OOPS, The Bailout Didn't Pass

Since the announcement of this rescue package, I've been trying to figure out if the markets are in the midst of a liquidity crisis. The markets worked on September 12, 2001. They didn't work very well in October of 1979 and again in 1987 (what's next month?). I just checked the funds rate, and overnight has averaged less than 2% for the last month or so. Seems to me, that if there was no liquidity, the funds rate would be higher. I have no idea about what's going on in the bond market - governments seem to be functioning just fine but I don't know about corporates and we all saw what happened to stocks today.

The more I think about it, my idea about doing a gigantic REIT would seem to have merit. The problem is, that the property underlying the defaulted MBS is not likely to come back to a value anywhere near the principal balance of the mortgage secured by it. If there are houses in the collective collateral pool that continue to be occupied, that implies that there is some ability to generate cash flow. Maybe not equal to the P&I necessary to amortize the loan according to schedule, but some. If the bailout is equal to the difference between the whole huge monthly P&I payment and what homeowners can afford to pay, it's likely that the total amount that the government will end up paying would be quite a bit less than $700 billion.

Somebody is servicing all of these loans. In the documents there should be information related to the mortgagor's income - not all of these loans were no-doc. A simple calculation by the servicer tells us what the borrower can afford to pay. That becomes their new P&I. The difference between that and the original payment is what the government subsidy ought to be. That gets the mortgages back on a cash flow basis.

As for the loans that have already defaulted ... there's not much that can be done if we assume that a third party has purchased the property. The original homeowner still has their obligation to pay the loan and the title holder who foreclosed has gotten some cash out of the sale of the property. Therefore, the original homeowner's debt has been lowered and the proceeds to the sale passed through to the trust that is secured by the mortgage. So, there is debt, but no cash flow.

Maybe I'm taking to simplistic an approach to this situation. But, if logic has anything to do with finding a solution, shouldn't it be getting the underlying mortgages back on a cash flow basis?

Something else I'd like to know - which institutions are getting the proceeds of the bailout and what are they giving up? Lehman, AIG, Merrill, Bear, WaMu and a few others have written their junk down to zero. What percentage of the mess did they own? Can there possibly be an additional $700 billion out there that has no cash flow? Why won't a REPO type deal work?

WILL SOMEBODY PLEASE TELL ME WHAT'S GOING ON?

$700 Billion Equals 1,400,000,000 Bicycles @ $500 Each

That's one billion four hundred million bicycles at a cost of $500 each - that's a lot of bicycles, almost five for every person in the USA.

I've been able to learn a bit more about what's in the works as it relates to the rescue plan. Rather than re-hash that, here's my two cents relating to a description of the securities and what it will take to price them.

Most importantly, there is no market for this stuff, so any value is completely arbitrary. If the purchase price of any of this stuff is equal to its book value, its current holders are getting the deal of the century. Further, under that scenario, there is a pretty good probability that this $700 billion will never be repaid on accounta the underlying property will never have enough value to generate the kind of cash flow to reach as far down the priority chain as to get to the bottom most tranches of the deals. (see below for a discussion of cash flow in CDO's - in a nutshell though, a pool of mortgages, say 5,000 with an average balance of $250,000 or $1,250,000,000 total, is pledged to the repayment of a series of notes. The notes get divided up and their cash flow gets prioritized with the highest rated classes [tranches] getting first dibs on principal and interest payments from the collateral pool. The last tranches in line are the equity portions of the deals. If there is not enough cash flow generated by the collateral pool, the equity gets nothing or, at best, less than what was originally projected.) It is the equity in the deals that the Street has for sale.

By the way, when the Street began to understand that the sub-prime market was a bit outside the range of their ability to comprehend, they "re-securitized" the equity that they were holding, making it into Collateralized Debt Obligations or CDO's. The Street held on to the equity of the new securities and sold what they could. Modeling junk like this is next to impossible. Not only that, but one needs to get ones hands on the indentures for each deal. I assume that they were all private placements, so there is a lower requirement for disclosure. In other words, there is a low probability that anyone other than the dealer that did the deal actually has the cash flow modeled.

Remember, the mortgages underlying this junk have defaulted. In addition, the property is worth much less than the mortgages. So, we have mortgages with no cash flow secured by property that has depreciated by about 50%. Do you think that the treasury is going to get its (our) money back?

Now, here is what I don't understand. 1. Who is responsible for pricing? 2. What is the treasury buying? Are the sellers taking any portion of the loss? Bigger picture question, is there a liquidity crisis? If there is, how come nobody is talking about it. It seems to me as though, that markets are functioning - but I'm pretty far away
and I haven't had time to speak to anyone who knows.

