Throw in the Kitchen Sink!!

On the front page of today's Money & Investing section of the Wall Street Journal the front and center article outlined all the new plans the Federal Government is putting in place to boost consumer loans and help keep yields low. The article was titled Fear Recedes in the Debt Markets, and it is quite clear why. The Federal government has decided they can't decide what new tool implemented out of all the various options considered in the last few months, so they have decided to do them all! I would hope fears have receded because the whole financial market has been effectively backed by a boat load of government guarantees.  

Here is a list of each program proposed to be implemented thus far (that I know of), some are old favorites but the Fed has some nice new ones:

 Directly under the Treasury 

• Troubled Assets Relief Program (TARP) - this program has changed over the last couple of weeks. First introduced as a tool to purchase toxic assets off the balance sheets of financial institutions, Secretary Paulson indicated 2 weeks ago will instead be making direct equity contributions. He has also indicated that he will reserve nearly $400 billion for the use of the next administration. 

 Directly under the Federal Reserve

• Term Asset-Backed Securities Loan Facility (TALF). This facility will lend as much as $200 billion to holders of certain high grade securities backed by assets such as student loans, credit-card loans, auto loans and small-business loans. Only $20 million of this $200 Billion of which will be backed by TARP. 
• Direct purchase of $500 billion of mortgage bonds guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. 
• Direct purchase of $100 billion of Fannie, Freddie, Ginnie and the Federal Home Loan Bank debt securities through a reverse auction starting next week.  Apparently Secretary Paulson didn't see this fitting into TARP but someone thought it was still necessary. I am assuming this will allow toxic debt to come off of balance sheets and held by the Fed. 

 Directly under the FDIC 

• FDIC insurance on Financial Notes. This is a boost to the bond markets. The FDIC backed the first issuance of financial corporate bonds Tuesday when Goldman Sachs issued $5 Billion of three year notes. The Government backing nearly halved the yield on the notes to about 3.25%. 

 Looking over the list I see everything. I have not heard of any other finance industry related rescue plan since this crisis began. It seems as though the Federal Government couldn't decide what would work so they swooped in and backed everything. We will never be able to know if this was all necessary. I would never want to be in Secretary Paulson's place now, so I will only assume he is making the best choices he can given the information. I just hope this is enough to stem market fears in the long term and induce private investors back in the market because this is it. The government is out of ideas.  

The Company Lost Billions this Year But Where is My Bonus!

Over the last two weeks the gloom and doom economic reports seemed to have no end. Citi got another boost from the government, the auto companies pleaded for help, the entire "free market" as I knew it seemed to have dissolved. I was left wondering the why and how, and then I was given a bit of clarity. A large part of the problem may be a poor incentive structure that rewards executives for very risky, short term, decisions. I want to focus on two stories about two companies, Goldman Sachs and the audacity behind the executive request to forgo bonuses, and the severance checks for the executives of the fallen Wachovia. Both circumstances, although different, point out a unique nuance to our "free market" incentive structure, one that may be responsible for short sided decisions that can contribute to a cataclysmic demise of a multi-national goliath.  

 

It seemed oddly out of place the other day when I read that many Investment Banking Executives have decided not to take bonuses this year, sending letters to the board of directors requesting their usual bonuses not be offered.  What seemed so wrong about this story is the notion of Executives making a request. Over the years Goldman Sachs has posted some of the highest profits on Wall Street, and as a reward their top executives have seen healthy bonuses for leading this highly profitable company. Last year Lloyd Blankfein, CEO of Goldman, received a salary and bonus worth $68.5 million, almost all in bonuses (his salary was approximately $600,000). This very lucrative compensation is supposedly  awarded by the board of directors, representing happy stock holders and showing their power over the company’s leadership. The fact that the executives requested bonuses be withheld tells a much different story. An effective board would insist that the CEO who lost billions of dollars in stock value and nearly bankrupt the company would not receive a bonus. This effective board would never honor a request from executives to forego a bonus because it is not their decision to make. The Goldman Executive request shows the board does not really have the power of the purse, or any real control, it is all held with the corporate executive. This is a problem because the two groups represent different time horizons. The Executive view is short term, how can they make profits as high as possible year over year to justify a huge bonus at year end. In contract the board is supposed to represent longer view, ensuring company sustainability to ensure the company they own rises in value indefinitely. When the balance shifts completely to the executive view, because there is a powerless board, it results in short sided, quick profit decisions. In this case it meant diving head first into high risk sub-prime mortgages to get a $70 million pay day. The consequences are then left to the long term stock holders when the bets go wrong and the company is brought to its knees.

