. Britain and the US have made the same mistake.

Homebuilding is an adjunct to economic upturns, it isn’t the basis for them.

For some time now, many economies, both local and national, have come to rely on the homebuilding business as an integral part of their base. A couple of years ago in California's central valley, the joke among some in the business was that “we are eating our young.” They had a vicious circle going. The pace of homebuilding was such that there weren’t enough personnel available. Thus, workers were recruited from other areas. Of course, these new hires needed somewhere to live, so production increased in order to provide homes for them to buy. Homebuilding was the new industry of the area. While there was some growth from other industries, there was not enough to sustain the real growth that the homebuilders needed. Local people “traded up,” assisted by easy credit, and prices accelerated. Note that I didn’t say values. As has been seen since then, the true value of homes in that market largely remained the same.

Homes aren’t speculative investments- they're where you live.

Unfortunately, in an attempt to make homebuilding an “industry,” many homebuilders moved away from the concept of providing shelter and embraced the idea that people should “move up” periodically. The concept that families only moved when they outgrew their homes, or the breadwinner took a new job elsewhere, became passé. Appreciation was to be counted on and the resulting increase in equity was to be exploited. Why let that asset lie unused, when one could get a newer, fancier house? Lenders and mortgage brokers have contributed to this bad idea by allowing people to “overbuy” with the theory being that appreciation would cure all ills. Hopefully with the meltdown, this practice won't be seen again.

Counting on appreciation lead to speculation. While there is speculation in all aspects of real estate, a relatively recent phenomenon is using one’s own home for speculation. This practice has been encouraged by builders, real estate agents, and lenders. It’s the equivalent of a gambler rolling the dice with all of his money, including that for food and rent. A bad idea. The culture that has encouraged this situation must change.

“Mark to market” continues to rule the day

And the world’s financial problems will continue to sour until true value is found

Greenspan says that there was a flaw in his economic theory.

Alan Greenspan says that he had “shocked disbelief” that financial companies failed to execute sufficient “surveillance” on their trading counterparties to prevent surging losses. Actually, I don’t think that he can be faulted too much for that assumption. The expectation would be that financial companies would do their own underwriting and not rely on others’ statements. As I have said before, greed entered the picture in relation to home mortgages packaged into debt sold on to other investors. The originators took the position that they wouldn’t have to worry about potential defaults and investors thought that the securities had been vetted by the offerors. An irresponsible position for both that was the root of the current worldwide situation.

So, what now?

Again, it’s been pointed out that investors have lost faith and trust. And for good reason. Mortgages need to be repriced to reflect the reality of the the underlying real estate’s value and the ability to the borrower to repay. No, I’m not suggesting “rewards” for people who took on more than they could afford. Of course, some people who gamed the system will come out better than they deserve, but overall, the market will become healthy again. That’s something that we need desperately in order to restore confidence.

We’re not in a recession…

It just feels that way.

Bernanke’s idea

US Federal Reserve chairman Ben Bernanke told Congress today that more government spending may be needed to tackle economic weakness. Statistically speaking, apparently the overall economy isn't all that bad, apparently. At least he thinks that we can spend our way out of it.

Congress’ duty.

An economic stimulus may be a good idea, but if it’s going to do any good, it needs to be better thought out than the last one. Most of the general public who received stimulus checks earlier this year used the money for necessities or to make debt payments. While there was a minor surge in spending, it didn't help the economy.

If Congress moves forward with a new stimulus package, it needs to do so promptly. The last go-around was too little, too late.

Positive signs…

and opportunities.

Warren Buffett

If Warren Buffett is buying stocks, does that mean that we should, too? He’s a smart investor, and obviously sees an opportunity. That people like him are coming back into the market to gather bargain priced stocks is a good sign. There needs to be market stability, of course, but hopefully investors will be prudent. As has been seen in this past week’s market gyrations, there’s a lot of uncertainty, which has caused major, heart-wrenching volatility. P/E ratios are now lower than they should be, a far cry from the bull market where ridiculous premiums were being paid.

Global market reforms

The leaders of most industrialized countries have finally come to grips with the need for a coordinated regulation of financial markets. Although this should have been done a long time ago, a positive outcome of the meltdown has been a realization by major (and minor) governments that proper regulation is required. Hopefully it will be done correctly.

