As I have said many times, the financial meltdown and the resultant economic doldrums came about because of erroneous valuation of assets. The core false valuation is that given to mortgage based assets, the so-called "toxic assets." I have now come to realize that all "models" used by those valuing these assets rest on prices in the property market. I will repeat, a mortgage loan is not property, which is the collateral on the loan.
Let me put it in another way. A typical mortgage loan over its lifetime will pay back a total of twice the sale price of a home. At no time during the course of the loan will an increase in the value of the collateral property increase income from the loan. Nor would it be any less because the value of the property falls. The loan held to maturity will yield income equivalent to twice the selling price of the home, no more, no less.
But here is where those valuing the mortgage based assets make their error. They assume that negative equity will pump up defaults at rocket rates making the loans dicey propositions. They do not believe that people will continue to pay on a home loan when the property is worth less than the loan balance. They forget that homes are also shelters so the payer has to measure paying on the loan against paying for other shelter, e.g. renting a place. And he knows that no matter how little the value in his home, it is still more than the residual value on a rental, which is zero. Thus the actual foreclosure rate remains relatively small, 3% this year when it was 1.5% in 2005. In other words the assumption that negative equity will cause rampant defaults is wrong, wrong, wrong.
While they are erroneous, the real estate models used to value mortgage based assets and other assets have devalued these assets to as little as pennies on the dollar. This has led to the stymied credit market and the economic tail spin.
I know, you say those doing the valuations are savvy financial people who have lots of experience on which to base their models. Well they are the same people who got us into the mess so their "expertise" is suspect. And I offer that the most public spokesman for my line of reasoning is Steve Forbes and I challenge anyone to say he, with his highly respected publication empire, is not an expert.
And this false valuation has led to wholesale dismissal of President Obama's stimulus plan and Secretary Gheithner's financial stability plan. In the case of the stimulus plan, they bleat that it is insufficient to turn the situation around. The American people themselves have little faith in the plan but thank God have faith in Obama. Geitner's plan has been dismissed by all financial "experts" because they say it cannot work with their false valuations and they are correct. The only way it works is to drop the false valuations and allow assets to be valued correctly starting with mortgage based assets.
Fortunately the Federal Government does not think like private investors who view all assets as items to be sold. The Geithner plan will work because the Federal Government can buy assets, be they the mortgage based assets or shares in General Motors, and hold them until the economy recovers. As I have pointed out, the Feds are borrowing at essentially no cost, so it will cost nothing to hold these assets. And when the economy recovers, the assets will bring much higher prices on the markets. Uncle Sam stands to make the biggest killing on Wall Street in the history of the USA.
So forget the financial gurus and concentrate on Federal Government actions. The private sector has dropped the ball and has no idea how to get back in the game. The main result will be that the nexus of our financial system, and thus the economy, will gravitate to Washington, leaving New York City without its main source of income. Hold on to your DC suburban home and get rid of your New York coop.
Tuesday, February 17, 2009
Friday, February 13, 2009
THE GEITHNER BANK STABILIZATION PLAN
I see allot of barbs being shot at Treasury Secretary Geithner and his plan to stabilize banks. Most come from financial leaders who favor forcing banks to devalue their balance sheets to the point where many go out of business for lack of sufficient reserves. Then the survivors will be able to buy up the assets cheap and extend their mini-empires. Of course collateral damage will be the US economy itself. And this is what worries the President and Geithner.
I have read Geithner's statement about the new "Financial Stability Plan." It works because the Feds continue to understand a basic point, the so-called "toxic assets" have a real value which I call the "maturity value," which means the balances due on the mortgages times the interest rate times the length of the payoff period (term) minus the loss due to defaults and foreclosures. Since the actual default rate on mortgages is 6% and foreclosures rate is 3% the loss is relatively minor. This stands in stark contrast to the current holder of these assets "marking them to the market" which means losses of up to 90%.