In yesterday’s Wall Street Journal, buried way back on page C5, was an article by Dan Fitzpatrick telling a story of the compensation received by executives in the wake of the Wachovia collapse. As a refresher Wachovia was one of the victims of the crisis, nearly collapsing under its exposure to sub-prime debt and eventually was acquired by Wells Fargo (Fargo won a fight for the company with Citi). In its wake was a devastated stock price, moving from about $50/share pre-crisis to today's value of about $5/share, and the prediction that most employees will be laid off as part of the acquisition. Today's WSJ article reports that the top 10 executives that controlled the helm of this company through its demise will be receiving a combined $98.1 million in severance for their fine work. I think a $100 million severance is a bit too high of a reward for destroying a company. Besides the obvious discomfort that comes with the fact that an executive is rewarded for bad work is the reality that this represents a backward incentive structure. In this case the severance is only accessible if the executive is let go. Similar to the Goldman situation they are now empowered to determine their salary. Looking at the fall of their stock options at some point a Wachovia executive would be better off letting the company fail and taking the severance rather than try to keep the company alive.

The stories of both companies point to an absurd incentive structure where executives may not be looking out for the best interest of their companies. By putting compensation decisions in the hands of those receiving compensation what is best for the company no longer persists, it turns into how someone can squeeze as much value out in a short period of time. In the Goldman case the CEO made very risky short term decisions to justify the enormous bonus he received, only to see the company approach collapse the next year. Then flexing his power, deemed it not necessary to receive a bonus for their own abysmal work. In the case of Wachovia one could assume at some point executives were inclined to cut and run from a failing company, a process that they put into motion. A publicly traded corporate structure means that at the end of the day shareholders have the ownership stake in a company, and therefore should be making the final decisions on the best path of a company. We toss around the phrase "a duty to the shareholder," but in these cases the phrase has little meaning. The above examples show real issues in the modern corporate structure because it does not hold Executives accountable over the long term. These are terrible market forces all working against long term sustainability and growth. 

Because I am never one to point out a problem without offering a solution, I will offer a simple and easy fix for this incentive structure: stock options only with a restriction on sale for 15 years.

For Wachovia a severance should only be offered as a certain number of stock shares and a restriction of sale for 15 years after the Executive leaves.  This assumes a severance is really necessary because of some belief that it is needed to attract talent. I really believe the best structure in this industry is no severance at all. Any highly paid executive has such a lucrative level of compensation that a comparable severance creates indifference for good work. (Go ahead and fire me I literally will make millions.) But if the market does somehow deem it necessary I think stock options instead of cash is a much better solution.

For the Goldman issue, the same solution. All executives of any company should only receive stock option bonuses, all with restrictions of sale of at least 15 years. By shifting from cash to stock with a long term outlook it would ensure decisions made in the short term are targeted at long term growth. If decisions made today go wrong these long term assets will be valueless.

This shift is not something that should be enforced by government but rather by shareholders through boards of directors. It is in the best interest of the stockholder to design a proper incentive structure; this change will do just that by making the executive reliant once again on the success of the company and the stockholder. 

Update on AIG, The President Defends The Invisible Hand of the Bailout

Today The Economist had a great article describing the need surrounding the revised AIG bailout. I assumed things at AIG had gone from bad to worse, prompting the government to react I just could not imagine a scenario that would cause such a lucrative government action (as I pointed out in my last article). I think The Economist describes the scenario nicely, and has the appropriate tone of how ridiculous things have become to result in a bailout of this size. In short AIG did not have the ability to repay the loan, and would have defaulted if the government did not act… again.