Which leads me to the World Bank and the International Monetary Fund

It’s been suggested that one or both of these institutions should be the global regulator of markets. An interesting concept, but history has shown that both of these agencies, like many UN-affiliated programs, are rife with politics. They have been easily manipulated in the past, though they have good track records overall. If there is going to be an international regulator, perhaps a new agency, specifically chartered for the task, would be a better choice.

errata…

When I started this blog, I entitled it Reality and the real estate market, as it was my intention to write about what was happening to the US real estate market. However, as readers have noticed, my focus has moved to the larger arena, the meltdown of national and world economies. The evolution was a natural one, as what originally was in one market (real estate and mortgages), moved on to effect the world economy.

Thus, as of today, I am re-titling this blog Reality and the economic markets to more fully describe what I write about.

Gordon Brown

A new plan…

Regulation

Yesterday, Gordon Brown, the British Prime Minister and former Chancellor of the Exchequer (equivalent to the US Secretary of the Treasury) said. "You can't deal with the problems of global financial markets within national systems of regulation."

He’s right. As I’ve said previously, the world’s finances are too interwoven for institutions to be regulated purely on a national basis. We need better oversight, and it needs to be coordinated internationally. While the concept will likely raise the hackles of nationalists, it’s past time to such a plan.

Inadequacies

Part of what lead up to the current economic situation is that oversight of financial institutions has been reduced over time. This is particularly true in the US, but has also occurred elsewhere. It’s new painfully obvious that a pure market-driven system doesn't work.

Let me clarify that. As has been seen, the “invisible hand” does work. However, the major market corrections that have recently taken place in many sectors aren’t palatable to most. Thus, we need a beefing up of regulation, and a workable system of international coordination.

It's about time…

Unfortunately, it will take more.

The markets seem to be responding positively to the enormous new commitments by the United States and Europe to shore up banks.

However, it will take a lot of time for them to recover. The record-setting run-up on Monday could just as easily be reversed tomorrow.

Remember, the recovery from Black Tuesday took a quarter century. Hopefully it won't take that long. It took fifteen months for the markets to recover from the 1987 crash. That reflects the changes to the financial markets over sixty years and we can hope that the continuing evolution will help.

In the interim…

The interventions by the governments have to be monitored and if necessary, tweaked, to keep things moving forward. Otherwise, it could be one step forward, two steps back.

A better idea.

The administration is rethinking the bailout that it crammed down Congress’ throat just a few days ago.

Now, they are considering emulating the British solution by partially nationalizing banks that are in trouble. This looks like a much better plan. One, it reduces taxpayers’ risk, and two, it provides a better return on investment for the Treasury.

But it needs to be combined with help for the mortgage liquidity problem.

As I suggested on Thursday, the Bank of America prototype makes sense. Since virtually all of the “toxic” mortgage-backed bonds and their underlying non-performing mortgages have already been “marked to market,” they should be recast to adjust the balances and terms to match home values and borrowers’ incomes. That will make the bonds and mortgages good investments again, which will return liquidity to the market.

A coordinated response.

The Group of Seven finance ministers are discussing responding to the market woes in a coordinated fashion. Hopefully the response will truly be coordinated and won’t be “too little, too late.”

The ongoing financial meltdown has had one positive effect. It has shown that the economists have been right all along. The world’s economies are connected, much more so than many believed or admitted to. We now know for sure that we’re all in this together and it is essential that all countries acknowledge this fact. The denial is one of many aspects that lead up to the current problems. We must not let this happen again.

Politics

A bad idea.

So far in this blog, I’ve left political commentary out, except on its periphery. However, Senator McCain’s proposal is so bad that I’m making an exception.

There’s bailout and then there’s give-away.
What the Treasury proposed that is going through its start-up stage, although not ideal, at least has the concept that gives the taxpayer the potential of the situation being neutral with its worst-case scenario. The McCain proposal doesn’t. As opposed to the Treasury plan, under which the mortgages are purchased as a severe discount, his plan is to buy them at face value. That amounts to putting all of the risk on the taxpayers’ backs and essentially rewarding lenders for bad decisions.

Mortgage write-downs

A potential solution.
Though pushed into it by their settlements with state attorneys general, Bank of America has come up with a solution to the mortgage melt-down that should be emulated. Though this seems on its face to be a radical response, a drill-down analysis shows it to be a shrewd move.

What it really means.
The loans had already gone through a “mark to market” revaluation. By recasting the loan terms, nonperforming mortgages can become performing again, thus increasing their value. If all holders of mortgages did the same, liquidity would return.

