As we pass the 1-year mark of having averted the collapse of the financial system, and 8 months since Treasury Secretary Geithner came up with (but never executed) a solution to banking liquidity, its time to ask where we have gone and where we are going.
At the end of Febuary, I recommended that ‘to big to fail’ banks be told to write down, over 30 years, their toxic-loan portfollio, thereby avoiding large government expenditures while penalizing the banks that made such loans, in a controlled way. And I suggested that the stress test was a backdoor to nationalization (which, incidentally, would have been my second choice as a solution).
So what happened?
Geithner came up with a plan that esentially allowed private investors to get a risk free (no penalty for default) loan that amounted to $19 from the government for every $1 put at risk by the investor. This zero-risk loan could be used to purchase the toxic mortgages.
The were several problems with this idea, though, from the total lack of penalty for extremely high risk behavior by banks to the taxpayer cost. And large banks could have sold their bad bundled mortgages for over 80% of face value, then, a few years later, purchased them back for a small fraction of what they sold them for in the first place. The bond investors would have made money, the banks would have made money, the taxpayer would have funded it all.
The plan never got off the ground because an all to under-reported change in accounting rules eliminated the need to proceed on any large scale with Geithner’s plan. In reality, the rule change really was his plan in the first place.
The accounting change, in April, allowed banks to avoid reporting any more loan losses from toxic mortgages if the bonds were going to be held to maturity. This bury the head in the sand approach also made it virtually impossible to fail a stress test.
This was a half-assed version of my proposal, with two distinct differences. First, there is no controlled writedown. Instead, banks take losses at their leisure in the coming years.
And when the banks decide when to try to recover from the losses, they indeed are far too aggressive. As should have been expected, they are hoarding money to offset worthless mortgage securities.
I recommended the losses be taken evenly over 30 years. Building reserves could then take place over time, allowing them to get back to the business of lending money out again.
It should be no surprise (except apparently to Treasury Secretary Geithner, who, somehow managed to pass in incompetance his predecessor, Secretary Paulson) that we are in a jobless recovery. Ask any entrepreneur, the banks are not lending money. The small business segment of the economy accounts for 50% of employment Because small business can not get working capital loans, not to mention loans for expansion, they are cutting back on payrolls in order to survive.
Recently Geithner rejected republican attacks on his competence stating that the economy was near depression and he saved it. While I would dis-agree with him on how he has helped the economy, I would propose that his job should be measured instead by the stability of the financial system: banks are not lending. This we know. That is the first measure of how he is doing his job.
The second difference in what I proposed versus what actually happened was that there was never any effort to solve the mortgage crisis.
In foreclosure, the banks loose at least 40% of the loan.
They would actually make more if bankruptcy judges could write down principle. I proposed that bankruptcy judges be given to authority to write down principle to an amount about 20% greater than the foreclosure value. But banks have resisted and politicians, both democrat and republican, have followed the demands of the banks.
If bankruptcy judges could write down loans, we could see foreclosures finally clearing the market in 2010 or 2011.
But as it is, we will be lucky to see the foreclosure crisis end before another five years.
And lasting economic recovery will not occur until both of the fundamental problems are solved:
1) Until banks lend again, small businesses will struggle, cutting costs instead of expanding. The jobless recovery will continue.
2) Until there is meaningful pressure on the banks to avert foreclosure, the housing market will not significantly recover.
So there are some bad signs for economy ahead, even as the economy starts to expand. Small business can not get capital. Foreclosures continue to devistate neighborhoods. And the ’stimilus’ funds run out late next year.
We are heading for the second dip in a double dip recession late next year or 2011.
It could still be averted. But Geithner is not up to the job.
Ideas taking hold in the banking crisis will have us in our own economic malaise. We need to learn from Japan’s mistakes.
We are creating solutions for a problem incorrectly defined. It was never about liquidity of toxic assets, as asserted by the Bush administration. Two years from now or 10 years, it does not matter, these so called ‘toxic’ assets never return to face value. Of sub-prime loans, almost 25% are 30 or more days delinquent. This number has been getting worse, and, with increasing job losses and scheduled rate resets, this downward trend continues.
The banks claim to be reworking loans, but, often, the interest only period is merely extended. Specifics aside, modifications have in common that the change is ephemeral. Over 50% of all modifications are in re-default by 30 days or more, only six months after an adjustment.