So, why not set up a program that is like what the Street was using before the meltdown. They were financing these positions until they ran out of cash flow and then capital. The firms that are left have capital but they need cash flow. If the treasury does a massive REPO secured by this junk, the Street will still be on the hook and there will be some accountability as it relates what happens down the road.

I don't know ... but I wish I did. I'll bet that someone makes a ton of money on this junk at some point in the future though.

Hey, why not do a MASSIVE REIT? Have the treasury buy it and the tax payers own it. As property is sold, dividends flow out to the tax payers as repayment of tax that we never should have had to pay.

I Had it Right Five Years Ago!

OK, I know that beating a dead horse is really a waste of time. However, I want to stress, that the US congress really does not have a clue about what is happening around it. You can surmise as you will, but congress (not the fun kind) is populated by very average power hungry people that really do not understand how complicated the world is at the moment. Further, thanks to that lovable exterminator from Texas, the Hammer himself, Tom Delay, the staffs of both houses as well as the committees, have been seriously diminished - both intellectually as well as physically. One would hope therefore, that when outside experts offer their opinions about impending disaster, the members of congress might listen ... or maybe think a bit.

So, here is an e-mail that I sent to my house representative on 8/28/03. Kennedy was a CFO at a decent sized company prior to going to Washington. As such, I thought that he may have some comprehension of the risks associated with the lack of disclosure both in company's financial statements as well as in the SEC documents related to the sale of securities ... like that crap that we are now being asked to buy ... all $700 billion of it.

----- Original Message -----
From: Harry Forsyth
To: mark.kennedy@mail.house.gov
Sent: Thursday, August 28, 2003 9:02 AM
Subject: Musings on economic cycles

Dear Congressman Kennedy,

I recently moved to Sartell.

I was happy to learn that our congressional representative is a member of the Financial Services Committee - an interesting assignment in the midst of a very interesting economic cycle.

I'd be extremely interested in knowing your views on:
1. the possible impact of an erosion in the value of single family property on the ability of Ginnie, Fannie and Freddie to stand up to a default rate greater than 10%.
2. the extremely liberal interpretation of the recent FASB FI 46 - that the accounting profession has taken as it relates to continuing to allow sponsors of SPEs to finance hundreds of billions in assets off of their books.

I've been suffering under the naive assumption that Sarbanes/Oxley and new SEC disclosure rules were going to force the accountants to actually disclose the real risks associated with off balance sheet vehicles.

I know that these are loaded questions. However, I also know, that the extreme amount of liquidity in the capital markets today is contributing to what could become a worse economic disaster than that of the 1930's. The exact same set of circumstances that inflated the Japanese bubble, e.g., the leveraging of the value of single family housing, is subtly doing the same thing here in the US. Ask yourself this, how could the capital markets possibly fund in excess of three trillion (what's that as a percentage of GDP?) in new mortgages this year. Where does that much capital come from and why do investors put up that much money? Does it make sound economic sense for the agencies to allow LTVs to exceed 95%? Who establishes that value and what kind footing does it really rest on. How much debt does the average consumer actually have, and what is their ability to repay it in a down cycle?

Next time you're in the district, drive around and count the number of for sale signs. Note too, the number of cars on the road - where has the money to pay for all of these assets come from?

It won't be long before prices start their inevitable decline.

Best regards,

Harry Forsyth

$700,000,000,000

SEVEN HUNDRED BILLION DOLLARS!
Think about that number ... it's really too abstract. It comes to $2,333.33 for every person in the US or roughly $9,000 per household. It's a lot of money. Golly, I sure am glad that we've got such smart people running for the presidency. Can we draft Bill Bradly ... PLEASE? How about Michael Bloomberg?
BTW, I heard that Henry Paulson left Goldman with about $400 million. Nice payday. Just in case you all didn't realize it, Goldman Sachs is probably the best Investment bank in the world. It is also staffed with the brightest people and it has the most tightly controlled partnership in the business. In fact, the ONLY way to get your capital out of the firm is to go into government. This is why John Corzine ran for the senate and why Paulson is treasury secretary. Conflict of interest - can't have that, no favoritism, no that would never do.
I found some old e-mails that I'll put up tomorrow.

A Little, Accurate, History

avarice |ˈavəris|
noun
extreme greed for wealth or material gain.

Harry's definition; an uncontrollable urge to look the other way when, in the face of making huge amounts of easy money, otherwise astute managers allow their staff to do deals they do not understand - even remotely.