According to today’s Wall Street Journal, “The relentless slide in home prices has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults -- the very misfortune that touched off the credit crisis last year.” By acknowledging the true underlying values securing mortgages, lenders could potentially preclude another onslaught of foreclosures. A healthy, realistic market will return value to the mortgages and mortgage-backed bonds, which will reverse the liquidity crisis.

Copyright ©2008 Dow Jones & Company, Inc. 

An alternative to the bailout?
If all mortgage holders followed BofA’s move, the Treasury wouldn't have to buy toxic loans, as they wouldn’t exist. This would be a much better solution than the bailout, as it is more orderly and eliminates taxpayers’ risk.

So much for “Band-Aid” approaches.

Well, surprise, surprise…
The markets didn’t immediately turn around after Congress finally passed the bail-out. They’ve gotten increasingly worse. What the politicians don't realize is that the problems with the economy and the markets are deep-seated. Yes, they originally emanated for the sub-prime debacle, but like viruses, they have mutated. Maybe if the mortgage situation was addressed responsibly a year ago there would have been a positive reaction, but it appears that addressing only one aspect of the problem won't fly.

Band-aids won't solve the problem, and putting duct tape on it won’t, either.
The base problem is that there is uncertainty about the value of investments, not just mortgage-backed bonds. Though many clamored for less regulation in the past, the result was not what they wanted. We need to find an equilibrium that works.

Wachovia
The situation with Wachovia points out truths about the market. The FDIC made a quick deal with Citigroup to rescue Wachovia, arranging a fire-sale price for the banking operations and agreeing to put a cap on potential losses. Then Wells Fargo came in and said that they would pay seven times what Citi would, and didn’t need government help. This shows that the market is able to work, even in this economy. It just needs time. Knee-jerk reactions aren't what’s needed. Time may cure all.

Fear mongers

1929 revisited: déjà vu all over again?

First, President Bush warned that if Congress didn’t pass the bail-out, we would enter a depression equivalent to 1929. Now, Germany's Interior Minister Wolfgang Schaeuble gave a warning that the financial crisis could be as bad as that one that lead to Adolf Hitler rising to power and the subsequent consequences.

Unfortunately the politicians are leading the fear parade. So far, the tactic has worked, but will the bail-out actually help? We needed a market correction, and got one. It will take time to sort things out. However, the real solutions are much harder politically than what the pols have come up with so far. We got here partly as a result of a lack of oversight. For stability to return to the markets, investors and lenders need to feel comfortable about values. Manipulation of them doesn't help. We need to take that factor out.

Now what happens?

Well, Congress approved the “bail-out” and Bush signed, it, but will it really help?

An opportunity.

There’s an opportunity now that the financial markets will stop freaking out, but it’s just an “opportunity.” The larger problem is that we have a partial solution to a world-wide problem. This was just step one. We need better financial oversight. The deregulation of banks and securities companies was a bad move. Their lobbyists will have a hard time convincing legislators that the rules shouldn't be ratcheted up again.

The greater problem is that the run-up has devastated financial markets and economies everywhere. It will take a lot of time to get the markets and lenders to feel better. Unfortunately, we’re in for the long haul.

A solution.

We need revised financial accounting rules. As I’ve said before, “mark to market”, while fundamentally a good concept, requires holders of mortgages and mortgage-backed securities to assume the worst. In come instances, that’s the right stance, but it’s been applied with a broad brush, which isn’t.

The SEC needs to bring back the “uptick rule”. While a good case can be made for short-selling, it needs controls. Short sellers shouldn't be permitted to have uncovered positions. As it is now, the stock market becomes a casino.

Temper the consolidation of the banking industry. Although allowing large “good” (or maybe the correct term is “better-off”) banks to absorb other large banks that are in trouble is a quick solution to some of the recent problems, is it really a long-term solution? Concentrating deposits in a few institutions creates the potential for a repeat of the Japanese banking debacle. We’re at the point in the US that over 30% of deposits will be in just three banks. That leaves the future potential of having many institutions that at “too big to allow to fail”- a bad position to get into.

Restore confidence in the housing market. We had a bubble, now a bust. But was it really? Homes are places for families to live, not investment vehicles. Unfortunately, they became treated as the latter, which lead to unbridled price growth and irresponsible production. Housing prices needed a dose of reality. Their values should reflect realistic affordability in tune with incomes.

The Chickens Have Come Home to Roost

Greed…

The fall of major banks in the US was just a harbinger of what is yet to come. Though there has been some fall-out in the past months from unwise investing in US sub prime loans, many people thought that the major effect would be domestic.