 

I find it ironic that this article describing the largest government bailout of any private company... ever, occurred on the same day the President made a speech (in the federal building on Wall Street) defending “American Capitalism”. The speech is not moving to any degree it has all the classic familiar President Bush elements including a 10 syllable limit per sentence, but you can find the full text here. For an excerpt, my favorite line completely out of context, “I'm a market-oriented guy, but not when I'm faced with the prospect of a global meltdown.” Such a wise businessman leading our country!

 There is one portion of the speech I want to focus on because it relates to AIG:

 “Secondly, we must ensure that markets, firms, and financial products are properly regulated. For example, credit default swaps -- financial products that insure against potential losses -- should be processed through centralized clearinghouses instead of through unregulated, "over the counter" markets. By bringing greater stability to this large and important financial sector, we reduce the risk to our overall financial systems.”  (note: I did not add the “” around "over the counter", it reads that way in the transcript, and I do not know what the president is referring to)

 I am curious what the President (really the Treasury, I think we all know this is not the President’s idea) has in mind for this clearinghouse. The President insists it prudent not to over regulate but how will the government set up this clearinghouse? AIG’s business and sole purpose of existence was to assess the risk of a security and assign the proper insurance premium to account for the risk level. Is the President implying a government vehicle can somehow be more efficient than this market driven entity, because clearly AIG was doing something wrong. I leave this to a future announcement of possibly (hopefully) our next president. 

When Government Becomes An Insurer: The AIG Revised Bailout

Every major U.S. Newspaper covered the revised AIG deal (WSJ,  NYTimes,  CNN,  MarketWatch,  Bloomberg) yesterday, but none of the articles explain the need for the revision.  As the NY Attorney General continues to probe some very lose spending habits post bailout,  I find it very difficult to trust this company, so any plan that shifts even more cost and risk to the government disturbs me a bit. Ideally we would examine the new needs AIG since the original bailout plan and how this revision satisfies those needs, but since need has not been made public we are left with comparing the old plan to the new. The analysis will show this is a much sweeter deal for AIG. This deal clearly puts more cost onto the government, injects significantly more capital into AIG, and gives all the momentous risk of real estate backed securities onto the taxpayer. I am left wondering in what way this is a better policy decision. 

When the first AIG bailout was announced I thought it was the best concept that had been put forward at the time. It was an $85 billion loan, the term was 2 years at 8.5% plus three-month LIBOR interest rate. In today's market the rate would be approximately 11%. The rate was way above prime which gave the incentive for the government to be a lender of last resort, the position the government should take in a free market economy. Together all of the above articles give enough detail on the revised plan to make some interesting comparisons between the old and new AIG bailout. (I thought the WSJ article was the best, even though the real juicy details were buried in the continued portion of the article on page A15 of the paper.) The new program reduces the loan amount to $60 billion, extends the term to 5 years and reduces the interest rate to 3% plus LIBOR, a total of about 5.5% interest rate in today's market. Hardly a deterrent for a lender of last resort, the government is giving a prime rate for an "emergency loan."

Here is a simplified (rounded to the nearest billion) chart comparison of the original and revised loan scenarios:

	Total Loan Amount	Total Interest Payments (nets out principle repayment)	Scheduled Monthly Payment (assumes 12 pmts/yr)
Original Bailout	85,000,000,000	10,000,000,000	4,000,000,000
Revised Loan Structure	60,000,000,000	8,000,000,000	1,000,000,000

 

In total there is a nominal loss of $2 billion in loan interest payments over the life of the loan.1 But what I think is most important here is the scheduled payment. The original plan had an extremely high month-to-month cost, which was a strong deterrent to use the program in the future. This is an important incentive structure the revised plan is missing which may make the government the first source of money instead of the last. 

