We’re seven weeks into the Obama Administration and still looking for a way out of both the banking and housing crises. TARP didn’t seem to work, at least not as its designers intended. The new housing plan hasn’t been well received and now that more details are out you’d think there would be an even more negative reaction, but the press doesn’t seem to have even noticed the details were released last week.
Had anyone actually read the press release they would have noticed the Obama plan is no longer limited to refinancing 105 percent of a home’s purchase price, but offers instead what’s essentially a 5/1 Adjustable Rate Mortgage for homeowners and lenders who participate. The new rules do not, however, REQUIRE lenders to accept or approve ANY customers, relying as always on “incentives.” Nor does it require ANY principle reduction on the part of the lenders, allowing instead for a notional 40-year loan term with the deferred principle covered by a balloon payment in some future year.
This isn’t terrible, but it isn’t great, either. It serves the primary goals of the government, which are boosting home prices while at the same time limiting the potential price tag for taxpayers. But the government continues to be too much on the side of lenders who shouldn’t be so easily let off the hook for their past behavior.
This 5/1 ARM strategy essentially spreads the recovery pain over a longer period of time, which is good for lenders. But it hardly offers the 15- and 30-year fixed-rate loans homeowners should really be looking for. The government’s choice to completely ignore fixed-rate financing will probably hurt both the success of the program and its utility for homeowners. The use of balloon payments and no principle reductions simply guarantee that while homeowners may be able to keep their homes for now – some of them – they are in for another unhappy surprise in about five years.
It’s time for a better plan. And Washington supposedly is open to one. The Obama Administration has been asking for suggestions, though without giving out any clear method for actually submitting them. So as a blogger I’ll just hold up my hand and say, “Call on me, Mr. Obama, me, me! I have an answer!”
And I do, or at least I think I do.
You’ll note this is my third try at such an answer since Washington didn’t pick up and run with ideas one or two. But I’ve got a million of them, folks, so here’s Plan Number Three, called the Not-So-Bad Bank.
The idea here is to do something that’s different because variations on the same old stuff aren’t working. The Fed and Treasury keep saying they are using all their tools; well then it is time to invent some better tools.
It might be good to start with some analysis of why what we’ve done so far hasn’t yet been broadly perceived as working or even enough.
You could get Rush Limbaugh and his two cousins in a room and even they would say things have not yet started to get better and are probably getting worse. One reason for this might be that we simply haven’t allowed enough time. That’s probably true for results, but not for perception. Nobody’s saying, “Well we’ve taken care of that one, now what about health care or Social Security?” Nope, we’re still stuck on banking and housing. It could be we simply haven’t done enough — not allocated enough money. It could be that what we’ve done so far were the wrong things to do. All of these possibilities are discussed in the press every day. What isn’t discussed, I think, is that we may have the wrong attitude.
The financial world, especially, has ways of doing things, and the number of approaches they’ll generally consider to ending a recession is deliberately limited — limited by what are perceived to be the available tools and limited, too, by how the financial establishment sees itself. These are proud people who think of themselves as smart and on top of most any situation. Tom Wolfe called them Masters of the Universe and they like that image. The problem is that now we’re in a situation none of them (or us) have been in before and we (they) are limited by both lack of experience and by the way we see ourselves. This is why, for example, banks accept Federal bailout money then don’t lend it. It’s also why our government gives Federal bailout money then doesn’t attach conditions. That’s not what they do.
Well maybe it is time to start doing things a little differently. It is time to start looking at the fundamental processes of this financial engine in a new way. That is done all the time for profit, of course. Every time a new derivative security is announced it is some company’s way of grabbing a little errant profit they sense in the market — it is a new way of doing business. New stuff in that context is considered good. I just think we need new stuff in EVERY context to track down the causes of our problems and fix them. Alas, when it comes to that sort of behavior the financial establishment gets a lot less creative.
To this point we as a nation have come up with three ideas about how to help the banks: 1) buy their bad mortgage securities; 2) invest lots of money in them to build their capital bases, and; 3) preserve them at any cost as being too big to fail. These are perfectly fine ideas, but I think we’re limiting ourselves far too much when it comes to exploring how they might work. We can be smarter and will have to be smarter before the day is over.
My idea involves only the first of those three parts, buying the bad mortgage securities, the so-called “toxic assets.” I think this is a valid thing to do but by limiting our view of it to how it helps the banks is keeping us from reaping the benefits this process could afford to all of us.
