Notorious R.O.B.

So the news comes that the bailout package has failed to pass the House with 133 Republicans and 95 Democrats voting nay.  Well, at least it was a pretty bipartisan fail.  I’m sure we will be treated to much sound and fury from the talking heads and the chattering class as to why, who’s to blame, and so on.  At the same time, things are going to get worse before they get better, so I expect something new to come down the pike any day now.

I would like to recommend three immediate things that Congress and the Administration can do to buy some time while they work towards a more comprehensive solution that can survive a vote.  What we need now is time more than anything else, so all three suggestions are geared towards things that they can do in the next couple of days.

1.  Suspend the mark-to-market accounting rule for 90 days.

The bailout package included a provision that would have enabled the SEC to suspend the mark-to-market accounting rule:

A provision in the bill, whose adoption was in doubt after the House of Representatives rejected it Monday, gives the Securities and Exchange Commission the right to suspend — by rule or order — mark-to-market accounting under Statement Number 157 of the Financial Accounting Standards Board.

While the article linked to above shows that there are some powerful and influential people (among them Arthur Levitt, former chairman of the SEC) who are against suspending mark-to-market rule, I believe that as a short-term, breathing-room measure, it makes sense to do so.  Hence, I would do it for 90 days.

I want to make clear that I’m not against mark-to-market rule in general.  There are lots of good reasons to have this rule.  But I do agree with Jeff Miller on TheStreet.com that there is a difference between a normal market and a panic-driven, illiquid one.

Furthermore, while mark-to-market in and of itself may not be a major problem, when combined with reserve requirements of banks and other financial institutions, it can become a catalyst for meltdown.  Say a bank has to hold 10% of all deposits as reserve requirements (the Fed can set it between 8% and 14%).  If mark-to-market rules require a significant writedown of assets, such as mortgage paper, then the bank comes under enormous pressure to sell assets to keep its reserve requirements up.  That in turn induces further declines in asset prices, as paper floods the market, which in turn runs into reserve requirements, and so on.  That’s a pretty crappy feedback loop.

I had the opportunity to speak with someone who should know some facts (he’s a representative of one of the largest foreclosure-related companies) recently, and he pointed out that some 95%+ of mortgages in the U.S. are absolutely fine.  The debtors are faithfully making their monthly payments.  Some of these mortgages were combined with subprime mortgages and other more dubious debts into exotic mortgage-backed securities and sold — the source of many of our problems today.

With a bit more time, analysts can begin to delve into the morass that is CMBS and CDO and other instruments and start to figure out which ones are good and which ones are bad.  That in turn creates folks willing to buy mortgage securities at deep discount.

Plus, that bit of time can give the legislators and regulators time to work with industries to come up with a stronger, less interventionist, program to help deal with the crisis at hand.

2.  Rein in the breathless media

While the First Amendment prevents any direct government action to restrain the media, certainly the various leaders from the President to the Speaker of the House to the candidates for various offices can step up and act like adults.  They can explain to the nation that while we do have some problems to work out, that (again) 96% of mortgages are not in default, that people are still making their monthly payments, and that the problem can be dealt with.  Someone needs to point out — and directly contradict the breathless press reports of doom and gloom — that the fundamentals of the economy are (were) pretty decent.  Employment is still high, Q2 of 2008 showed a 4.3% gain in productivity, and things just aren’t that bad.

The whole situation, to some extent, was a creation of the media.  Part of the short-term solution needs to be putting the idiots running our newsrooms in their place.

It is no secret that most business and finance journalists have absolutely no idea what the hell they’re talking about.  Business leaders, economists, and others who do know need to step up now and start speaking up directly to the American public.

3.  Trial Run of Insurance Plan

While it would be great to have a single bailout package that calmed everyone down, without turning into a fascist/socialist state, I’m afraid it’s going to take some time to get done.  Why not try a trial run of the least-intrusive plan, that of the House Republicans?

Of course, it would be helpful if the “patriots” on the Left would stop playing partisan politics for a moment, but I think the Democratic leadership could probably make that happen if they wanted to do so.

Again, as a short-term measure to buy time and create breathing room, why not go forward with a $10B or so plan to insure “toxic assets”?