Additionally the government will purchase $40 billion in preferred shares which bumps up the total upfront bailout cost by $15 billion (total of $100 billion loan+shares now compared to $85 billion loan originally). These shares will carry a 10% annual interest payment. How this 10% is calculated is  not entirely clear to me so I cannot do comparison against the original bailout. A preferred stock option usually pays a dividend, a certain dollar amount for each outstanding share, the WSJ states these shares "carry 10% annual interest payments", it is not clear if the payments are calculated off the principle $40 billion, or the value of the shares at time of payment (which would be calculated as: number of shares*share price at time of calculation). These details could have a significant impact as AIG shares still have the potential of dropping further, which would expose the government to further loss.  

The most interesting of the new proposals are two new entities that will be created to remove the toxic assets off of AIG's balance sheets. These entities will be almost entirely funded by the government. 

The first entity will be capitalized with $30 billion from the government and $5 billion from AIG. The entity will purchase securities that AIG agreed to insure with credit default swaps2.  The entity will pay about 50 cents on the dollar for these securities. Unless I am viewing this wrong, this vehicle will pay AIG Parent 50 cents for each dollar of toxic debt it takes off the balance sheets. Essentially allowing another $12.5 billion (half of the government infusion minus AIG portion plus the return of half of the AIG portion) to be added to the parent company's bailout in exchange for its riskiest holdings. The separate entity that now holds all of this toxic debt, is essentially a government funded (and therefore controlled) company, with very little chance of surviving, let alone returning a profit to the taxpayers. This seems like an extremely risky bet with tax dollars. 

I saved the best for last. The second entity is designed to solve the liquidity problem in AIG's securities-lending business. This business lent out securities to short sellers in exchange for collateral, AIG then took this collateral and invested it for gains.  Unfortunately for AIG these gains turned into losses and now they owe a substantial amount of money to return the collateral.This business epitomizes risky behavior and the bailout plan is a wonderful example of a terrible incentive structure. To establish  this entity the government is expected to foot a $20 billion bill, while AIG contributes $1 billion. The government will inherit all of these bad debts and AIG will walk away risk free. I cannot imagine a plan that rewards a company better for risky behavior. 

These two entities will essentially remove all of AIG's high risk debt and hand it over to the taxpayer. Taxpayers may see a positive return if these assets, which are tied to the housing market, begin to recover. But these entities also open taxpayers up to what I think is the more realistic scenario of losing a substantial amount more as these assets continue to decline in value.  In theory the housing market will eventually come back, and hopefully every penny invested in AIG will be returned, however this new program seems extremely lucrative to the surviving AIG entity and gives taxpayers an extremely risky portfolio. Without knowing the whole circumstance of AIG's current situation it is hard to judge if they are taking advantage of the situation, but when all the numbers are worked out in this new deal you can't help but think they are greatly benefiting from shedding all risk at little cost. From a policy perspective this seems to be the worst incentive structure I have seen thus far. The program has changed from making the government a lender of last resort, to a prime lender that pays a risky company's debts at little or no cost... Is this still America? 

 

 

1.   These are nominal calculations because I did not think it was appropriate to compare by present value since the government is not weighing the opportunity cost of two investments but rather the nominal value of two costs it will put onto AIG to use the government bailout.

2.   A credit default swap is insurance against a bond default.  

Economic History in the Making, Iceland’s “el error de diciembre”

As an economics student one of  the most fascinating topics I ever studied was the Mexican Peso Crisis (nicknamed “el error de diciembre”, in Mexico). When studying the Mexican crisis and the ripple effect it had through the developing world (the ripple was a run on several developing Asian countries because of a fear that even well maintained small economics were exposed to similar risk) I never thought it possible in a modern developed economy[1]. Now, after watching Iceland approach the brink of disaster I have an entirely new perspective. Here is a brief background on how a currency crisis occurs and overview of what is going on in Iceland.

 

 

 

Monetary Economics 101 - A brief background.

Currencies are traded on an open market. Businesses make transactions in a specific currency, and then deposit those transactions in a bank. The bank acts as a clearinghouse by trading large quantities of their deposits on the foreign exchange market so they can provide domestic currency to customers at local branches. The foreign exchange market determines the currency’s value using a supply and demand model.

