I got off my flight down to Los Angeles a few hours ago and was pleased to see that Congress had rejected the bailout bill, woops I mean Financial Stability Act. I would not be surprised though to see it come back from the dead, given the fear today's large stock market drop will put into many politicians.
In many previous posts I've talked about how this proposed bill simply was throwing money into a fire and would do nothing to solve the fundamental economic problems or even unfreeze the credit markets. I've referenced many alternative plans by various economists and financial experts to address the root causes of this crisis, but I wanted to take my time to articulate a plan in my own words.
First Define the Problem
One of the things I noticed in talking to offices of dozens of Senators and Congressmen over the past several days is very few of them knew what problem they were trying to solve. The only common theme was, they were afraid of something really bad happening and felt like they had to act now to prevent it or be blamed later. Just remember, panicked people often do stupid stuff.
So, lets define the problem. It is no exaggeration that the situation in the credit markets and financial system is dire, bordering on a collapse. There are a number of ticking time bombs in the financial world, some commonly known and some still below the surface. The fear and uncertainty has caused the credit markets to lock tight, banks won't lend to each other and credit is quickly being cut off to consumers. These problems in the credit markets spread throughout our entire economy. Without a healthy credit market you can't have a recovery in the housing markets.
Most critically we've got to defuse these bombs that haven't exploded yet to keep the situation from getting MUCH worse, and we've got to solve the fundamental trust problems so the credit markets can start recovering that will lay the ground work for a broader economic recovery. Too many politicians, are doing what is akin to trying to rebuild a house while it's still on fire.
Acceptance
Just like a recovering alcoholic needs to accept that they've got a drinking problem, we need to reach acceptance of our financial problems. We've been binging on credit the last ten years and this country at almost every level is deeply in debt. This credit bubble fueled what we now call the housing bubble as well as similar bubbles in several other asset classes. Our whole system is over-leveraged and way out of equilibrium. A common principal in many physical sciences as well as economics is systems, that are out of equilibrium will snap back, no matter how hard we try to prevent it. The harder we resist the more violent this correction ultimately is. For example many of today's problems can be linked to steps we took in trying to prevent a recession after the dot com collapse.
We've got accept that to return to a healthy financial system, economy, and housing market is going to require a deleveraging of the system and that implies a vast amount of "wealth" will evaporate. Just accept it, it's going to happen no matter what we do. What we do have control over how orderly or unorderly this process is and thus how hard it is for the average American. Do we have a hard recession, depression or worse? That's the choice we're making, right now.
The Plan
Below is my articulation of a plan to move down the path of solving this problem and minimizing economic damage. This is not intended to outline economic stimulus steps, or some specific housing related problems which I do believe also need to be addressed once the big problem has been dealt with. Almost all the points in it are common themes in plans from various financial experts and economists and ALL of them are missing from the current plan being discussed by the government.
1. Introduce regulations to defuse the bombs threatening to make things much worse and restore the trust needed to unfreeze intrabank lending.
Right now everybody is afraid to lend. It's not that no one has any money, they just don't think they'll get it back because they don't know who's solvent. These three critical pieces of legislation will help restore trust and expose the insolvent institutions so they can be dealt with.
a. Get rid of the accounting loopholes, no more level 3 assets, no more off-balance sheet crap. When an investor looks at a balance sheet they need to be able to trust it. It's gotten to the point everybody is now assumed to be lying about their financials and nobody will invest.
b. Restoring sane leverage requirements on in banking system. Prior to deregulation about 5 or 6 years ago leverage, for financial institutions was capped at maximum of 12:1. Many of the companies that are failing (Bear Stearns, AIG, Lehman, Fannie, Freddie, etc) are ultimately failing because they over levered themselves over the last several years. They were running leverage ratios of 30:1 or worse. When you are running 30:1 leverage that means, if you loose about 3% on you investments you are wiped out.
c. Regulate the derivatives market by forcing all derivatives onto an exchange where margin requirements can be monitored. People are fixated on the mortgage problems, that could just be the blasting cap that sets off the derivative bomb.