The key to each part of Geithner's plan is that the Feds will hold their asset purchases in "trust funds" instead of "investment portfolios." To explain let me use my pet analogy. You have a trust fund set up by your late Uncle Harry from which you receive $50,000 per year. You may not sell or take more from the fund. What is its value? The "mark-to-market" crowd say it would be zero since it may not be sold. But the value is actually $50,000 per year over your lifetime. The Feds look at acquiring "toxic" assets, investing more funds in banks, and other infusions of Fed funds as part of a trust fund, not an investment held to be sold.
Whatever infusions of Fed funds that occur, they will stay the course. And these funds will rebuild balance sheets thus allowing the lenders to provide credit once more.
With these understandings in mind let's look at the Geithner Plan.
FINANCIAL STABILITY PLAN.
This is essentially a continuation of the first use of the "TARP" funds, i.e. capitalize banks by buying shares in them or lending to the banks. It strengthens the balance sheets.
PUBLIC-PRIVATE INVESTMENT FUND.
This is a plan to combine public and private funds to buy up the so-called "toxic assets," or as I call them, "mortgage based assets," and the plan now calls, "legacy" loans and assets. The plan is looking at spending up to $1 trillion.
CONSUMER AND BUSINESS LENDING INITIATIVE.
This is a plan to inject as much as $1 trillion into lending for consumers and businesses. The vehicle will be the "Federal Reserve's Term Asset Backed Securities Loan Facility." Well would you believe, the Feds want to provide lending by "bundling" the loans into assets. Sound familiar, yes, the same thing as "mortgage based assets" or as the market valuation slaves insist on calling, "toxic assets."
Remember my litany, no credit, no buying, no buying, no production, no production, no jobs. Uncle Sam, now in the guise of Secretary Geithner, means to revive the economy by opening the credit lines again. He will do this by rebuilding the balance sheets of the lenders and by injecting massive amounts of funds into the system.
Of course I cannot conclude any piece without reminding you of the tectonic shift in the US economy - Uncle Sam is now the largest single investor in the economy. Added to his role as the largest single consumer, the central banker, and rules maker, Uncle Sam's control over the economy is at a new high. No wonder the Wall Street crowd worries about the nexus of the US economy moving from New York City to Washington DC. Being a native Washingtonian I welcome the move.
Leo Cecchini
February, 2009
I have read Geithner's statement about the new "Financial Stability Plan." It works because the Feds continue to understand a basic point, the so-called "toxic assets" have a real value which I call the "maturity value," which means the balances due on the mortgages times the interest rate times the length of the payoff period (term) minus the loss due to defaults and foreclosures. Since the actual default rate on mortgages is 6% and foreclosures rate is 3% the loss is relatively minor. This stands in stark contrast to the current holder of these assets "marking them to the market" which means losses of up to 90%.
The key to each part of Geithner's plan is that the Feds will hold their asset purchases in "trust funds" instead of "investment portfolios." To explain let me use my pet analogy. You have a trust fund set up by your late Uncle Harry from which you receive $50,000 per year. You may not sell or take more from the fund. What is its value? The "mark-to-market" crowd say it would be zero since it may not be sold. But the value is actually $50,000 per year over your lifetime. The Feds look at acquiring "toxic" assets, investing more funds in banks, and other infusions of Fed funds as part of a trust fund, not an investment held to be sold.
Whatever infusions of Fed funds that occur, they will stay the course. And these funds will rebuild balance sheets thus allowing the lenders to provide credit once more.
With these understandings in mind let's look at the Geithner Plan.
FINANCIAL STABILITY PLAN.
This is essentially a continuation of the first use of the "TARP" funds, i.e. capitalize banks by buying shares in them or lending to the banks. It strengthens the balance sheets.
PUBLIC-PRIVATE INVESTMENT FUND.
This is a plan to combine public and private funds to buy up the so-called "toxic assets," or as I call them, "mortgage based assets," and the plan now calls, "legacy" loans and assets. The plan is looking at spending up to $1 trillion.
CONSUMER AND BUSINESS LENDING INITIATIVE.