To really grasp what went wrong, one must go back to the immediate post ENRON period. The Financial Accounting Standards Board, FASB and the Securities Exchange Commission, that oversees it, were charged with coming up with new accounting guidelines that would dictate that ALL financial companies keep ALL of their assets on balance sheet. The new rules would eliminate the off balance sheet treatment used by ENRON (and most major banks) for "subsidiaries" referred to as Special Purpose Entities or Corporations (SPE's or SPC's). The abuses employed by the companies that used this off-balance sheet treatment was rotten to the core and really misstated their financial positions.

FASB actually came up with a decent set of new guidelines. The process took about two years to complete. When it was all over though, the new guidelines were completely gutted and loopholes inserted where there had originally been pretty tight reporting requirements, e.g., any parent company was to be required to consolidate all of its subsidiaries regardless of their SPE status. At the time, the new FASB requirements were aimed, primarily, at asset-backed commercial paper issuers. Most of these companies were were owned by large commercial banks. All of them were, effectively, guaranteed by those banks through the issuance of stand-by letters of credit. The regulators looked the other way though, in the face of a very effective lobbing effort by the ABA and the new regs. were gutted and the banks continued to use off-balance sheet entities as a way to generate new business with corporate borrowers.

Fast forward to the rise of sub-prime mortgage lending. As is the case with any non-agency MBS, there needs to be an issuer. The issuer needs to some kind of a corporate entity, usually and SPE and the SPE is usually owned by a shell company. The difference between mortgage finance and other types of ABS though, is that an MBS issue really needs to have actual equity. Some times, dependent upon the prospect for defaults, slow payments, fraud or etc., the equity classes of securities within a deal may be as high as 10 or 15%.

This might be a good time for a primer on the way ABS work. All deals are based upon cash flow. Cash flow is based upon a regression analysis of the way that a particular asset class has worked in the past. Credit cards and auto loans are considered to be the easiest to model and mortgages the most difficult on accounta the correlation between interest rates and mortgage re-finance or prepayments. Defaults, unlike other asset classes, were never a real issue in MBS until the introduction of sub-prime loans. So, cash flows were modeled and a couple of standard deviations were built into the rating process to protect buyers and hundreds of billions of deals were sold. Except for those times when there were were spikes in interest rates, resulting in extreme extension or shrinking of the lives of MBS assets, the market worked pretty well. This is owing to the fact that mortgages were really good loans. Fanny and Freddie were tough lenders that used well thought out underwriting standards and their guarantees were never tested because the default rate on conventional fixed-rate conforming loans stayed at less than 1/2 of 1% for decades. There were hiccups related to qualifying ARM's at teaser rates, but nothing like the current fiasco.

Back to the present: we were discussing the equity classes of MBS deals. This has always been where the risk has been buried in MBS finance. For the most part, if a lender understood the elements of prepayments, it could estimate risk within 100 basis points or so. Relating to sub-prime though, traditional cash flow analysis went out the window. It was replaced by analysis that was based on LTV as opposed to the strict underwriting qualification of borrowers. This meant, that if the shit hit the fan,
lenders had to rely on the liquidation of the underlying value of the mortgaged properties instead of the excess cash flow that was typically built into MBS deals. Now, LTV has always been important and it was in sub-prime as well. Except, the buyers of the equity class in sub-prime placed their bet on the continuation of a rising real estate market, not sound lending. As we now know, the deals had no excess cash flow. They had a bunch of defaulted loans and the underlying property has yet to be liquidated.

This gets me to the point that I have been trying to make in previous posts, e.g., there must have been a ton of money in these deals because there is no way on Earth that the Street would have bellied up to the bar to buy this crap unless there was. Now, we come around to off-balance sheet financing. I really don't know for sure because I wasn't there. However, there is a pretty good bet, that the entities that held the paper and for which the Street was the only source of financing were not reported until it was too late. In the case of Bear, they were "funds" and Bear was the sole agent responsible for doing the repurchasing agreements that kept them afloat. Bear was also the guarantor - just like the ABCP programs that were so effectively used by the commercial banks. So, one must ask ones self, if the FASB and the SEC had not caved when trying to eliminate off-balance sheet financing, would we be in this pickle now?

Congress (not the fun kind)

Remember that I told you that I'd written my congressional representatives. I pointed out that there was a very serious crisis in the offing and that I had some constructive suggestions as to how to get in front of the whole mess. I really focused on the leverage of FNM and FHR with emphasis on a mild increase in foreclosures and that effect on their meager capitalization. Well guess what, I found a response. Here it is:

September 6, 2007


Dear Harry,

Thank you for contacting me about the regulation of the federal housing finance system. I appreciate hearing from you on this important issue.