The “insurance” plan works by creating incentives for private market participants to take the risk of buying mortgage securities, because if they go into default, the insurance pays off.  But until they go into default, there is no massive cost on the part of the insurer (aka, the government).

The thought appears to be that offering to insure “toxic assets” might provide enough incentive for private entities to start going bargain hunting.  Again, with 96% of all mortgages safe and sound, it seems like a great time to go buying up mortgages for pennies on the dollar.  Insurance adds a layer of risk protection that further incentivizes private market players.

If the first $10B worth of securities are federally insured, and those securities get snapped up by the market, then the program can be expanded.  If they all go into default, then the losses to taxpayers is limited to $10B or so.  Seems like a low-risk approach to take that will have the effect of reassuring the credit markets that there are indeed buyers out there, if the risk/reward is low enough.  Again, while that is working its way through the market, legislators have time to work on the bigger package.

Breathing Room

This whole affair really reminds me of a Chapter 11 bankruptcy filing.  Contrary to popular imagination, there are situations where companies go into Chapter 11 (Reorganization) bankruptcies not because their business is fundamentally screwed, but because they experience short-term cashflow problems.  They may have customers, may have a valuable ongoing business, but due to loan covenants and the like, they face going out of business.  Seasonal companies, such as retailers, or big-ticket sellers (who may have $50m in outstanding invoices, but only $2m of cashflow) often face problems like this.

Oftentimes, they go into pre-arranged bankruptcies to buy some breathing space while the business works itself out.  Lenders are happy, as they get to reorganize the debt and get paid, instead of having to liquidate at cents on the dollar.  The business keeps going, the employees keep getting paid, etc.

What we need now is that pause, that breathing room, while Congress and the White House get together again and try again for a more comprehensive bill.

I think the three things above could help, not in the permanent solution, maybe, but certainly in the short-term (say the next 90 days or so).

Or… I could be dead wrong.

-rsh

I don’t normally write much on financial matters connected to real estate, because I recognize it as an area where frankly, I have no real expertise. I know generally how mortgages, CDO’s, subprime and so forth work, but beyond the basics, I get lost. Tanta, over at Calculated Risk, however, does not get lost. In fact, you might say he illuminate the path. I think this site is a must-read for serious real estate industristas.

His latest post discusses a story in the New York Times reporting an effort by various gargantuan banks to get the feds to bail them out of their current financial woes. Tanta’s analysis of the proposals by the banks to create “a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.”

According to this proposal, with Bank of America’s name on it, there are some $739 billion (that’s Billons, not their low-rent cousins on the wrong side of the tracks, the Millions) worth of mortgages that are at moderate to high risk of default. So the thought is that the Federales should step in and bail out these banks and borrowers to avoid foreclosures and so forth.

The New York Times itself argues against such a bailout:

In practice, taxpayers would almost certainly view such a move as a bailout. If lawmakers and the Bush administration agreed to this step, it could be on a scale similar to the government’s $200 billion bailout of the savings and loan industry in the 1990s. The arguments against a bailout are powerful. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers.

A rescue would also create a “moral hazard,” many experts contend, by encouraging banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.

If the government pays too much for the mortgages or the market declines even more than it has already, Washington — read, taxpayers — could be stuck with hundreds of billions of dollars in defaulted loans.

Let’s leave aside for the moment how amusing it is (in a deeply unfunny way) how “news” articles in the Gray Lady have a tendency to make arguments. As if the New York Times were a partisan in the matter. Which, I guess, it is — if you’re honest with yourself, at least. Because in this case, Keller’s boys and girls have a point.

And Tanta expands on the undesirability of such a bailout by pointing out the institutional barriers to executing such a grand plan:

Nobody is going to create a functioning new agency with the relevant expertise and staffing and funding and clear mandate out of thin air fast enough to do what this wants to do, if what we want to do is stave off recession. FHA probably has the expertise to credibly attempt the loan-level workouts, but not enough hands to get saddled with $739 billion worth that has to be dealt with before everybody’s lawns go brown. Ginnie Mae is, in my view, one of the most efficient and quietly professional government agencies ever: they run a highly successful program with a tiny staff. I can’t imagine Ginnie Mae is ready to manage reporting and remittances on a brand-new government-owned pool o’ junk of this size with existing resources.