2. Recapitalize the financial system
Simply buying assets from banks is possibly the most inefficient way to recapitalize these institutions. The most successful recapitilzation strategy in past financial crisis' has been debt to equity swaps. Basically companies proven to be insolvent (see point 1 above) are brought into conservatorship, stock holders get wiped, bond holders become equity holders, and new bond holders can now come in and recapitalize an essentially debt free company. For institutions where they are still insolvent after a debt to equity swap they go through an expedited Chapter 11 process, where assets are liquidated. This recapitilization would require almost no tax payer funds, investors who made bad investments will take the losses, while at the same time the financial system will remain operational.
3. Immediately recapitalize the FDIC
If people loose trust to store their money in a bank and everything breaks down. The FDIC is severely under capitalized to handle the coming bank failures and people are starting to catch on. If banks start failing in mass and the FDIC is disorganized and can't efficiently make good on insurance, you will have REAL "in the street" panic. Congress needs to move now to shore up the FDIC, and this is going to require a lot of capital which politicians are trying to hand to Wall Street firms right now. If needed to restore trust, temporarily raise FDIC insurance limits on existing deposits. Trust in the banking system is critical right now, and it's quickly evaporating.
I think we are all tuned in. If certain elected officials want their jobs next time around I suggest they take a good hard look at this issue, and not just put a bandaid on it.
The $700,000,000,000 (more meaningful with 0's) bailout should not be about ANYTHING except to restore confidence in our financial markets. Any financial deal politicians make can and will be modified or unmade to suit the current political situation.
I think they may also want the new proposal to revisit the troubled mortgages that have the most gotchas... for instance converting adjustables to fixed rates... the loans that reset in wild ways. Sure... some money (future) interest will be sacrificed but it could help curb the number of foreclosures and, perhaps begin to restore home values.
Chuck: This may not be a popular opinion here, but home values still have to come down in most areas as part of this deleveraging process. Trying to artificially prop home prices up will, just extend the pain, and actually delay a housing market recovery (which is beneficial to real estate agents).
We are going to have to do some targetted economic stimulus and plans targetted at underwater homeowners but in my plan I'm trying to concentrate on the single most critical problem at hand, the credit markets. If we don't fix this soon or apply the wrong fix (the bailout) things will get MUCH worse for everybody in the US very quickly.
I understand that you think that the BAIL out will not help.. but don't you think that we need SOMETHING.... a lot of people will be loosing their job.. and that why I'm think that we should do something.... I beleive that things will be BAD before it gets BETTER.... We will be feeling it ... If we can't make a change..... What a time to be BORN..
Donna: I think it is CRITICAL to do something just not the wrong thing that flushed $700B down the drain and makes the problems doing worse. The plan I outlined above is a huge something and I think correcting those issues now is critical to avoid something worse than a severe recession.
Matt, I do agree with you and I have no problem saying the words "PRICE REDUCTION" when it comes to home prices here in the PacNorWest! I am just so damn mad at all of this! I worked in Escrow in California during 2003-2006 and saw horrible horrible things happening - but no one would listen. I was just an escrow processor so my calls and attempts to do some "whistle blowing" were just ignored.
Matt,
Can you fill us in on
1- What is likely to happen to the$60T in CDO's. I understand CDO's are a quasi insurance policy, which if the system goes bust, then the CDO's are worth nothing. For example. If I want to take out a $1M CDO on my toll road earning 10% return and it only earns 9%, that creates an event for which I can claim, but it may have only cost me $1000 to take out the policy. (Thus only $1k is really at risk even though the policy is for $1M)
2-
I keep hearing hedge funds are the elephant in the room. These are even more leveraged than investment banks. So what is a hedge funds relationship to the real economy, and what would likely make them implode?
Thanks.
(Looks like your lobying may have made a real difference to the vote outcome)
Just wanted to say.. you are so smart and I'm glad there are people who can think like you do :)
Matt, Now you have confirmed what I have suspected - YOU know more about this than the people running the country... President Heaton has a nice ring to it.