This is a plan to inject as much as $1 trillion into lending for consumers and businesses. The vehicle will be the "Federal Reserve's Term Asset Backed Securities Loan Facility." Well would you believe, the Feds want to provide lending by "bundling" the loans into assets. Sound familiar, yes, the same thing as "mortgage based assets" or as the market valuation slaves insist on calling, "toxic assets."
Remember my litany, no credit, no buying, no buying, no production, no production, no jobs. Uncle Sam, now in the guise of Secretary Geithner, means to revive the economy by opening the credit lines again. He will do this by rebuilding the balance sheets of the lenders and by injecting massive amounts of funds into the system.
Of course I cannot conclude any piece without reminding you of the tectonic shift in the US economy - Uncle Sam is now the largest single investor in the economy. Added to his role as the largest single consumer, the central banker, and rules maker, Uncle Sam's control over the economy is at a new high. No wonder the Wall Street crowd worries about the nexus of the US economy moving from New York City to Washington DC. Being a native Washingtonian I welcome the move.
Leo Cecchini
February, 2009
Monday, February 9, 2009
CONVERSATIONS WITH A FORMER MORTGAGE BROKER
John
There is another aspect of mortgages and their value as investments that will become more well known as President Obama implements methods to build bank balances. As a former mortgage broker, you probably know that the lender may have earned more from loan origination than from the loan itself. Moreover, the origination fees came up front, while the interest return is realized over the life of the loan. As the Feds buy up mortgage based assets, they will not see the income stream coming from these that made them the hot ticket item over the last decade. But even without the origination fees, mortgages and mortgage based assets earn better than most other bonds.
I personally favor insuring the so-called "toxic" assets rather than buying them. I believe as people come to understand that they have been devalued beyond any reasonable amount, they will see their intrinsic value and the market will grow rapidly.
I still believe that suspending the "mark-to-market" rules is the cheapest and most accurate way to correct the savage damage done to bank balances by rushing to devalue mortgage based assets to notional markets. But if Federal guarantees are needed to make the market slaves come on board, do it.
Meanwhile, the stimulus part of the President's rescue plan must also be implemented. The financial sector has done too much damage to the "real" economy and correcting the financial sector will not resurrect the economic body fast enough. We still need to put the "paddles" to the body to get it beating again.
Leo Cecchini
John
Negative equity means non-payment, that is the premise on which all mortgage based assets were sharply devalued. However, one has to remember that a home is also a shelter. The person who leaves that mortgage leaves the home and must find another place to live. He measures the payment for the mortgaged home against the cost of renting another place. Thus, in this case, he does not act like a normal investor who would drop paying too high a price for a devaluing asset. As long as the home owner pays, the mortgage maintains its value, in your case, $800,000 at whatever the interest rate. The return on the mortgage remains constant and is not affected by changes in the value of the underlying property.
More interesting, "investors" who bought properties at subprime rates, and these were the main users of subprime mortgages, continue to hold their "negative equity" homes because they rent them out and continue to earn money on the property. They too continue to pay with a small default or foreclosure rate. Again, the rental income is not affected by the value of the underlying property.
My point is that mortgages, and their associated properties, are not like other assets with a market that reacts to the usual rules. Moreover, the value of the mortgage is not the value of the property, since the property is only collateral. I insist, that as long as the foreclosure rate remains relatively low, we should continue to value the mortgages at their maturity value, i.e. the balance of the loan times the interest rate over the full term of the loan.
All of this is said in the context of the "financial crisis" scenario. Now that the panic has spread to the "real" economy we will see a different situation. As the unemployment rate goes up you can be sure that foreclosures will rise in tandem. The foreclosure rate during the "Great Depression" stood at something like 25%. The immediate problem is to get people back to work and the Obama plan may help here. For the long term, however, we must revalue the mortgages and the mortgage based assets to a more realistic level which is not the "market."
By the way, I have recently bought shares in Fannie Mae and Freddie Mac, so to anwer your question, I continue to invest in mortgages. Others continue to buy less risky mortgages. The point is that they still maintain their intrinsic value, i.e. they pay better than other debt instruments and that is why they were bundled and served up in large portions to investors as "securitized debt."