Tanta’s conclusion is that the Feds ought to find some smart private company or two and outsource the administration of the whole thing to them. I think that’s very smart.

However, I have a different question on the issue.

What’s in it for US?

And I use the word US in two senses — “US” as in the United States, and “us” as in the taxpayers who are funding these bailouts.

In theory, I suppose the benefit is that using taxpayer dollars to provide welfare to Bank of America, Goldman Sachs, and other ginormous financial institutions would increase stability in our financial markets, soften a recession, etc. etc. Seems kinda remote. And a terrible investment.

So I have a better idea.  Well, probably a better idea.

If we’re going to do a bailout of any kind involving $739 billion, I suggest we do it as an equity investment in these large and wealthy banks and hedge funds and insurance companies. The Feds ought to go to Warren Buffet and tell him, “Okay, we’d like you to identify the banks, Wall Street firms, and insurance companies who have large exposure to subprime debt — then buy them on behalf of the people of the United States. Here’s $750 billion to work with, Warren. Get us some good deals.”

Rather than buying BofA’s crappy debt, let’s just buy BofA.  Bank of America’s market cap is only $189B or so, and their stock price hit a 52-week low on Feb 22.  Seems like it’s a bargain, maybe, for the taxpayers to snap up.  That way, the Federales are backing BofA’s debt as well, and the taxpayers could be stuck with hundreds of billions of nonperforming loans. But at a minimum, once the loan losses are written off, the good loans rescued, and the market turns around, and BofA starts to throw off billions in profits, the gubmint will share in that turnaround as well. And the gubmint can use that money to (a) issue a profit-share to each taxpayer on a pro-rata basis, or (b) reduce taxes (which amounts to the same thing).

As it stands, BofA had profits of $14.9 billion in 2007, and $21.1 billion in 2006.  And the bank executives are crying in their beers.  Okay, so let’s buy ‘em out, and see if profits in 2008 go back to $21 billion, and go up from there.

Add in JP Morgan, Citigroup, Morgan Stanley, and any other financial institution who wants some of the government handout, and we’re looking at what may possibly be a pretty good investment for the American people.  Yes, this does mean dilution for existing shareholders — their choice is to accept the dilution, or watch the stock price float to zero as the bank gets overwhelmed by bad mortgage debt and CDO instruments.

Seems to me that the troubled banks can get over this hump with an injection of capital to the tune of $739 billion from the Feds. In return, the Feds get huge chunks of these very valuable, very profitable financial institutions. In all honesty, the employees of said financial institutions might find their annual bonuses curtailed a wee bit to pay the new owners their fair share of the pie. But that’s better than looking for a job after one or more of these banks go under, no?

Since none of us want a nationalization of our money center banks, the investment can have very specific mandatory out-clauses. At a certain price level in the stocks of these companies, or at a certain profit multiple, the Feds will start to liquidate the holdings in banks by selling shares to the private market.  That has the added benefit of capturing any appreciation in the stocks of these banks, which then can be used to pay down the government’s debt (probably incurred in the course of trying to bail out these banks in the first place).

So, the Rob Hahn plan for bailing out our mortgage banks.

1.  Go hire Warren Buffet.

2.  Invest $750 billion in 2008 into these banks who want government welfare, as equity — and only as equity, not as loans or loan guarantees.  Yes, this probably means dilution for all of the current equity holders.  Too bad, so sad, guys — you knew what you were doing when you invested in financials.
3.  $750B buys you, in today’s valuation, the following financials:

• Bank of America ($189B)
• JPMorgan Chase ($148B)
• Countrywide Financial ($4B)
• Citigroup ($125B)
• Wachovia ($67B)
• U.S. Bancorp ($57B)
• Wells Fargo ($103B)
• American Express ($52B)

4. Make money, use the money to lower taxes (which has the benefit of stimulating the economy, thereby making recovery faster), then sell the stocks once certain triggering conditions are met.

I’m sure someone more versed in the arcana of the financial markets will point out various flaws in this plan.  But as you do so, please then answer the question: What’s in it for US in any bailout plan?

-rsh