Saturday, January 31, 2009
Balderdash! Yes, Fannie Mae and Freddie Mac created the bundled mortgages that we call "securitized debt" or as I call them, "mortgage based assets" but the financial groups on Wall Street raised these to a size that went well beyond what the two quasi-government companies had envisioned. Worse, they did not create a transparent market in which a price could be established for them. So when a small uptick in foreclosures occurred, the analysts panicked because they had no idea how to properly include this in the valuation of the "mortgage based assets." In their panic they valued them to whatever formula they could invent and all the inventions were overblown doomsday scenarios. Net result, an economy in a tailspin.
Get off the fake valuations. A mortgage held to maturity yields a high return. If all defaults end in foreclosures the asset base will only deteriorate by 7%, ditto for current earnings. These fake valuations have devalued these assets by as much as 90%. There can be no recovery until they regain their true value.
Wednesday, January 28, 2009
I have called for valuing these assets to their long term or maturity value instead of what they bring at sale in today's market. My reasoning here is that, since you cannot sell it, you continue to hold it. The assets do not vanish.
More importantly, I have noted that the actual default rate on mortgages in 2008 stood at 6% and the foreclosure rate was just over 2%. My argument was that the underlying asset, i.e. the mortgages themselves, were still performing well enough to value them to their maturity value.
The problem lies in the fact that when the holder of the toxic asset devalues it to a non-existing market or a notional market based on fear of massive foreclosures, it sharply reduces its value on the holders books. This leads to not having sufficient reserves to lend or borrow. Thus the failure of our financial sector, the so-called "financial crisis of 2008."
But we are now beyond the "financial" crisis. The crisis has now spilled over into the so-called "real" economy which means actual output of goods and services. In essence we have less credit, thus less demand, thus less production, thus lower employment or higher unemployment. Unemployment is now putting more pressure on ability to pay debts, most importantly mortgages. The default rate has now grown to 7% and the foreclosure rate to 3%.
Much of the debate over the new Obama plan to revive the economy revolves around the proper valuation of the "toxic" assets to be purchased by the Feds and housed in an "Aggregate Bank" (popularly being called the "Bad" Bank). The theory here is if the Feds buy the "toxic" assets they will establish a market for these assets and thus raise their value on the books of those still holding them.
This is good but a bit late. We don't have time to wait for establishing the market. Thus I insist, as does Steve Forbes, that we suspend "mark-to-market" rules. Valuing the assets at their maturity value would reestablish balance to the books of those holding the assets to a level where they can borrow and lend again, immediately.
As for the rest of President Obama's plan, we have let the financial crisis cause so much damage, we need to do more than simply reestablish credit channels. We need to put people back to work and keep the "real" economy moving. The plan will do this, no matter how the funds are spent. Build a bridge, build a road, refit a classroom, improve energy efficiency, spur research. All of these put people back to work and thus provide funds for them to buy and spur production of all goods and services.
Of all of Obama's plan I am most pleased to see the block of funds going to state and local governments to help them out of financial crisis brought about by the other end of the real estate decline, rapidly declining revenues from property taxes. It is no surprise that foreclosures for failure to pay taxes are running more or less the same as foreclosures for failure to pay mortgages. The Fed fund here will more than cover the anticipated shortfalls in state and local government budgets.
Most importantly, no matter how the drama is played out, we have a "New Economy" in which the Federal Government plays a much larger role than before. No longer is it just the main consumer of our output of goods and services, the Federal budget equals 20% of our GNP, or the rules maker and central banker, it has rapidly become the single largest share holder in our private sector - banks, insurance companies, mortgage companies, auto markers and more. Our economy will now be seriously affected by how the Federal Government acts as a share holder, a whole new dimension for government involvement in the economy.
Even more interesting is that the Feds are buying up the private sector with funds borrowed at no cost, i.e. Treasury Bonds or "T-bills" are being sold with interest rates less than the inflation rate. In other words Uncle Sam is buying these assets with today's dollars that he will pay back in the future at devalued dollars. All investors should have this situation.