Leo
-
I believe the reason that foreclosure rate only going from 1% to 2 or 3% is causing problem now is that in 2004 and 2005 prices were still going up or holding strong as the top did not come until late 2005. Therefore when the banks went to foreclosure they either sold it at the courthouse for a profit or took the property back and made money on the REO. Let me ask you if you look at one mortgage say in California that was originated in late 04 and the purchase price was $800,000 and was of course a neg am no down payment loan, now properties in this town are selling for 500,000 a 37% decline. Now this homeowner’s loan is going to adjust and the payments are going to double, they can’t refi because the houses next door are only selling for $500,000. There are billion, $ wise, of these type of loans. All the banks have these on their balance sheets, and this is why there is no market for the securities. What would you pay for a $800,000 note backed by a property worth $500,000?
John
John
Yes, the real problem is no one knows the full extent of what I call debt becomes asset becomes debt becomes asset structure we built. My point is that if a 1% foreclosure rate in 2004 and 2005 caused no problem, then a 2% rate should not bring down the house. I use the foreclosure rate in Lee County, where I sold homes, as my base number and it is the highest foreclosure rate in the nation. Do not confuse depressed value of homes with foreclosures. Loss of equity may induce many to stop paying their mortgages but that is a assumption. As I have laid out before, if you have a $1 million portfolio of mortgages backed by $100,000 in deposits or other reserves and there is a 2% foreclosure rate you stand to lose $20,000 in a year and reduce your reserves by that amount. You are still very solvent and earning on the $980,000 in other mortgages.
The problem is that those doing the valuations were panicked by the rising foreclosure rate and had no idea of the actual size of mortgage based securities. They simply devalued all mortgage based assets to the depressed value of the real estate market and they did not use a uniform valuation of the real estate market. I heard the CEO of BlackRock say they used the depressed value of the real estate market in Southern California as their bench mark.
My point remains that the underlying asset, mortgages, are still basically sound, so the assets built on them should not be devalued beyond the actual foreclosure rate. That is not what has happened. The result is an economy in the tank that has led to higher unemployment rates. And I will be the first to say that higher unemployment will lead to higher foreclosure rates. In essence we have built a self-fulfilling prophecy.
Leo C
----- Leo,
I understand that a very low percentage of loans are in default, but when you look at the market’s overall decline in value and add to that the leverage that some of the investment banks used it only takes a modest 5-10 percent decline in home values to wipe out all the capital. That is the real problem. There is not a liquidity problem it is a solvency problem. I agree that all the assets do not need to be marked to market because there really is not a market for some of the debt instruments and the majority are performing and can be valued at a discounted cash flow model. But with the securitization of the debt into different levels of risk it is nearly impossible to separate the good loans from the bad. From my experience here in Florida seeing first hand the amount of debt that lenders have on properties purchased between ‘04 and ’08 they are under water anywhere from 25% to 60% in certain areas. This amount of debt really gives no incentive for homeowners to continue paying their mortgage the best option for the lenders is to do an aggressive loan modification which includes principle reductions, which they have not been willing to do it will likely take tax payer money. There is a lot of moral hazard that could be created and could encourage a wave of new problems if not implemented correctly. I am attaching a report that really delves into how everything went wrong and what is happening now, it is a long read but lays it out pretty straightforward. If you are looking for the next shoe to drop I would take a look at what is going on in the credit card business. There models are not prepared for unemployment above 8%. Here is a little excerpt about leverage from the report:
…with Leverage?
How could $1.2 trillion in subprime mortgages outstanding cause such a large global financial disaster? Leverage
is certainly a part of the problem. If banks maintain a leverage ratio of 10:1, only $120 billion of capital can
support $1.2 trillion. With such a small amount supporting such risky loans, a 10 percent decline in the $1.2
trillion of assets could wipe out all of the banks’ capital. Of course, some institutions were more highly leveraged
than 10:1, and in some areas, home prices have fallen much more than 10 percent; so too has the value of the
subprime mortgages. (If the ratio were 30:1, which was the case with some firms, then the supporting capital
for $1.2 trillion would be only $40 billion.) These situations can force some institutions into insolvency if capital
cannot be raised to offset the decline in the value of assets.