 

The demand side of the market, can be described through a simplistic example. An Icelandic businessman makes a transaction in dollars, deposits the dollars in his Icelandic account, the Icelandic bank trades dollars for Krona in the foreign exchange market, then the Icelandic businessman is able to withdraw Krona and use it to buy things. This basic process happens in bulk countless times throughout the day, more demand to change dollars into Krona will push the value of Krona (relative to dollars) up.

 

The supply side of the market is controlled by a Country’s central bank. A central bank uses open market operations to reduce or increase the amount of currency in circulation, thereby inflating or deflating the currency. An open market operation can be demonstrated through another very simplified example. The Icelandic Central Bank holds several different currencies including U.S. Dollars. Through a direct open market transaction it can “buy” Krona using its dollars, then hoard the purchased Krona, thereby reducing the supply of Krona in circulation. Central banks can also indirectly effect the money supply through the interest rate (in the U.S. the federal funds rate). By increasing this rate a central bank makes it relatively more expensive for commercial banks to make loans, less loans means slowing general economic activity, which translates into lower amounts of circulating domestic currency.

 

During a currency crisis there is a sudden drop in demand for the at-risk currency. There is a fear that a country is having some catastrophic problem, and will not be able to control the value of the currency through an open market operation. As demand for the currency drops, the value of the currency (in relation to other currencies) follows. A central bank can raise interest rates and/or buy domestic currency directly in the foreign exchange market using foreign denominated assets (from the example above a central bank can take all the US dollars it holds and buy as many Krona as possible to hoard from the market, which decreases supply). These actions will attempt to curb the fleeting value of the domestic currency measured as the inflation rate. The problem is if the fear factor that set off the crisis cannot be stemmed. As world demand for a currency spirals downward a central bank will have an increasingly difficult time keeping up on the supply side. Just as a bank run this is a self fulfilling prophecy, a country’s currency is perceived to be highly risky, so demand for the currency drops, and that makes the currency even more risky. A central bank will continue to fight the run on the currency by continuing to contract the money supply, but once this snowball starts it is often difficult to stop.

 

This crisis also has far reaching effects on the domestic economy. With the central banks raising the interest rate there is an automatic cooling effect on the economy, unemployment will start to creep up and business credit will slow. For small and developing countries there is often a huge problem with foreign debts. If a business has any debts denominated in foreign currency a rapid inflation can be devastating. For example if I owe someone $100 when 1 dollar = 1 Krona, and now 1 dollar – 10 Krona my debt just increased to $1,000. Multiply by the billions of dollars in trade and even the slightest drop in value could bankrupt a country.

 

 

What happened to Iceland

On October 7^th Iceland made drastic moves to protect its financial system by nationalizing two of its three major banks. Within days the last and largest of the three banks was also swept under the control of the Icelandic central bank, triggering a fear driven collapse of the foreign exchange market for the Icelandic Krona. It is a mark of how serious the liquidity crisis has become.[2] The fear was that Iceland was overexposed to U.S. sub-prime real estate market, and the Icelandic banks would not be able to meet their debt obligations given the collapse of the real estate market. Once controlled by the Icelandic Government, the concern passed onto the central bank. Further a lot of these debt obligations are denominated in U.S. dollars, and as noted above this can compound debt many times larger than its original principle. This tiny country with far less citizens than many U.S. cities was forced to defend its currency against a run.

 

Iceland at the start of this financial crisis had all cards stacked against them. The country’s leading export in recent years is financial services. Iceland’s major banks were heavily leveraged in foreign mortgage markets which were all denominated in foreign currency. It led to a boom in Iceland’s GDP during the golden years but left the country open to a disaster when the U.S. housing bubble popped. As soon as the instability was apparent Iceland’s central bank immediately requested support from allied nations to shore up the balance sheets of its financial institutions with foreign investment. Unfortunately with all major countries looking at a global recession Iceland suddenly found itself without any friends. The member of NATO found its only hope for survival with Russia, and the IMF.