And if you think the Feds have acquired a massive stake in the private sector so far, what would it be if they take the step being advocated by many to take over all the banks, i.e. "nationalize" the banks? I don't believe we are at that stage yet but who knows?
Wednesday, January 21, 2009
I watched two Republican senators on TV today arguing for using "mark-to-market" rules to make banks immediately take the hit for estimated losses on "toxic assets" and thereby restore confidence in the financial system. I then watched the darling of many economists, Sheila Bair, head of the FDIC, state that the markets are not giving the correct value for assets. She noted that 98% of banks representing 99% of all assets have sound balance sheets. But as we all know, the market for their shares has tumbled. Her call is for us to get "correct values for our assets."
Ms Bair offered two ways to get better valuation for our assets. First, would be for the Feds to use their funds to buy up the so-called "toxic assets," the original idea of the TARP fund. The Feds would also get preferred shares in the financial institutions that sell these toxic assets to the Feds. The result would be what is being called an "aggregate bank." A second option would be to use Fed funds to insure these assets. Either way Bair would see Fed funds stabilizing the market for these assets and thereby establish a "market" to which these assets can be valued correctly.
If you have been following my line you will know that I have consistently stated that the markets are no longer able to give correct value to assets. I have consistently noted that mortgage based assets have seen their values drop by some 30% or more based on fears of rampaging defaults and foreclosures on these mortgages. I have also noted that according to the Mortgage Bankers Association, the only organization that represents a major part of mortgage lending, defaults in payment of mortgages is running at 6-7% and foreclosures are running at just over 2%. I do not believe that these still low rates for defaults and foreclosures merits the massive devaluation of mortgage based assets.
More importantly, I have noted that the devaluation has not been done in strict accordance with "mark-to-market" rules. Since the market for mortgage based assets, the so-called "toxic assets," has dried up all together, i.e. there are no sales, their values should be dropped to zero. But such is not the case, various organizations doing the valuations use varying rules. The CEO of BlackRock, a major source of valuation of these assets, said they use the depressed value of the real estate market in Southern California to devalue mortgage based assets.
While devaluing the mortgage based assets has caused enough of a calamity to those holding these assets, it has spread throughout all assets. Result, the yo-yo process of shares on the major stock exchanges. Worse, it has led to a general loss of confidence in the economy and the resulting fall in consumption, loss of jobs and so on.
There is no debate about the basic problem, we must get the balance sheets of banks and other financial institutions on a sound basis. Getting rid of all toxic assets sounds like a straight forward way to do this. The problem is, at what price do you get rid of the assets? Zero or some fabricated value? Mark them to an assumed market and what is that market? Have the government buy them up or insure them and thereby create a "market" for them? Both sound plausible. But they overlook the real problem, no one knows the full extent of these assets. I have heard estimates for "credit default swaps," the elaborate schemes to insure the mortgage based assets amounting to $55 trillion.
Can we really suffer a 30% devaluation of $55 trillion in assets, or a loss of $16.5 trillion, a sum equal to the GNP of the whole USA? Leaving aside the consideration of credit default swaps, can we really afford a 30% devaluation of an estimated $15 trillion in mortgage based assets?
More sobering, can the Feds really buy up the toxic assets? Lets say the Feds only have to buy 30% of the credit default swaps and/or mortgage based assets. That would mean an expenditure of $5 to $21.5 trillion, far more than the TARP of $700 billion or any other Fed fund suggested.
No, the only way to correct the balance sheets of the banks is to suspend "mark-to-market" rules since they no longer work. Then allow the holders of the assets to value them to their long term values, i.e. the return on the underlying mortgages held to maturity. The only adjustment to this really needed is to deduct a loss due to defaults, 6%, and/or foreclosures, 2%. This would not cost a single penny of public funds. I can already hear the chorus singing, "false valuation." Well we already marking them to a false valuation, a sentiment shared by Sheila Bair. And yes, suspending "mark-to-market" would deter investors from buying the assets. So what, they are not buying them now anyway.