There is another aspect of mortgages and their value as investments that will become more well known as President Obama implements methods to build bank balances. As a former mortgage broker, you probably know that the lender may have earned more from loan origination than from the loan itself. Moreover, the origination fees came up front, while the interest return is realized over the life of the loan. As the Feds buy up mortgage based assets, they will not see the income stream coming from these that made them the hot ticket item over the last decade. But even without the origination fees, mortgages and mortgage based assets earn better than most other bonds.
I personally favor insuring the so-called "toxic" assets rather than buying them. I believe as people come to understand that they have been devalued beyond any reasonable amount, they will see their intrinsic value and the market will grow rapidly.
I still believe that suspending the "mark-to-market" rules is the cheapest and most accurate way to correct the savage damage done to bank balances by rushing to devalue mortgage based assets to notional markets. But if Federal guarantees are needed to make the market slaves come on board, do it.
Meanwhile, the stimulus part of the President's rescue plan must also be implemented. The financial sector has done too much damage to the "real" economy and correcting the financial sector will not resurrect the economic body fast enough. We still need to put the "paddles" to the body to get it beating again.
Leo Cecchini
John
Negative equity means non-payment, that is the premise on which all mortgage based assets were sharply devalued. However, one has to remember that a home is also a shelter. The person who leaves that mortgage leaves the home and must find another place to live. He measures the payment for the mortgaged home against the cost of renting another place. Thus, in this case, he does not act like a normal investor who would drop paying too high a price for a devaluing asset. As long as the home owner pays, the mortgage maintains its value, in your case, $800,000 at whatever the interest rate. The return on the mortgage remains constant and is not affected by changes in the value of the underlying property.
More interesting, "investors" who bought properties at subprime rates, and these were the main users of subprime mortgages, continue to hold their "negative equity" homes because they rent them out and continue to earn money on the property. They too continue to pay with a small default or foreclosure rate. Again, the rental income is not affected by the value of the underlying property.
My point is that mortgages, and their associated properties, are not like other assets with a market that reacts to the usual rules. Moreover, the value of the mortgage is not the value of the property, since the property is only collateral. I insist, that as long as the foreclosure rate remains relatively low, we should continue to value the mortgages at their maturity value, i.e. the balance of the loan times the interest rate over the full term of the loan.
All of this is said in the context of the "financial crisis" scenario. Now that the panic has spread to the "real" economy we will see a different situation. As the unemployment rate goes up you can be sure that foreclosures will rise in tandem. The foreclosure rate during the "Great Depression" stood at something like 25%. The immediate problem is to get people back to work and the Obama plan may help here. For the long term, however, we must revalue the mortgages and the mortgage based assets to a more realistic level which is not the "market."
By the way, I have recently bought shares in Fannie Mae and Freddie Mac, so to anwer your question, I continue to invest in mortgages. Others continue to buy less risky mortgages. The point is that they still maintain their intrinsic value, i.e. they pay better than other debt instruments and that is why they were bundled and served up in large portions to investors as "securitized debt."
Leo
-
I believe the reason that foreclosure rate only going from 1% to 2 or 3% is causing problem now is that in 2004 and 2005 prices were still going up or holding strong as the top did not come until late 2005. Therefore when the banks went to foreclosure they either sold it at the courthouse for a profit or took the property back and made money on the REO. Let me ask you if you look at one mortgage say in California that was originated in late 04 and the purchase price was $800,000 and was of course a neg am no down payment loan, now properties in this town are selling for 500,000 a 37% decline. Now this homeowner’s loan is going to adjust and the payments are going to double, they can’t refi because the houses next door are only selling for $500,000. There are billion, $ wise, of these type of loans. All the banks have these on their balance sheets, and this is why there is no market for the securities. What would you pay for a $800,000 note backed by a property worth $500,000?