Now it’s Europe's turn. Their institutions saw the same thing that US institutions did- a lot of profit, and they didn’t do their due diligence either. Now they are seeing the same problems. Hopefully their regulators and governments will have better solutions than their counterparts in the US have come up with.

A proposal…

In yesterday's London Times, Gerard Baker, their US editor, commented “In the 1930s, the US Congress did more than its fair share in helping to turn a financial crisis into a global depression. Yesterday it looked as though it was auditioning to assume that role again.”

An interesting view. Granted, in the 1920’s Congress passed many near-sighted and, in retrospect, clumsy and often stupid self-serving laws that when looked at in their entirety set up the “Great Depression.” I don’t believe that the non-passage of the administration’s bail-out proposal equates.

However, likely everyone agrees that the markets’ responses to the vote’s failure were not good. But I feel that it was an overreaction, as many of the responses to the ongoing market turmoil have been. The reality is that there are no guarantees for investors. The risk factor is what ROI and interest rates are based on. To take away risk lowers the return. That’s why mattresses don’t pay interest. Part of the problem that lead to the current debacle is that lenders and investors tried too hard to shield themselves from risk. By “insuring” against risk, they avoided proper due diligence and basically increased it.

So, what do we do now? Maybe a bail-out isn’t the right solution. It's really just a Band-Aid on a far larger problem.

The Citigroup takeover of Wachovia’s retail banking operations might be a good prototype for what should be done to solve the situation. Instead of buying the “toxic” loans and bonds, perhaps the Treasury should put a cap on losses through a guarantee program and take preferred equity stakes in institutions that come to its window. Granted, we might end up having a semi-nationalization of the banking industry, but it at least gives John Q. Public a better potential security on taxpayer funds than a straight payout.

As I said yesterday, “mark to market” has become a disaster. A reconsideration of accounting rules for financial institutions should be part of the package.

Maybe Adam Smith's principals should be given a chance to work.

It’s possible that the members of Congress are smarter than they're often given credit for being.

Right now, we’re in a “market correction.” a tough one, maybe as bad as the Great Depression. Hopefully not.

We’re where we are as a result of lack of oversight, greed, and the concept of letting others be responsible for actions. A bail-out isn't a good thing in concept. It lets people and companies get a free pass for the bad decisions that were made. Granted, as a result of the mess that we’re in, something needs to be done quickly to restore faith in the markets. But it has to be done right.

And there are more ramifications to it being "done right."  For instance, as it stands now, three banks hold over 30% of all of the deposits in the U.S.  A perfect recipe for them being classified as "too big to fail."  It's a potential disaster in the making.  Remember the Japanese financial debacle that resulted from too many banks being protected from their own mistakes?  We don't want to see that again.

© 2007, Despair, Inc.

Fortunately, with Congress’ balk, the administration seems to be more open to compromise and making the proposed legislation more of a true “Fix” than the original proposal that hoped that throwing money at the problem it would make it go away. The real issue is to regain market stability is to have depositors and investors again be comfortable. Raising the FDIC insurance limits will go a long way to comfort the former. It’s been stuck at $100,000 for 28 years, far too long. The suggested quarter million limit is a nice round number and will help.

Getting investors comfortable will be another mater. It’s being proposed that the “mark to market” accounting rule be eliminated. This is a problematical issue. Investors want to know what their investments are really worth, so theoretically the concept is a good one. But when there are uncertainties, the question becomes “what is the true value?” In the case of securitized mortgages, many felt that the best way to value the bonds was on a worst-case basis. But is the worst-case the reality? True, there have been many defaults, but over time the value of the mortgages is likely higher than they appear in the short term. Thus, “mark to market” became a rush to judgment that didn't help the situation. An adjustment to the accounting rules may help.

Fool me once, shame on you; fool me twice, shame on me.

Oversight…

Quite rightly, Congress is reluctant to give the Bush Administration a “blank check”, like they did with the Iraq War. While time is of the essence, Congress and the Treasury have to “get it right”. This shouldn't be a bail-out. The banks are big boys and did some stupid things. They shouldn't be rewarded. Actually, maybe they should fail. But I don't think that the politicians (nor the economy) can accept that.

What shouldn’t be done:

    Buy the bad loans at par.
    Give the Treasury a free hand without congressional oversight.

What should be done:

    Negotiate a deep discount for any loans or bonds that are purchased.
    Require that the banks take responsibility for fraud and bad underwriting.
    Have a requirement for them to take back certain loans.

Also, mergers need to be vetted carefully. We’re getting closer to the fabled “one bank” scenario.