CORRECTING THE FINANCIAL CRISIS AND THE NEW ECONOMY
All of this does not change the tectonic change in the economy I point to as formulating our "New Economy," the Federal Government has become the single largest shareholder in the private economy. We now have Uncle Sam joining the ranks of those investing in the economy itself. This changes the whole structure. We cannot now foresee the full impact of this participation by the Feds in the private sector. Will the Feds lead the economy? Deter its progress? Alter it to serve political ends? All of these are serious questions to consider. We are at the cusp of a new course for the American economy. Truly exciting stuff.
Tuesday, January 20, 2009
1. Fact - over the last decade we have greatly increased home ownership in America, we have brought the "American dream" to more Americans than ever.
2. Fact - Housing prices have risen to levels that exceed income levels, the familiar average home price exceeds the capacity of the average income to afford. Of course this rests on a key assumption, housing costs should not exceed 30% of your income. But then, why 30%? This rests on more assumptions about how one should spend his income. It is not a hard and fast rule. Young ladies spend on average more than 40% of their incomes on clothes and accessories. Perhaps the average home owner can spend more than 30% on his home.
3. Fact - people have been using their homes as "ATMs" to spend beyond their means. Home owners have been borrowing against the equity in their homes to supplement their incomes.
4. Fact - This supplemental income allowed consumers to continue to be the motive force for economic growth.
5. Fact - The decline in housing values has caused this source of supplementalincome to dry up.
1. Fiction - subprime mortgages were given to people too poor to buy a home. In fact, these mortgages were given mainly to finance purchases of second and third homes by relatively wealthy middle class investors.
2. Fiction - the foreclosure rate for non payment of mortgages has grown faster than ever. Fact, the foreclosure rate for mortgages, according to the Mortgage Bankers Association, the most authoritative voice for this information, stands at 2% when it was 1% in 2005, well before the financial crisis. Yes, a 100% increase but still small. The foreclosure rate in the Great Depression was 25%. And foreclosures due to non payment of taxes run about the same as for non payment of mortgages.
3. Fact - with default rates on mortgage payments at about 6-7%, mortgages remain a good investment. To illustrate, say you hold mortgages that total $1 million. The average return will be $60,000 a year. With a 6% default rate you will earn only $53,700, not a major loss. Of course you are still at risk for the defaults that could wipe out $60,000 of your investment. But you will continue to earn on the remaining $940,000 investment in mortgages.
4. Fact - mortgages were bundled into bond issues that were sold to investors as "securitized debt" or "collateralized debt" and other terms. I refer to all of these as being "mortgage based securities." No one knows how much of these bonds actually exist, since many were used as collateral on loans taken out to buy more of these bonds. Since no one had a handle on the full extent of this debt come asset structure, the relatively minor increase in mortgage foreclosures was blown out of proportion and caused the value of these bonds to tumble.
5. Fiction - Mortgage based assets must be "marked to market." This is an accounting principle that is used to value your assets. Pretty straight forward, you value the asset at what it will bring in a market, in this case what this bond will bring in the bond market. In the panic caused by the relatively small increase in mortgage foreclosures these assets found their market dry up and no one was buying them, there is no market. If the rule was followed honestly the assets would have to be valued at zero. But such has not been the case, they have been arbitrarily devalued down to the depressed price of real estate in extreme locations, typically 30%.
6. Fact - The false "mark to market" for mortgage based assets caused big losses for almost all major investors. They saw their balance sheets fall 30% or more.
7. Fact - the Feds "TARP" plan of $750 billion has been aimed at correcting the balance sheets damaged by the arbitrary devaluing of the mortgage based assets. But it is rather a small assistance. I have heard estimates of $55 trillion in mortgage based assets and the "debt swaps" taken out to insure these assets. The amount of paper loss is staggering, 30% devaluation of $55 trillion equals $16 trillion in loss. Obviously multibillion dollar injections of capital cannot replace this loss.
8. Fact - suspending the "mark to market" rule for valuing mortgage based assets would allow the holder to value them at their "long term" value, i.e. the payment of the underlying assets, mortgages, over their full term. In other words, we should treat the mortgage based assets as investments to be held, not investments to be sold. This would allow financial institutions to pump up their balance sheets by trillions of dollars, not billions.