 

The central bank followed protocol, and raised its key interest rate 6 points overnight on October 28th, putting the rate at 18%. The estimated $6 billion IMF loan will be denominated in dollars giving some added protection to shore up the currency but the country is facing some serious economic hardship ahead, adding fuel to the problem.

 

To add insult to injury Iceland probably never expected to be stabbed in the back by the Brits! An important modern twist to this story was reported in last Sunday’s New York Times. For reasons described above Iceland moved to liquidate many of their non-Krona based assets in an effort to buy up as much Krona as possible. Britain, fearful that Iceland may default on their government debt held in British banks, used a broadly defined anti-terrorism law to freeze all Icelandic assets held within the country. In one quick move Britain classified this NATO ally as a terrorist state, and tied their hands from protecting their currency. The public relations disaster did not help in curbing the fear that the country could not meat its debt obligations, further fueling the problem.

 

Iceland’s situation is a tragic piece of economic history. The country has not survived this crisis yet, there are dismal growth projections and still the possibility of hyper inflation but I am confident it will overcome eventually and sit next to Mexico, and the Asian countries as another to weather the storm. In a final note when Mexico entered their crisis in 1994 the U.S. stepped up through a series of emergency loans to try to stabilize the country. It is sad to see (obviously we were in a much better situation in ‘94) we could not have done the same for Iceland, and even sadder to see the acts of Britain in their time of need.

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[1] Britain had a devastating run on the Pound in 1931 when it abandoned the gold standard, which is why I specify modern developed economies.

[2] This is not the only currency crisis occurring right now. There is the well known currency crisis that has gone on for a long time in Zimbabwe that is absolutely out of control. In August the inflation rate in Zimbabwe hit 11.2 million percent. I would argue this is not due to the global credit crisis as much as it is a result of a mismanaged government. 

When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 3of3)

In the first two parts of this series I discussed two of the leading programs currently being considered to solve the home mortgage crisis in America. In this final installment I would like to address a widely ignored issue, the moral hazard these policies create by providing publicly funded safety nets for risky practices. I do not contest that something needs to be done to protect our financial institutions, however I do believe it should be considering when deciding which is the best rescue policy.


Circling back to a discussion I started in “Truly understanding the credit crisis, and why this isn’t really all Alan Greenspans’s fault” I think it is important to examine the risk structure these policies are creating. The lending side of this crisis was fueled by an incentive structure that put risk onto public entities while the benefits were held by private banks. Both proposals presented in this series make this incentive structure worse by moving more risk from banks to the Government, thereby creating a moral hazard which encourages risky behavior. Given the situation we are in we may be left with choosing the better of two evils for the sake of saving our country’s financial market, but it is worth an exercise to examine both proposals through this lens.

A loan guarantee is a strong moral hazard for both the lender and the borrower. In this case the borrower is rewarded by receiving a government backing for real estate they cannot (and never could) really afford and the lender receives an unwarranted guarantee for lending to risky borrowers. It is easy to see the moral hazard here. If the bank is able to lend to risky borrowers in good times, and then receive government backing for these loans in bad, what becomes of the risk adverse incentive to have strict underwriting requirements? I also outlined in my first installment of this series how this program creates an extra reward for banks if they foreclose, possibly creating more of an incentive to foreclose. This program creates a win win deal for banks (win if they continue poor underwriting practices, and win if their bets go wrong and have to foreclose) who made poor decisions. The guarantee program has not included any discussion about adding cost to banks or troubled home owners to make the government option a last resort, and a guarantee inherently does not have the flexibility to punish lenders for making the risky loan in the first place. Of all options this one seems to have the worst long term consequences.[1]