Liquidity is not the primary issue as these loans are worth a shrinking fraction of their face value. In the first half of 2008, the value of a foreclosed property was 40% less than the amount owed to the bank. With recent data showing that in 2008 home prices dropped over 30% in markets where the foreclosure crisis is at its worst, asset-recovery is likely far lower now.
Banks would often be better off modifying principle but its not a real option because, to do so on a mass scale, obliterates their capital. So, instead of reducing a note by 1/3, for example, they instead take over a 50% loss on foreclosure, giving them more time before the loss hits their books. It’s a game; the loss is already there.
A stress test of the banks, as proposed by the Obama administration, is a horrible idea. It’s a code for pending nationalization, which while among the popular proposals to fix this problem, fails for several reasons.
It is extremely costly: Many top banks will not pass. It puts banks that are have exposure to toxic assets, but even so are solvent, at risk as private capital sources immediately dry up with investors fearing ‘it will be next.’ Strong institutions are penalized for good risk management by having now to now compete with the Treasury. And rational decision making for the government run bank is deferred to political realities.
Buying toxic assets and reselling them fails too. For buyers to have confidence they can dispose of the assets, ideally through restructurings but foreclosures as well, they will have to be sold at a significant discounts. Valuation will be a huge obstacle. In the long run it works, but it is very costly to the taxpayer as the largest burden of the write-downs falls on the Treasury, so as not to deplete our banks capital. It also removes responsibility of bad decisions from selling bank. Once past these hurdles, too much time has passed from start to finish.
The answer instead lies in the underlying strength of the banks with the problem assets.
A version of ‘bad bank within a bank’ takes advantage of this strength while holding accountable their shareholders. Worked correctly, the banks need little in the way of direct capital infusions. The Treasury, rather, guarantees a separate subsidiary within each bank, the value of which, in many cases, will far exceed their capital. The value would be written off over 30 years though, and, because the Treasury would be backing its assets while it was being written to zero, our large banks could maintain capital requirements.
A group of the top banks, perhaps the top 50, would be analyzed for ability to generate profits and cash flow if toxic assets were written down over many years. Many would be otherwise profitable and would be given a one time opportunity to shift all potentially toxic assets to their ‘toxic-asset bank’ (though they would probably name it differently). This might involve a substantial part of their sub-prime and Alt-A categories as well we recent commercial and high-risk consumer installment credit assets.
Comprehensive bankruptcy reform would be required at the same time, as leverage for homeowners, allowing judges to reset principle on mortgages if a set of conditions were met. First, so as not to give-away bank assets, the principle could not be decreased below perhaps 120% of the foreclosure value. Second, the borrower would have to be able to make payments employing traditional affordability standards with a 30 year fixed mortgage. Third, there can be no giveback requirements. The value to a homeowner of walking away from a property, and then investing the surplus over the cost of renting, is too high and must be reduced.
Two things will happen to these toxic-asset subsidiary banks. First, they will move assets out of their toxic-asset subsidiaries as they discover that substantial portions do not need any modification. Second, they will start to recover a portion of the remaining assets either through legitimate restructurings, that effectively turn a failing note into a strong one, or, through foreclosure. The remaining amount would be reduced to zero though the remaining 30 years
The concern that measures like this would encourage even credit worthy homeowners to request a restructuring is nullified by the fact that bankruptcy would not be a legitimate threat for someone who can make their payments, even after resets.
When this all started, I, like many, was of the opinion that people got themselves into this mess and I did not want to have to pay for, or subsidize, their irresponsibility. I could see this coming years ago and never considered buying in the frenzy, so, why should I now help out those who did?
My view has completely turned in the last two years. Until we get past this crisis there is no economic recovery. Blame goes to far too many parties, not just the homeowner. Lenders threw out standards and created rules, such as stated income loans, that encouraged dishonesty. The Bush/Rove administration encouraged an ‘ownership society’ to gain political points, ignoring affordability. Mortgage brokers made huge bonuses knowing they were pushing loans that could never be repaid according to their terms.
Last week the Obama administration reacted all too quickly to rants from commentators, going out of its way to set aside criticism by gleefully pointing out that irresponsible borrowers would not be assisted. But this mess is all about irresponsibility, from the lender to the borrower to the regulatory agencies. To solve it, we have to accept these failures and move on. To deny it means that we are talking about how the foreclosure crisis is holding back the economy, five years from now.
Finally, to a commentator’s question ‘do we really want to subsidize the losers’ mortgages,’ perhaps we could re-word the question and see if the answer changes: “do you want to see a half-dozen foreclosures on your block?”