1. Fiction - the TARP and other US Government efforts to cure the financial crisis are hand outs to be repaid by the US taxpayer.
2. Fact - the TARP and other US Government funds have been used to acquire a ownership stake for Uncle Sam in several key private sector "industries." Uncle Sam has acquired large stakes in major US banks, an investment that has already grown by 3% in its first month. Uncle Sam now owns the core of our mortgage industry, Fannie Mae and Freddie Mac. Uncle Sam now owns our largest insurance company, AIG. And Uncle Sam has bought part of General Motors and Chrysler. I foresee these investments as paying back more than their cost and thus becoming a major new source of government revenue, which is good, since this will reduce government need to increase taxes.
3. Fact - In my articles on the subject we now have Uncle Sam as a major stake holder in the private sector. He already accounts for expenditures worth 20% of our GNP. He already sets the rules for interstate commerce and taxes on our output. Now he is the single major share holder in the private sector. Several have written about the "New Economy" in terms of moving to a service dominated economy instead of one led by manufacturing. Others have written about the "New Economy" in terms of "globalization." To these we can now add Uncle Sam being the main investor in the economy.
HOW TO SOLVE THE PROBLEM?
1. Fiction - stopping foreclosures and helping people stay in their homes will solve the economic mess.
2. Fact - stopping foreclosures and helping people stay in their homes is a good in itself, but not the cure for the economy.
3. Fact - the only way to revive the economy is to pump up demand.
4. Fact - increased Federal spending will pump up demand.
5. Fiction - Tax cuts for businesses will revive the economy - business has no incentive to spend on increasing or upgrading capacity when there is no demand for its products.
WHAT SHOULD PRESIDENT OBAMA DO?
First, continue to inject Federal funds into the economy either to pump up demand or correct balance sheets of major financial institutions or acquire more shares in the private sector or all three.
Second, take whatever action he can to ease credit. The cost to borrow is low, we need to make loans available.
Third, instead of using Fed funds to assist those with mortgage problems, use them to generate new mortgages. As much as it may sound like heresy, Uncle Sam could use his funds to get Fannie Mae and Freddie Mac back to issuing new mortgages.
Fourth, suspend the "mark to market" accounting rules.
Saturday, January 17, 2009
There is the concern that Uncle Sam will use his stake in the private sector to further political objectives. I postulate that he will act as any other investor, try to maximize his return, with an added objective, to promote general economic progress. But we already have a case of using his stake to further political aims. The US Senate is looking at the overseas operations of the banks and companies receiving Federal funds under the rubric of "tax havens." The assumption is that, if a company has an operation in certain countries, it is doing so to avoid paying US taxes.
This happens to be an area in which I have considerable experience. During my career in the Foreign Service and subsequently in international business I have come across a wide range of tax issues involving business that transcends national borders. For example, it is common practice for exporters manufacturing in what we call a "cost center" to send its exports through a third country or "profit center" en route to the customer in a second country. You guessed it, the "profit center" is a country with low taxes. Of course the "profit center" may be called a "distribution center."
While taxes may be the reason to funnel international transactions via a low tax country, there are other reasons. Business law may favor doing this as well. Most countries allow "temporary imports" which means a product may be imported and reexported without having to pay import duties. This is the back bone of the widespread practice of adding value to a product in a country to make it eligible for lower tariffs in another country. An example here would be bringing components from one country to another to be assembled into a product going to still another country. The country doing the assembly would have an agreement for lower or no tariffs in the recipient country. I have personally structured such an arrangement for a company.
Another example would be operating in a country that is part of a duty free consortium, e.g. the European Union. General Motors and Ford manufacture their cars for the European market in Europe and thereby avoid the high tariffs imposed on autos coming from non-EU countries.
You get the drift, the global economy is firmly rooted in the concept of companies operating in several countries for various reasons.
The Senate's attempt to examine the overseas operations of US companies receiving Federal funds is an example of the type of political baggage that comes with taking the "king's coin." As Uncle Sam gets deeper into his new role of being the major investor in "Corporate USA" we will no doubt see more politically motivated attempts to alter the course of "globalization." What next, exploring the "outsourcing" practices of companies receiving Fed funds? You betcha.