A program similar to the HOLC also has some moral hazard issues, but can be designed to “punish” borrowers, and to some extend lenders, for their risks. As I noted in part 2 extending the term of mortgages are a key part of this policy. As such borrowers will need to maintain their entire debt service. A borrower will not be rewarded for taking the risk of an unsustainable home purchase price. If I were designing this policy I would also recommend adding some additional costs onto the troubled buyer. These costs should be high enough to prevent performing mortgage holders from abandoning their private loan because the government program is more favorable. These costs can best be added through deed restrictions, which could prevent a homeowner from selling their property for a certain time period. It is similar to the way New York City (and possibly other cities) prevent recipients of below market housing to profit by quickly flipping their property. The policy will keep troubled borrowers in their homes, punish them for risky decisions, and make the government program a last resort instead of a first. For banks the story is not as easy. A cost can be added by purchasing the mortgage at "bargain prices" essentially paying some discount from the principle+amortized value of the loan. This will further help the government to reissue the loan at a lower interest rate. But this punishment should not be so great that the bank is better off foreclosing. It will have to be a delicate balancing act but at least the flexibility exists.

Hopefully Alan Greenspan was right when he last spoke to Congress saying this is a “once in a century event.” If true, the Government will not be constantly needed to keep our financial markets healthy. It is difficult to think of a perfect policy where a Moral Hazard could be completely avoided, after the $700 Billion bailout bill was past the damage was already done. We can however try to prevent the next crisis. Any government bail out program must come with some innovative, yet flexible, new regulation. I think the bulk of this new regulation will be left to our next President (the Republican's do not want to touch that) so I wait with baited breath to see what President Obama will be coming up with.

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[1] With all discussion about how bad government guarantees are, I thought it appropriate to describe a situation where it works. The government can solve a market failure with a guarantee. Micro loans (average of $10,000) are a great example. These loans are too costly to issue for banks because they are risky and provide low return, but are vital for micro-business (1-15 employees). A guarantee on these loans make them more cost efficient because they lower the risk, giving micro-business access to much needed credit and banks a cost savings inducing them to lend. Note these are always for new loans and do not address businesses that are over leveraged.

Nice To Know Henry Paulson Agrees a Loan Guarantee Will Not Work

Today’s Wall Street Journal shed some new light on the Government’s plan to create a loan guarantee program. The article indicates that Henry Paulson seems to agree with my analysis that a programs only targeting interest rates will not solve the fundamentals of the mortgage crisis, namely that the average troubled borrower is overleveraged. The October 30th New York Times article was a bit vague on detail for the loan guarantee and led me to believe this was a program being pushed by the Treasury. Today’s WSJ (sorry the website link above is subscription only, it appears p. A2 in the paper) describes the plan as one of several plans the White House is considering, and is being formulated and pushed by the FDIC, not the Treasury.

Mr. Paletta and Mrs. Solomon, the WSJ authors, briefly outline Mr. Paulson’s objection with the plan. The authors write, “Treasury Secretary Henry Paulson agrees with FDIC Chairman Sheila Bair that the administration needs to take additional steps to help homeowners, but has concerns with some aspects of Ms. Bair’s proposal… Among his concerns is that sharing eventual losses with the government could give lenders an incentive to push homeowners into foreclosure.” Secretary Paulson seems to share a concern I outlined in “When government becomes a bank, anyone else concerned with moral hazard? (part 1 of 3)”. My concern which Secretary seems to share, is that a guarantee may make the crisis worse by putting a new and dangerous incentive structure in place to encourage foreclosure.

As the recession deepens high risk borrowers become even riskier. To keep interest rates artificially low (perhaps as low as 3% ) the government will have to increase the guarantee to compensate. At some point the guarantee will be so high a bank will be better off cutting their losses and foreclosing on a property, selling it at auction, and collecting the government guarantee. It is an important concern that the FDIC should really consider when pushing their plan.

Further I think it is important to note the WSJ article does not address how a guarantee could address the fundamental problem that many homeowners are overleveraged. Without addressing how to manage exorbitant principles that were incurred during the real estate bubble, I do not believe the plan can be considered a comprehensive policy that creates an effective market structures.

The article also did not elaborate on any key details for government restrictions on restructured loans, which may make this program even less effective because it adds cost and reduces flexibility.