Matt ~ Having been a political science major, I appreciate your lobbying Congress for your beliefs. While the politicians will never make everyone happy, I am hopeful that people will become involved as you did rather than just fussing about the issues. Thank you for sharing your thoughts with us and with our elected officials. :-)
"Right now everybody is afraid to lend." Though very similar, I would also say that right now everybody is afraid to extend credit. Just like lenders did with HELOCs, look for consumer lenders to start lowering credit card limits. There's going to be a major move from our 'buy now, pay later' society to one that is much more cash based.
Leigh:
1. I think you are referring to CDS or Credit Default Swaps not CDO's. A CDS is a type of derivative that acts like an insurance policy for debt. If the debt it was written against defaults the writter of the CDS has to pay the person who holds the contract. Nobody knows the exact quantity of these contracts out there, but $60 Trillion is likely on the low end. The problem is because the market is totally unregulated and off-exchange, there is no one making sure that the people who wrote these insurance contracts can actually pay up if a default ocurrs.
Yet at the same time from an accounting standpoint the CDS holders are treating it like their bad debt is insured so they won't take a loss (hidden losses) It looks very likely that many of the CDS writters in fact never reserved any money to pay out at all. For example AIG was backing some $500 Billion in CDS's with almost liquid capital, that's what blew them up.
Now what happened is a lot of institution wrote and bought CDS's on the same debt from different people and pocketed the difference in premium as profit. For example I sell a CDS on some of Lehmans bonds for $100k and buy one on the same bonds from another party for $90k, pocketing the $10k difference as profit. From an accounting standpoint it looks like I have no exposure because the contracts cancel each other out. But in reality if the person they bought the contract from can't pay, I can't pay on mine and this creates the domino effect in the financial system. One company defaults, pushing another company into default, pushing another company into default, etc. That's why derivatives are the ticking bomb in our financial system right now. Once the chain reaction starts, it leaves a big smoking crater in our financial system, but nobody really knows how big the blast will be. That's why it is absolutely critical that we move these instruments onto an exchange and expose the risk so we can start defusing the problem before this chain reaction starts.
2. Yes, many unregulated hedge funds are massively over leveraged, some running leverage as high as 100:1. They are blowing up as we speak, it's just because of their shadowy offshore/unregulated nature we often don't learn about it until later. Lots of high net worth investors are in for a very nasty surprise when they get their quarterly statements shortly, if they ever receive them.
What makes them implode is thatwhen you run high leverage you don't need to take big losses on your investments whether is commodities, stocks, bonds, etc to be wiped out. If you are leveraged 10:1 that means a 10% loss on your investment wipes out 100% of your capital. Think if you were leveraged 10:1 in the stock market today, you just lost 70% of your investment. The big ones that have been imploding in the last month have mainlybeen hedge funds invested long in commodities as the commodities market has collapsed very rapidly.
Thanks for the explanation.
So effectively, new finanancial instruments have been promoted over the last 20 years that have created capital market inflation (such as housing, land, businesses to lesser extent) well above the 2-3% that a normal economy grows at. The debt was onsold by banks to the rest of the world as CDO's, and insured using CDS's. Ultimately though, the yeild from these assets (for example housing which should run at maximum 30% of average houshold income for an average house) will not even service the debt used to purchase them and the CDS's aren't worth the paper they are written on.
So we can say the financially illeterate were suckered because government was not willing or was unable to create legislation to protect them from capitalistic market vultures.
Therefore, much of the valuation in hedge funds, investment banks, and chartered banks is ficticious. Thus we need to let wall street go bust, let rich people holding derivatives go bust, revalue assets that allow people who overpaid for them still be accountable, but lets them keep their asset (home or business), and most importantly provide liquidity to the banks that do real banking (So business does not grind to a halt)
So really we are talking about seperating the financial system in two. One that firewalls exotic (or fraudulent or fake money) finances from real ones (Such as deposit accounts, normal intercompany transactions for real goods and services, company lines of credit) It seems though the current bailout doesn't address these issues.
Okay - I"m with you - but it still doesn't fix the extra inventory in the housing market... what about this...
We, the people, will own 2 out of 5 houses in many areas - either through F/F or taxes - so if we own vacant homes - why don't we "burn them down." I know we would have to do something ecologically sound - but what if we got rid of the houses and sat on the land? Wouldn't we come out better than having to service all of this???