Remember, even if this works, It's not going to turn the economy around immediately.

As they used to say on TV, "Stay tuned". It's going to be interesting.

Fannie and Freddie

An interesting development

Treasury Secretary Henry Paulson is putting Fannie Mae and Freddie Mac into a conservatorship.

A bold move.

A conservatorship sounds like a euphuism for a bankruptcy trusteeship, and it likely is. The real question is, which way will the treasury and the Fed go? Chapter 11, or 7?

The former would “clean house,” and likely reduce the equity holders’ stakes significantly, but keep the entities in place with greater oversight. They might even be merged. This could be a good thing.

The latter, which appears to be a "Plan B," if the current option doesn't work out, is a more radical move, as it could result in the entities being converted into a fully-government operated entity like FHA or possibly liquidating them and removing that source of funding from the market. Either is a bold move.

Whichever way it goes, it will be an interesting ride for the mortgage and residential markets.

Frustration- and opportunity…

Development opportunities

I have a niche business. I’m a commercial real estate broker and development consultant in Northern and Central California. I specialize in acquiring land for developers and assisting them with getting their governmental approvals for their projects.

The Market

I think that everyone will agree that the current market is a bit unique. Over my thirty-plus year career, I’ve seen many up and down cycles, but never one like the one we’re currently in. This situation seems to have confused many people in both the commercial and residential development industry, including developers of retail projects, retailers, and homebuilders.

There are many opportunities out there. Prices have come down and sellers are, for the most part, more negotiable and flexible than they have been in a long time. The “conventional wisdom” would be that developers would be taking advantage of these opportunities and be aggressively tying up property for the future. But, no, for the most part, they are sitting on their hands.

Granted, financing is more difficult to obtain, and there is concern about whether the “bottom” has been reached, but the housing market, especially in areas with high barriers of entry, is recovering, mostly due to more people being able to afford to buy homes.

For the most part, the development cycle in my market is longer than in most parts of the country. This is a result of several factors- limited supplies of developable land, onerous regulations, and community activists who question everything. I’m not saying that any of that is necessarily bad, but it is a fact of life. As a result, a new project, whether residential or commercial, takes two or three years from the point where the developer has optioned the land to the place in time when all permits have been received and the project is ready to start construction. Then, it takes between six and twelve months before the shopping center is ready to open or the housing tract is ready for sales.

Even the most pessimistic economists and pundits believe that the economy will turn around within that timeframe. So, why aren’t developers taking advantage of this opportunity? It would seem that they have a relatively unique opening to obtain land at better prices and to be able to get their projects through the approval process while the governmental entities aren’t overburdened with work. In addition, they can design and entitle their projects without the customary time pressures.

So, why aren’t they?

Reality and the mortgage market

How did we get here, and can be done to avoid a repeat?

Greed!

Yes, I said the “G” word. While there have always been people in the market who are greedy, usually they were a minority, and weren’t spread throughout the parts of the industry in such mass. There’s plenty of blame to pass around, as the problem didn't stem from just one industry segment.

So, what happened? Let’s take it a segment at a time:

Homebuilders

Traditionally, homebuilders have been local to one community or one region. Over the years, many grew larger and became national. Some of the growth was internal, and some was through mergers. As growth happened, many of these companies became less providers of housing and more financial machines. They lost their soul, their old reason for being. It didn’t matter what they were producing- it could be ball bearings. All that mattered was feeding the machine and increasing revenues while keeping costs down.

Lenders

It used to be that when a bank made a home loan, it kept the loan in its portfolio. Over the years that changed, as securitization of mortgages allowed lenders to sell their mortgages on Wall Street. This theoretically was a good thing, as the banks were then able to lend more. However, since someone else now owned the loans, underwriting became more lax. After all, the reasoning was, it’s not going to be our problem. Initially, securitized mortgages were prime loans and there was little risk for the eventual owners of the mortgages. But that changed.

Subprime loans

Initially, lenders who specialized in sub-prime mortgages kept them on their books, as there was no market for a securitized product backed by them. As time went on, the market for mortgage backed bonds outstripped supply. The solution was to put those loans on the market. The problem was, they weren’t the same as higher-quality mortgages. The lenders who specialized in such loans had become experts on them over the years and knew how to underwrite, price, and manage them. They had high interest rates that compensated for higher delinquency rates. The lenders’ underwriting standards and risk awareness worked together so that the net income was about the same as for prime loans. This wasn't fully understood my the bond market, which just looked at the interest rates, and had lax due diligence regarding the quality of the underlying mortgages.

