Most attribute the "The Financial Crisis of 2008" to "securitized or collateralized debt" or bundled mortgages which allowed credit to grow far beyond previous systems. These comprised the so-called "toxic assets" which the Feds now call "legacy assets." I use the term "mortgage based assets."
Well guess what, we will now go back to using "securitized debt" to revive the economy. The first will be securitized mortgages. Uncle Sam now controls Fannie Mae and Freddie Mac and thus over half the mortgages in the USA. The Geithner Plan calls for putting $400 billion into these two organizations to push home sales. These new funds will be used to, you got it, bundle new or reworked loans into securitized debt to be held by Fannie and Freddie or sold on with Fannie and Freddie guarantees.
To complement this move the Federal Reserve will now open its, "Term Asset Backed Security Loan Facility," (TABSLF). It will use this to buy up non-home loans, e.g. auto loans, commercial credits, credit card debt. It will then bundle these loans and sell them as "securitized debt."
What's that you say, we are headed right back to where we started the bust, "securitized debt." Yes we are, but with a big difference, the Feds will be in the driver's seat. Presumably the entire process will be transparent and valuations will therefore be more precise. More importantly, Uncle Sam will hold most of the debt. Again, he does not have to sell these bonds and can hold them to maturity. That means that the assets will not have to be "marked-to-market," but valued at long term or maturity values, the very thing I have been demanding from the beginning.
The rest of the world has now learned what I, and some others, have recognized for a long time, the US economy has been enjoying strong growth over the last two decades because of the innovative new ways of creating credit. Unfortunately the market analysts were not able to correctly value these new debt based assets. They valued the mortgage based assets on the property market instead of the mortgages themselves. By valuing them at the property market they devalued them by at least one third. If they had valued them to the mortgages themselves they would have devalued them by the actual loss to foreclosures, i.e. less than 3%. The result has been the "financial meltdown" followed by the "economic crisis."
We have come through a laborious process to arrive at the same place we were up until about a year or two ago. But again, this time Uncle Sam will be controlling the process, so it should be more sound.
Of course the bottom line is the "New Economy," or an economy in which the Federal Government will have even more control over its progress. As I have said repeatedly, Uncle Sam already was the central banker, rules maker and largest consumer of the economy. Now he owns the mortgage business, the largest and growing share of banking, the largest insurance company, much of the auto industry and more. His next big buy will probably be the health sector since no one else can put it on a financially sound basis.
Yes, we have a "New Economy" in which the private sector will be even more dominated by the public sector. I suggest you make your personal plans accordingly.
Leo Cecchini
February, 2009
Tuesday, February 24, 2009
Wednesday, February 18, 2009
SAVE OUR HOMES
President Obama has unveiled his program to save our homes. The focus of the program is to stabilize home values, thus stabilizing the value of mortgages based on those homes, thus stabilizing the mortgage based securities. Whew, sounds like a complex, round-about route to doing what I have been demanding in my articles. I suggested simply revaluing mortgages to "maturity" values, instead of the "market."
But the Obama housing plan does have popular appeal. It is being sold by talking about saving your home, instead of such exotica as stabilizing values of mortgage based securities. It should sell well.
As for the details, there are parts that will work and parts that could be disastrous. First, the workable parts. Under the plan Uncle Sam will pump up to $400billion in new funds into Fannie Mae and Freddie Mac, the two mortgage giants that house over half the mortgages in the USA. Uncle Sam now owns these two outfits. This is almost a no-brainer, put more money into the two mortgage giants and mortgages will be more readily available. This program will do much to help.
I also like the provisions to forestall foreclosures. Several actions designed to do this have already been adopted by the government and private lenders in the last year. The Feds will do well to increase this effort by providing funds to make them work.
I have problems with the plan to combine public and private funds to lower the payment on mortgages not in danger of foreclosure. The intention is to help people with "underwater, upside down, or negative equity" situations, i.e. the house is worth less than the mortgage on the house. The plan calls for bringing the payment to less than 31% of the home owner's income. Not hard to see where this came from, that was the FHA rule used by mortgage brokers to give the loan in the first place, be it an FHA loan or otherwise. Of course this will help those who have seen their income go down or their mortgage payment go up smartly. But the vast majority of loans have not seen their cost go up and home owners, by and large, still see the same income.