I am pleased to see that Secretary Paulson is insisting we do not hurry into a program because it sounds advantageous politically, but rather insists on creating policies that create effective market structures.

When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 2 of 3)

Since the last debate Senator McCain cannot stop talking about renegotiating mortgages. I am partial to a plan that is in the likeness of the Home Owners Loan Corporation (HOLC), although I should make it clear this is not the Senator’s idea. Thanks belong to FDR (or one of his brilliant advisors) and Chairman Bernanke who happens to be a great depression scholar. Bernanke and Secretary Paulson reintroduced America to this concept over the summer, way before McCain claimed it for his own in the last debate at the end of October. The details of any government backed plan have not been released but this article will take a look at how a potential program could help the current crisis.

Part 2 - Home Owners Loan Corporation

A program like the HOLC has two core principals: (1) A government lasts forever, which means they can wait forever for a return on investment; (2) A government has easy and inexpensive access to capital by way of issuing treasury bonds. Putting these two principles together the HOLC worked by issuing long term cheap government debt, and then used this capital to buy out troubled mortgages, taking the place of a private bank. The terms of the restructured mortgages were also extended (allowable by principle 1) spreading out the mortgage amount over more payments, which reduced the monthly payments substantially. [1]

Access to inexpensive capital will help the general liquidity crisis the banks are experiencing and allow homeowners access to a fixed rate. One can easily imagine a government backed program that can offer even the riskiest lender somewhere around a prime rate because the cost to obtain capital is so low. Today’s 10 year treasury sits just below 4%, add approximately 3 points for administration costs (I think this may be underestimating for a government run program of this size) and you have just about today’s Wall Street Prime. With this in place we can get homeowners out of their high adjustable rates and down to a reasonable 7%.

To address the problem of the overleveraged troubled borrower outlined in my previous installment, the term of each loan must be a cornerstone of the program, which may be politically sensitive. The 1930s HOLC program extended terms from the common 10 years to one more typical of today’s market, 25-30 years. As a core principle of this program the restructured mortgages must increase the term of the loan to reduce monthly payments. By extending the term the inflated principle can be spread out over a longer period, reducing monthly payments to an affordable level, keeping borrowers in their homes, and allowing the real estate market to turn around. I can only assume today’s 30 year mortgages would need to be extended to a minimum of 50 years, possibly longer depending on an applicants mortgage amount. The increased term makes these inflated prices affordable on a monthly basis avoiding foreclosures. I anticipate political sensitivity because a 50 year mortgage is a very new concept to most Americans (not all, it has had a limited introduction in very expensive markets, New York and California). It brings with it the reality that mortgages may be passed down through generations and a new time horizon for owning a home that many Americans may not be comfortable with. I think this John McCain is not telling Americans about this important concept because he cannot sell it in a 40 second news clip.

A new HOLC is a good idea but we all have to recognize it will take time and have some upfront government costs. The administrative cost can (ands should) be tied up into the issuance of each loan but this is a massive government undertaking and should not be taken lightly. As of September 4 million American Homeowners, many more may be making payments but barely staying above water. These troubled mortgages will need to be reassessed through this program. The loans will have to be underwritten again, and a reasonable long term debt service established. Individual attention will need to be given to each applicant which prevents a cost saving pre-packaged design. Since a general form cannot be created, loan officers with a fairly high skill level will be needed to run this process (lucky enough there are a lot of bankers looking for work right now). Dare I suggest Freddy and Fannie could do the work because they may have the infrastructure. If this were to occur they would have to act as government agents, restricted from profiting from the new loans while the government takes on all the risk otherwise we will create another bubble (see “Truly understanding the credit crisis and why it isn’t all Greenspan’s fault). The ideal would be an organization that acts solely in interest of the government, (is the government) and with the goal of structuring loans that protect taxpayer capital. Government once again becomes our bank. Sound expensive and complicated? – It will be, but at least it might work.

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[1] I have just recently started educating myself on the details of the HOLC process. I do not claim to be a great depression scholar but this site was great for a pointed description and the Washington Post had a great article back in the spring.