Friday, January 9, 2009
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Thursday, January 8, 2009
The typical observer would assume that as Federal debt goes up, the cost for the Feds to borrow will increase. You know, the more you are in debt, the riskier additional loans become. But guess what, the cost for the Feds to borrow is currently "zero." Yes, it costs the Feds less than the inflation rate to borrow. When the cost of borrowing is less than the inflation rate, you have to borrow, since you will pay less for the loan in future dollars than the amount you receive now in current dollars. You really do get something for nothing.
Again, the way is works is that Uncle Sam issues bonds, T-bills, that investors buy and treat "as good as cash." He then uses the proceeds for the TARP and other new devices for him to acquire assets. He now owns major stakes in the largest banks, the heart of the mortgage industry, the largest insurance company, and major stakes in two auto makers. BUT MORE IMPORTANTLY, HE IS BUYING THIS STAKE FOR NO COST SINCE HIS BORROWING COSTS LESS THAN THE INFLATION RATE.
Wow, I sure wish I could get money for nothing to build my asset base. Who would turn this down?
Enter the naysayers. They warn that Uncle Sam is running up a monster deficit. Yes, the borrowing is against future income. But if the "zero" interest rate continues, the tax payer will pay less in future dolars, than the cost of financing the deficit in current dollars. The tax payer is getting more for his money than he would normally.
More importantly, the assets Uncle Sam is acquiring have a value. They provide current income and future capital gains. As I mentioned in an earlier note, Uncle Sam has already gained 3.2% on his TARP investment in major banks in one month! And as I also noted, Uncle Sam does not have to pay capital gains tax on future earnings nor any taxes on current income.
I predict that the assets being purchased by the Feds now, will, say over the next decade, pay back more than their present cost. In other words, Uncle Sam will wind up buying assets at no real cost, and these assets will pay off his borrowing to buy them. Who would have thunk that Uncle Sam would be the ace investor on Wall Street?
Wednesday, January 7, 2009
But then all investments are essentially debts. Issuing shares in a company is simply another way to raise capital instead of borrowing directly. The difference is that the "borrower" pays back from profits, rather than from operating income. We own a home, but in most cases that is simply a very large debt. Even a deposit in a bank is used to lend out to others since that is how the bank can pay you interest on the deposit.
We now have the rather absurd situation where the only investment being made by the private sector is in Federal Government debt instruments, i.e. T-bills. And this in turn is being used by the Feds to invest in shares in private companies. The result, Uncle Sam is becoming the largest single share holder in corporate America.
I chuckle at those calling for channeling Fed funding of the banking system to businesses in hopes that this will stimulate the economy. The old supply side argument about prodding the economy through investment. I chuckle because the concept of encouraging business investment, when demand for its output is down, makes no sense. Why build larger capacity when you are operating at low rates of capacity utilization? Witness the auto industry, that has to close plants, not build new ones. Yes, you can make your production more efficient, but to what purpose if no one buys your output?
No, the only way to stimulate the economy is to stimulate consumer demand. To do that we must incur debt. Very few automobiles are sold for cash. Very few vacation trips are paid in cash. Very few homes are sold for cash. Not even such items as large TVs and refrigerators are sold for cash. Yes, health care is paid in cash by insurance companies. But education is paid largely through loans.
So, what should we do? Well in spite of all the ruckus, the best way to stimulate demand is to invest in a home. Yes, invest in that very debt that is blamed for all the mess. But it gives you shelter, as well as an investment, something T-bills or shares in General Electric cannot offer. How to stimulate demand for homes? Yes, direct Federal funds to this activity. Make funds for home buying attractive once more.
Does this sound familiar? You betcha. This is what we have been doing for the last decade. As much as one may lament the property fed boom, it did keep the economy going well. And it is probably the only way to get it cranked up again.
I am not alone in calling for this, the entire "Economic Greek Chorus" is chanting that there will be no recovery until the housing market rebounds. A corollary will be to invest in mortgages, no, not direct purchase of mortgages, but to invest in those granting mortgages, or, dare I say it, mortgage based assets.