The real problem with this measure is that it allows for substantial fraud. We all saw fraud in issuing mortgages. The fraud typically came in determining what constitutes 31% of a home owner's income. The fraud in issuing the loan involved including "phantom" income. The fraud in this new case will involve excluding unreported income. The way it will happen is that the mortgage broker will tell his client to hide income that does not show up in public records. Anyone in the middle of doing his taxes knows about this. If you need advice, just ask former Senator Daschle.
The next problem with this also comes from the complexity of melding public and private funds. The private lender will try to maximize the Feds payment for any loss due to bringing the loan payment to the magic 31% limit. Redoing one of these loans will take very skilled operators and there are very few of these. I can see mountains of complaints and infractions of law in this process.
As bad as this proposal may become, it pales in comparison with the idea of allowing mortgage balances to be decreased to the present value of a home. Again, a mortgage is not property. This could open a Pandora's Box of every mortgage holder trying to dump part of what he owes. The way it would work is to allow judges to decide that mortgage balances excess to home values are "unsecured" debt. Ridiculous. Mortgages are backed by promissory notes that say the borrower pledges all his resources to paying the debt, not just the collateral property. A very dangerous move.
While I have problems with some of the program, in sum this could be a good PR program. "Save our homes" has a good ring to it. But as I have said all along, ending foreclosures will not correct the mess, since the foreclosure rate is not really high, about 3%. It may help the individual home owner, but it is too uncertain and too late to correct the credit freeze. It could also cause even larger problems.
Leo Cecchini
February, 2009
But the Obama housing plan does have popular appeal. It is being sold by talking about saving your home, instead of such exotica as stabilizing values of mortgage based securities. It should sell well.
As for the details, there are parts that will work and parts that could be disastrous. First, the workable parts. Under the plan Uncle Sam will pump up to $400billion in new funds into Fannie Mae and Freddie Mac, the two mortgage giants that house over half the mortgages in the USA. Uncle Sam now owns these two outfits. This is almost a no-brainer, put more money into the two mortgage giants and mortgages will be more readily available. This program will do much to help.
I also like the provisions to forestall foreclosures. Several actions designed to do this have already been adopted by the government and private lenders in the last year. The Feds will do well to increase this effort by providing funds to make them work.
I have problems with the plan to combine public and private funds to lower the payment on mortgages not in danger of foreclosure. The intention is to help people with "underwater, upside down, or negative equity" situations, i.e. the house is worth less than the mortgage on the house. The plan calls for bringing the payment to less than 31% of the home owner's income. Not hard to see where this came from, that was the FHA rule used by mortgage brokers to give the loan in the first place, be it an FHA loan or otherwise. Of course this will help those who have seen their income go down or their mortgage payment go up smartly. But the vast majority of loans have not seen their cost go up and home owners, by and large, still see the same income.
The real problem with this measure is that it allows for substantial fraud. We all saw fraud in issuing mortgages. The fraud typically came in determining what constitutes 31% of a home owner's income. The fraud in issuing the loan involved including "phantom" income. The fraud in this new case will involve excluding unreported income. The way it will happen is that the mortgage broker will tell his client to hide income that does not show up in public records. Anyone in the middle of doing his taxes knows about this. If you need advice, just ask former Senator Daschle.
The next problem with this also comes from the complexity of melding public and private funds. The private lender will try to maximize the Feds payment for any loss due to bringing the loan payment to the magic 31% limit. Redoing one of these loans will take very skilled operators and there are very few of these. I can see mountains of complaints and infractions of law in this process.
As bad as this proposal may become, it pales in comparison with the idea of allowing mortgage balances to be decreased to the present value of a home. Again, a mortgage is not property. This could open a Pandora's Box of every mortgage holder trying to dump part of what he owes. The way it would work is to allow judges to decide that mortgage balances excess to home values are "unsecured" debt. Ridiculous. Mortgages are backed by promissory notes that say the borrower pledges all his resources to paying the debt, not just the collateral property. A very dangerous move.
While I have problems with some of the program, in sum this could be a good PR program. "Save our homes" has a good ring to it. But as I have said all along, ending foreclosures will not correct the mess, since the foreclosure rate is not really high, about 3%. It may help the individual home owner, but it is too uncertain and too late to correct the credit freeze. It could also cause even larger problems.
Leo Cecchini
February, 2009
AT WHAT COST?