Why not let us reblog on this? The more it gets out the better.
Matt, I learn a ton with your every new post. And, I think I even understand the majority of your explanations. I really appreciate what you're doing here, and thank you for all the time it takes. I agree with what I hear you saying about the real solutions that are needed at the government and regulatory levels. But, what can the average "Joe" like me, do to either help this situation, or protect my family and our future?
"Therefore, much of the valuation in hedge funds, investment banks, and chartered banks is ficticious."
In essence yes, the same way Enron's valuation was ficticious.
Missy: You should be able to reblog this post, I encourage it.
Matt, You as the founder should know that AR is a real estate site. Our concern should be for real estate not Wall Street.
This rescue plan will staunch the flow of foreclosures. The banking rules almost certainly promote foreclosure over workout.
If the Treasury becomes the owner of these mortgages they can restructure many of these loans.
Foreclosures are driving down home values (below 2002 levels), destabilizing neighborhoods, providing attractive nuisances which promote crime, and demoralize everybody.
Solving the foreclosure problem will still allow for your shake-out in the larger credit markets. I agree that some of these traders need to be taken down.
We also need to separate the secondary mortgage market from the international market for other financial derivatives.
The bank failures since this crisis began have been primarily thrifts. Now they are "owned" by financial center commercial mega-banks. This is bad for America. We need more savings-and-loans not less. Had we passed this bill the first time around WaMu and Wachovia might have survived.
I say let those traders dealing in Credit Default Swaps take their chances. Let's change the rules on bank defaults so that big banks don't get bigger. Let's encourage the formation of new S&Ls. Let's charter a dozen new secondary market makers like Freddie and Fannie but require them to operate responsibly, not politically.
Let's "worry" about the real estate market. It is the bread our butter is on.
Bill Roberts
Bill: I am worried about the real estate market, it all relies on a health credit market. My analysis is this bill would have ZERO impact on helping the real estate markets recover. This bill is being sold like snake oil, everybody is being told it's going to cure their individual ills.
The most dangerous thing is it distracts resources from real solutions to help cure the financial problems and lay the ground work for a recovery in the real estate markets.
I agree on the home price values- they're unreasonably inflated in some areas... I don't know that there is anyone who knows what values really are. This in large part, because we live in a market that has been manipulated. It's not a free market when we can allow some of the existing oddities (mark to market activities, over-leveraging mortgage backed securities, ratings-inflation of such securities, rampant lobbying of legislators who had the power (but lack of fortitude) to regulate questionable practice... ok... there's more... and I'm sure you could add to the list- or modify it to your heart's content.)
One simple concern I have is the after-effects of bad loans. I could show you entire subdivisions where people were sold homes that they were qualified to buy. Sure- many of them ended up in homes for which they were not qualified. However, when such loans reset- the new rates can be pay-day-loan-esque (I'm sure there's a newer/hipper word for, but I'm using what I've got here.)
If lenders were willing to change a few terms of such loans many people could afford the home they currently live in. Problem is- so many people have wrecked their credit by the time they reach their breaking point. I know. This is only one part of the problem. But when I have people calling me to short sell their homes... and I see how little they owe I wonder why the banks would be willing to spend up to $50k or more to foreclose... sell the note for pennies on the dollar... and watch the customer become uncredit-worthy for years to come. We have an ever-expanding group of people who are in for a long haul... and few takes will be able or willing to accept them as clients. If only they could have known that paragraph 270 of page 57 in their loan read "check out what happens if you're late on payments."
Now... on the bailout. I'm not in favor of it either. We can ask Japan how their ten year recession felt... and if all the money they threw on the fire helped bring it to a close any quicker. In retrospect... would they have allowed the market to self correct? I don't know... I only know that congress can see where we went wrong... will they have the guts to fix a few of the broken pieces rather than pay off those who got us here.
It has now been alleged that the Reason the Banks won't say what they did with the first $300 Billion in Bailout money is because they have used the bulk of these monies to back Corporations taking jobs out of the USA and expand their foreign manufacturing and financial operations outside the USA ... It's time we get the money to the struggling American Homeowner on the brink of Foreclosure and put an end to this masquerade!