A-Alt loans

Should "A" stand for "abuse"? It shouldn't. These loans were created for a special purpose. Many creditworthy self-employed borrowers used to have trouble "proving" their income for loan applications. This was because they often used creative accounting, moving expenses from the personal side of the ledger to the business side. While this reduced their taxes, it played havoc with showing their true income to lenders. Thus, these loans, often referred to as stated income, were developed. Originally, they were carefully underwritten to make sure that the borrowers really had the income that they claimed. However, some lenders and mortgage brokers decided to bend the rules to get more income for themselves,. They used the loans for people who didn't really have the qualifying income, thus earning the nickname liar loans.

Payment-option adjustable-rate mortgages

Again, these loans were created for a legitimate purpose, but ended up being used wrongly. The concept was that the borrower generally had three monthly payment options each month- pay the regular amount (which included the interest and amortized principal), pay just the interest, or pay a "minimum payment", which kept the loan current but raised the principal by the difference between the interest amount due and what was paid. The theory was that these loans gave a borrow great flexibility if there was a temporary reduction in income, say due to a health problem.

Underwriting

When a loan is underwritten, the lender looks at the borrower's creditworthiness, ability to make the monthly payments, and the value of the collateral, in this case the home. Abuse here was using the initial or "teaser" interest rate for an adjustable rate mortgage for determining whether the borrower could afford the loan, rather than what the rate would be when it went to "normal" in a couple of years. This is a bad situation for both the borrower and lender, as it sets up a likely failure scenario.

Mortgage Brokers

Most people used to go directly to lenders to apply for home loans. As the market expanded, mortgage brokers were employed by lenders to generate business and to do the initial underwriting. Theoretically it was a good idea, if the broker-generated loans were adequately monitored. The problem was that they weren't. 

Incentives

In addition, the way that many lenders compensated brokers was by "yield spread premiums", which invited abuse. How? The way that this method worked, like all things, started out to be a good thing for the borrower, but again, greed and abuse got in the way. The lenders had rate sheets wherein they quoted different combinations of rates and points (prepaid interest). This allowed the borrower to have the option of paying a lower rate by paying more points up front, or vice-versa. The rate was determined by the borrower's creditworthiness. What happened was that the broker wouldn't show the rate sheet to the borrower, but would make selected quotes. For example, a borrower qualified for a 6% loan at 0 points. The broker would quote 1 point for that loan. As the additional point was higher than the lender's quote, the broker would get the extra, as a premium. This situation gave an incentive to some agents to push borrowers into higher cost mortgages in order to fatten their paychecks.

A rising market

Some loan agents (including those working for lenders, mortgage brokers, and builder-affiliated mortgage originators) encouraged home-buyers to buy homes that were clearly out of their financial reach. By using faulty loan underwriting, they were able to "prove" to the buyer that he or she could afford to buy the house, even though in the real world this wasn't true. When the potential buyer addressed this situation, the answer was that the house would soon be worth more that it was now and that it could be sold or refinanced before the higher payments kicked in. This was a total reversal from the "conventional wisdom" that people bought homes to stay in, rather than as a speculative investment.

Appraisers

Generally, most appraisers are honest. Appraising real estate is more of an art than a science, maybe even a "black art". A good appraiser understands the market and its nuances and gives a fairly accurate idea of a home's worth. However, with the demand for loans, lenders started to be less picky about the people who did this work. In addition, in order to handle the larger number of appraisals, many stopped employing independent appraisers directly and instead hired large regional or national appraisal management firms which contracted with local appraisers for the actual work. Unfortunately, sloppiness crept in and pressure was placed on appraisers to "make the numbers". Intimidation was used was to have the purchase contract price be a "comp" (comparable sale), with the theory being that the price was a true reflection of the market, though at that time the purchase wasn't complete, and thus in normal appraisal practice wasn't given full weight.

The bottom line is, it was a disaster waiting to happen.

So, what now? First, there needs to be some house cleaning. More supervision needs to be in place for the disparate parts of the lending chain. Second, the incentives for bad underwriting and fraud need to be curtailed. And third, what we don't need is knee-jerk reactions from Congress. We need real reform, not band-aids clamping down so hard that the credit markets can't service the industry.

What else can be done?

A good start would be to change the securitization model to "covered bonds", which are more the norm in Europe. The primary difference from the current bond model is that the lenders keep the loans on their books and issue bonds secured by them, rather than selling the loans. This creates an incentive for the lender to make sure that the loans are properly underwritten.