John
John
Yes, the real problem is no one knows the full extent of what I call debt becomes asset becomes debt becomes asset structure we built. My point is that if a 1% foreclosure rate in 2004 and 2005 caused no problem, then a 2% rate should not bring down the house. I use the foreclosure rate in Lee County, where I sold homes, as my base number and it is the highest foreclosure rate in the nation. Do not confuse depressed value of homes with foreclosures. Loss of equity may induce many to stop paying their mortgages but that is a assumption. As I have laid out before, if you have a $1 million portfolio of mortgages backed by $100,000 in deposits or other reserves and there is a 2% foreclosure rate you stand to lose $20,000 in a year and reduce your reserves by that amount. You are still very solvent and earning on the $980,000 in other mortgages.
The problem is that those doing the valuations were panicked by the rising foreclosure rate and had no idea of the actual size of mortgage based securities. They simply devalued all mortgage based assets to the depressed value of the real estate market and they did not use a uniform valuation of the real estate market. I heard the CEO of BlackRock say they used the depressed value of the real estate market in Southern California as their bench mark.
My point remains that the underlying asset, mortgages, are still basically sound, so the assets built on them should not be devalued beyond the actual foreclosure rate. That is not what has happened. The result is an economy in the tank that has led to higher unemployment rates. And I will be the first to say that higher unemployment will lead to higher foreclosure rates. In essence we have built a self-fulfilling prophecy.
Leo C
----- Leo,
I understand that a very low percentage of loans are in default, but when you look at the market’s overall decline in value and add to that the leverage that some of the investment banks used it only takes a modest 5-10 percent decline in home values to wipe out all the capital. That is the real problem. There is not a liquidity problem it is a solvency problem. I agree that all the assets do not need to be marked to market because there really is not a market for some of the debt instruments and the majority are performing and can be valued at a discounted cash flow model. But with the securitization of the debt into different levels of risk it is nearly impossible to separate the good loans from the bad. From my experience here in Florida seeing first hand the amount of debt that lenders have on properties purchased between ‘04 and ’08 they are under water anywhere from 25% to 60% in certain areas. This amount of debt really gives no incentive for homeowners to continue paying their mortgage the best option for the lenders is to do an aggressive loan modification which includes principle reductions, which they have not been willing to do it will likely take tax payer money. There is a lot of moral hazard that could be created and could encourage a wave of new problems if not implemented correctly. I am attaching a report that really delves into how everything went wrong and what is happening now, it is a long read but lays it out pretty straightforward. If you are looking for the next shoe to drop I would take a look at what is going on in the credit card business. There models are not prepared for unemployment above 8%. Here is a little excerpt about leverage from the report:
…with Leverage?
How could $1.2 trillion in subprime mortgages outstanding cause such a large global financial disaster? Leverage
is certainly a part of the problem. If banks maintain a leverage ratio of 10:1, only $120 billion of capital can
support $1.2 trillion. With such a small amount supporting such risky loans, a 10 percent decline in the $1.2
trillion of assets could wipe out all of the banks’ capital. Of course, some institutions were more highly leveraged
than 10:1, and in some areas, home prices have fallen much more than 10 percent; so too has the value of the
subprime mortgages. (If the ratio were 30:1, which was the case with some firms, then the supporting capital
for $1.2 trillion would be only $40 billion.) These situations can force some institutions into insolvency if capital
cannot be raised to offset the decline in the value of assets.
Tuesday, February 3, 2009
THE OBAMA STIMULUS PLAN
I got an email from a friend asking me what I thought about President Obama's stimulus plan. Here is my reply:
My summary comment on the stimulus plan is that it doesn't matter how you spend it - build bridges, improve classrooms, automate medical reports, put money into research, and so on. The money will be spent and thus enter the economy. I am not very interested in the debate about the "proper" or "best way" to spend it. Tax incentives such as rebates will also induce more spending. I am not so sanguine about giving business tax breaks since, with already holding large inventories, I don't see why any company is going to invest in expanding supply. And we certainly do not need investment in automation to reduce labor costs. But by and large I really don't care how the money is spent, just spend it.