In recent years, information has surfaced about mismanagement and financial irregularities at Fannie Mae and Freddie Mac, two government sponsored enterprises (GSEs) that hold a large percentage of America's outstanding mortgages. In response, Congress has considered several pieces of legislation to strengthen accounting practices and regulation of the GSEs and the overall federal housing finance system.

As you may know, Representative Barney Frank introduced H.R.1427, the Federal Housing Finance Reform Act of 2007, on March 9, 2007. This bill would create a new federal regulator, the Federal Housing Finance Agency, to oversee the GSEs and ensure that they accomplish their mission of creating a secondary mortgage market that expands the flow of mortgage money in the American economy in order to better meet the nation's housing needs. As a member of the House Financial Services Committee, I firmly believe and understand that a new regulator is necessary to ensure the safety and soundness of these enterprises.

The bill would also create an "affordable housing fund" by taking a percentage of the GSEs' total mortgage portfolios to pay for housing grants and projects. While I support improved access to affordable housing, I believe this is a damaging course of action. The additional cost to the GSEs will inevitably be passed along to consumers in the form of higher fees, thereby raising the costs of purchasing a home or refinancing an existing mortgage. In other words, the fund could effectively result in a tax on middle- to lower-income American homebuyers. Consequently, I opposed the bill when it came to a vote on May 22, 2007.

The Federal Housing Finance Reform Act is now awaiting consideration by the Senate. I believe establishing a world-class regulator for the GSEs is critical and it is my hope that concerns regarding the affordable housing fund will be resolved before H.R. 1427 returns to the House for a final vote. I can assure you that I will continue working to strengthen our housing finance system, to help all Americans realize the dream of home ownership.

Once again, thank you for contacting me. Please keep in touch.


Sincerely,

Michele Bachmann
Member of Congress

Isn't it grand when our representatives are so understanding of what's going on around them? I was VERY specific on what was happening as it relates to, 1. GSE leverage and 2. the folly related to underwriting based (solely) on expected LTV - no mention of either. I also like the part about a possible tax increase to ordinary Americans. What, do you suppose, will happen to our already burgeoning federal deficit and who will pay for it?

Who Couldn't See it Coming?

I really wish that I hadn't pulled the first posts down ... they told the story rather well. There is a certain glee that I feel as it relates to being right about this mess. However, that is (way) overshadowed by the knowledge that things are going to get worse. I will really never understand how things could have gotten this bad. Three or four years ago, when I was railing against the GSE's, I was actually beginning to believe that they might survive. It then became more and more obvious that the supply/demand equation relating to housing was skewed much to far on the supply side. The inevitable conclusion, a major sell-off, has begun to take effect. I think that it's going to get worse and the fact that the federal government has set a precedent by coming to the rescue of the GSE's will make it worse still. I know that the country really couldn't let Fanny and Freddie fail, but the tab for the rescue is staggering - people in Washington actually speak about $1,000,000,000,000 (that's one trillion, one thousand billion) as if it's a number that they actually understand. They don't. By the way, the budget as submitted by the administration for FY 2009 amounts to roughly a $42,000 tax bill for every household in this country (what they actually pay about $12, to $15,000, largely because of the mortgage deduction) - that did not count defense and it certainly did not count the cost of the subject bail-out.

Anyhow, I am one of three partners in a newly formed small business. Each of us has put our "life savings" into it. We sell bicycles and cross country skis. What is the prospect for our future in a recession caused by the excesses of an easy credit culture? Will the federal government come to OUR rescue if we begin to fail? The government is saving the financial institutions that have given us the credit that we needed to open our doors. Now, however, those companies will be the beneficiaries of the GSE bailout for which we bear the ultimate financial responsibility. It will be interesting to see, should businesses like ours begin to get behind the old eight ball, just how understanding the banks will be when they begin to start collection procedures - remembering, that they are in business simply because they have been saved by the government. I suppose that, in our society, that gives them the right to make the lives of we citizens miserable.

As I point out in the previous post, I have written to many people, both in and out of government, to warn of this disaster. Again, because I felt that you had to be a complete financial moron or to be in the pocket of those "special interests", not to see this coming. Now that it's here, it's too late to stop and the people to whom I've written are more concerned with getting re-elected than devoting any energy to solving this problem.

We deserve what we have gotten ... we vote based upon trivia. We are all victims of dopes like Carl Rove whose single-mindedness has won elections for a bunch of, at best, average intellects. We are about to vote again. Look at who's running - what is their agenda? Really? What do we ask of them?

I've said for the last few years, that if Fanny and Freddie fail, that it will make the depression look like a walk on the beach. That is nothing more than a hollow cliche. However, is it true?