Let's review the cost of the massive federal government effort to revive (save?) the economy. First is the TARP plan adopted last fall at a cost of $700 billion. Now we have the Obama Stimulus Plan with a $789 billion price tag. The new Financial Stability Plan speaks of spending up to $1 trillion to buy up undervalued assets. This adds up to maybe a total cost of some $2.5 trillion, a sum equal to one-sixth of the US GDP (total output for the year) or just short of the current federal government budget.
Next let us remember that all of this cost will be paid from borrowed funds, not current income. In other words Uncle Sam's famous "national debt" will increase by maybe $2.5 trillion. The national debt now stands at some $11 trillion which is equal to 75% of the GDP.
What's that you say? We will burden our children, grandchildren, in fact our entire lineage with debt. Guess what, the United States of America has been in debt since the day it was born. In 1791 US Government debt amounted to some $75 million. We usually measure the size of the national debt against our national income. The highest point reached on this scale was at the end of the Second World War when US debt was equal to 120% of GDP. The USA has always been in debt, and will continue to be so for the duration of the Republic.
Back to the recovery plan cost. Uncle Sam will borrow up to $2.5 trillion. But at present the cost of this borrowing is relatively small, maybe 1% interest per year. This is because everyone is putting his funds into Treasury Bills that are considered as "good as cash" since they are backed by the Republic itself, just like the bucks in your pocket. So the actual cost of the borrowing will be $25 billion per year, a very small cut from the Federal budget for 2009 of over $3 trillion.
Let me make it perfectly clear, the cost of the recovery effort will be relatively small, less than 1% of the federal budget per year. I would suggest that the Obama team highlight this fact when it makes its pitch for public support.
As interesting as this may be it does not reveal the truly fascinating aspect of this process. As I have been saying for the last six months Uncle Sam is buying up the private sector at little or no cost. It took the Bolsheviks a sea of blood to do this in Russia. Uncle Sam is doing it for peanuts.
I can hear the chorus now, "socialism." Well if this be "socialism," so be it. The private sector has withdrawn from the battlefield leaving Uncle Sam to soldier on alone. Yes, the Financial Stability Plan calls for joining private with public funds to buy up undervalued assets. But I fear that the private sector will put few funds into this plan. Private investors ain't doing it now, so why expect them to do so in the future?
Where does it all end? I repeat that this is fascinating stuff. We are in the midst of creating a "New Economy" and no one really knows what the final product will be. Stick with me on this amazing journey.
Leo Cecchini
February, 2009
Next let us remember that all of this cost will be paid from borrowed funds, not current income. In other words Uncle Sam's famous "national debt" will increase by maybe $2.5 trillion. The national debt now stands at some $11 trillion which is equal to 75% of the GDP.
What's that you say? We will burden our children, grandchildren, in fact our entire lineage with debt. Guess what, the United States of America has been in debt since the day it was born. In 1791 US Government debt amounted to some $75 million. We usually measure the size of the national debt against our national income. The highest point reached on this scale was at the end of the Second World War when US debt was equal to 120% of GDP. The USA has always been in debt, and will continue to be so for the duration of the Republic.
Back to the recovery plan cost. Uncle Sam will borrow up to $2.5 trillion. But at present the cost of this borrowing is relatively small, maybe 1% interest per year. This is because everyone is putting his funds into Treasury Bills that are considered as "good as cash" since they are backed by the Republic itself, just like the bucks in your pocket. So the actual cost of the borrowing will be $25 billion per year, a very small cut from the Federal budget for 2009 of over $3 trillion.
Let me make it perfectly clear, the cost of the recovery effort will be relatively small, less than 1% of the federal budget per year. I would suggest that the Obama team highlight this fact when it makes its pitch for public support.
As interesting as this may be it does not reveal the truly fascinating aspect of this process. As I have been saying for the last six months Uncle Sam is buying up the private sector at little or no cost. It took the Bolsheviks a sea of blood to do this in Russia. Uncle Sam is doing it for peanuts.
I can hear the chorus now, "socialism." Well if this be "socialism," so be it. The private sector has withdrawn from the battlefield leaving Uncle Sam to soldier on alone. Yes, the Financial Stability Plan calls for joining private with public funds to buy up undervalued assets. But I fear that the private sector will put few funds into this plan. Private investors ain't doing it now, so why expect them to do so in the future?
Where does it all end? I repeat that this is fascinating stuff. We are in the midst of creating a "New Economy" and no one really knows what the final product will be. Stick with me on this amazing journey.
Leo Cecchini
February, 2009
Tuesday, February 17, 2009
BYE BYE NEW YORK, HELLO DC
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.
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.
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
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