If you read my articles you will see that I have found the financial crisis to be the unnecessary child of panic reactions to a relatively small uptick in the foreclosure rate on mortgages. This rate was just over 1% in 2004. It was just over 2% in 2008. But this caused analysts to devalue all mortgage based securities, as well as mortgages themselves, by up to 90%. "Panic" devaluation of assets worth up to $70 trillion, the estimated $15 trillion in mortgages and bundled mortgages, and the estimated $55 trillion in credit default swaps created to insure these bundled mortgages, blew a big hole in our credit system. All financial institutions saw their balance sheets fall dramatically thereby ruining the whole credit system.
The financial crisis has now infected the whole economic picture with rising unemployment the key issue. Higher unemployment will undoubtedly make the problem much worse, since that affects consumption, that does not require credit. Needless to add, those unemployed will have no chance to get credit.
While I don't really care how the stimulus money is spent, I do not see it as the solution to the basic problem. We have taken maybe $35 trillion off the books and balance sheets of financial institutions and other investors. That is equivalent to twice the 2008 GNP for the whole USA. Uncle Sam has deep pockets but not that deep. He cannot replace this loss.
No, the only way to restore the economy to a sound basis is to give a more accurate value to the mortgage based securities and their further derivatives. To do this we have to suspend the "mark-to-market" rules that call for valuing assets to the "market." At present there is no market for mortgages and mortgage based securities (well there is, but no one knows where it is). Since the actual foreclosure rate is still not high, about 3% now, the actual potential loss on these securities would be just that, 3%. Given this relatively low loss, I say it is proper, indeed vital, to value these assets to their "maturity value" which means a mortgage held for its full period. If we do this we would automatically restore trillions of dollars, maybe $30 trillion, to the economy, instantly. I know that this is dismissed by those who maintain that the market is the only true indicator of an asset's worth, but how do you deal with an asset that has no market?
I am not alone in calling for this remedy. Steve Forbes is perhaps the most visible promoter of chucking out the "mark-to-market" rules.
No matter how the "crisis" plays out, it has produced a major change in the US economy, which has led to what I call , "The New Economy." What I mean is that the crisis has forced Uncle Sam to buy up substantial parts of the private sector - banking, insurance, mortgages and even the auto industry. He is now the single largest shareholder in "Corporate America." Until now the Federal Government has been the largest consumer of the economy, a budget that equals 20% of the whole economy, the central banker and the rules maker for the economy. Now Uncle Sam is the main shareholder. This changes the whole equation.
I have also noted that Uncle Sam has acquired this massive share of the private sector at not cost. Since all investors are shoveling their funds into Treasury Bonds to the point that they go for interest rates less than inflation, i.e. Uncle Sam gets funds to invest at no real cost. We have the absurd situation in which private investors are putting their money into government debt so that the government can buy up the private sector. The ridiculous has become the sublime.
Leo Cecchini
January, 2009
My summary comment on the stimulus plan is that it doesn't matter how you spend it - build bridges, improve classrooms, automate medical reports, put money into research, and so on. The money will be spent and thus enter the economy. I am not very interested in the debate about the "proper" or "best way" to spend it. Tax incentives such as rebates will also induce more spending. I am not so sanguine about giving business tax breaks since, with already holding large inventories, I don't see why any company is going to invest in expanding supply. And we certainly do not need investment in automation to reduce labor costs. But by and large I really don't care how the money is spent, just spend it.
If you read my articles you will see that I have found the financial crisis to be the unnecessary child of panic reactions to a relatively small uptick in the foreclosure rate on mortgages. This rate was just over 1% in 2004. It was just over 2% in 2008. But this caused analysts to devalue all mortgage based securities, as well as mortgages themselves, by up to 90%. "Panic" devaluation of assets worth up to $70 trillion, the estimated $15 trillion in mortgages and bundled mortgages, and the estimated $55 trillion in credit default swaps created to insure these bundled mortgages, blew a big hole in our credit system. All financial institutions saw their balance sheets fall dramatically thereby ruining the whole credit system.
The financial crisis has now infected the whole economic picture with rising unemployment the key issue. Higher unemployment will undoubtedly make the problem much worse, since that affects consumption, that does not require credit. Needless to add, those unemployed will have no chance to get credit.
While I don't really care how the stimulus money is spent, I do not see it as the solution to the basic problem. We have taken maybe $35 trillion off the books and balance sheets of financial institutions and other investors. That is equivalent to twice the 2008 GNP for the whole USA. Uncle Sam has deep pockets but not that deep. He cannot replace this loss.
No, the only way to restore the economy to a sound basis is to give a more accurate value to the mortgage based securities and their further derivatives. To do this we have to suspend the "mark-to-market" rules that call for valuing assets to the "market." At present there is no market for mortgages and mortgage based securities (well there is, but no one knows where it is). Since the actual foreclosure rate is still not high, about 3% now, the actual potential loss on these securities would be just that, 3%. Given this relatively low loss, I say it is proper, indeed vital, to value these assets to their "maturity value" which means a mortgage held for its full period. If we do this we would automatically restore trillions of dollars, maybe $30 trillion, to the economy, instantly. I know that this is dismissed by those who maintain that the market is the only true indicator of an asset's worth, but how do you deal with an asset that has no market?
I am not alone in calling for this remedy. Steve Forbes is perhaps the most visible promoter of chucking out the "mark-to-market" rules.
No matter how the "crisis" plays out, it has produced a major change in the US economy, which has led to what I call , "The New Economy." What I mean is that the crisis has forced Uncle Sam to buy up substantial parts of the private sector - banking, insurance, mortgages and even the auto industry. He is now the single largest shareholder in "Corporate America." Until now the Federal Government has been the largest consumer of the economy, a budget that equals 20% of the whole economy, the central banker and the rules maker for the economy. Now Uncle Sam is the main shareholder. This changes the whole equation.
I have also noted that Uncle Sam has acquired this massive share of the private sector at not cost. Since all investors are shoveling their funds into Treasury Bonds to the point that they go for interest rates less than inflation, i.e. Uncle Sam gets funds to invest at no real cost. We have the absurd situation in which private investors are putting their money into government debt so that the government can buy up the private sector. The ridiculous has become the sublime.
Leo Cecchini
January, 2009
Saturday, January 31, 2009
LET ME MAKE IT PERFECTLY CLEAR
A friend sent me an online video showing how poor regulation of Fannie Mae and Freddie Mac is to blame for our econ mic plight. Here is my reply:
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.
Leo Cecchini
January, 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.
Leo Cecchini
January, 2009
Wednesday, January 28, 2009
THE OBAMA PLAN: WILL IT SAVE THE ECONOMY?
I watched Steve Forbes being interviewed at the World Economic Forum in Davos, Switzerland. His simple, straightforward cure for the financial crisis is the same that I have been preaching since last summer, suspend the "mark-to-market" accounting rules. I have added that the rules are not being followed anyway. The so-called "toxic assets" or mortgage based assets have no market, thus if mark-to-market rules were strictly followed, they would be marked to zero. But that is not what is being done. They are being marked to notional markets that may or may not reflect the actual value of the asset.
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?
Leo Cecchini
January, 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?
Leo Cecchini
January, 2009
Wednesday, January 21, 2009
CORRECTING THE FINANCIAL CRISIS AND THE NEW ECONMOMY
The battle lines are drawn. The battle is to correct bank balance sheets and thus allow the financial system to return to its normal business of financing our economy. On the one side we find the "mark-to-market" warriors and on the other we find those who share my opinion that the market no longer values assets correctly.
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.
Leo Cecchini
January, 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.
Leo Cecchini
January, 2009
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