The way most pundits expect the toxic assets to be bought up is through the creation of what’s called a “bad bank.” The Resolution Trust Corporation (RTC) was our bad bank the last time we went through something like this during the 1980s savings & loan crisis. The RTC bought bad assets of those many S&Ls and slowly resold them into the marketplace as houses were sold and mortgages were refinanced. Though it took 15 years to do so, the RTC eventually got rid of all those toxic assets and even made a small profit, too, holding those assets effectively to maturity. It was a low-risk process but low reward, too, because it took so long.
That’s the archetype for this next Bad Bank; buy up the toxic assets and dribble them back into the market over time. The one big issue that’s keeping such a bad bank from being created is deciding what price to put on those toxic assets. The banks want the government to take all the risk and bear all the cost so they’d like to sell their toxic assets for 100 cents on the dollar, please, which is lunacy since such securities are selling now on the open market (when a buyer can be found) for 15-20 CENTS on the dollar.
If the Obama Administration follows recent tradition, they’ll give the banks a good deal. This is bad in that the cost will be higher but good in that the Credit Default Swap market will be helped and those costs, at least, will be lower. So I can see reasons to do it both ways, though frankly I’d like to see these bankers and insurance companies pay a bit for their folly.
The problem with the bad bank scenario is that it does nothing – nothing at all – to help homeowners. Bad banks just help banks, not people who own houses, which is why I think we need a Not-So-Bad Bank (a term I just invented) that will help the banks AND homeowners.
Here’s how it works. The so-called toxic assets bought by the bad bank are, for the most part, bonds called Collateralized Mortgage Obligations or CMOs. These were created originally by pulling together a huge pile of mortgages about $100 million high and chopping that amount of debt into various classes of principle and interest and risk amounting typically to 4-5 different types of bonds that were sold to institutional investors. CMOs are types of derivative securities, many of which are protected by Credit Default Swaps (CDS’s), another class of derivative securities sold usually to insurance companies like AIG. That $184 billion given to AIG to keep it afloat was to cover bad bets on CDS’s, remember, because the CMOs were going down in price, homeowners were defaulting in high numbers, The banks were being forced to mark the asset value of their CMO’s to that depressed market value (mark to market) triggering claims against the CDS’s, which turned out to be a VERY bad bet for the insurance companies.
One thing important to remember about CMOs is that, as the banks continually explain, they are so complex and so dispersed that there is no way to put them back together again prior to maturity. Can’t be done. And since politicians are particularly stupid when it comes to math (being only able to understand negative numbers, it seems), they buy this argument, which is supported to some extent by experts at the Treasury and the Federal Reserve who I think, frankly, identify maybe a little too closely with the bankers.
The fact is that Wall Street has all the time had the ability to put those CMOs back together again, just like Dorothy was all along able to return to Kansas by simply clicking her heels. Computers are very good at keeping track of deals like CMOs and they have to because – contrary to what the bankers and brokers tell us — CMO’s are put back together again all the time. This happens every time a mortgage is retired either through the sale of a house or a refinancing.
CMO’s were invented in 1973. That date stems from the arrival of several market conditions, one of which was having the available technology to both create CMO’s — to tear apart and securitize the mortgage pools — AND TO KEEP TRACK OF ALL THE DISPERSED BITS FOR REPAYMENT. If we could do it in 1973 we can do it EASILY today and the fact that we are continually told that it is difficult or impossible probably represents ignorance, institutional inertia, or someone not really wanting to try. Heck, I think they’re just lying.
Think about it: you’ve sold your house, the mortgage is gone (repaid), so the CMO, which is where the mortgage debt obligation actually lies, has to have been repaid, too — every little bitty piece of it, held in different proportions by at least four different bondholders. And as long as there have been CMOs it has been thus.
The funny part is that what is supposed to be impossible happens so easily and so often. A typical CMO deal involves about 10,000 mortgages, the bank knows the shelf life of those loans is three years, which means they get paid off or adjusted after the first year at about 5,000 loans-per-year or around 15 loans-per-day.
So the CMO that was so dense as to be indecipherable is actually deciphered 15 times per day after the first year.
It takes time and effort on the part of mortgage servicers to figure out CMO’s and it costs them money, too. That’s one reason why they want a pre-payment penalty if you pay off your mortgage in the first year.
Understanding all this, let’s now go ahead and fix the system by first figuring out how to price the government purchase of those CMO’s.
If President Obama wants to be a good guy, which he will if he’s planning on having a second term, he’ll come up with some plan that doesn’t hurt the banks too much, doesn’t hurt the insurance companies too much, oh and by the way maybe even helps homeowners. That smooth move would be to create a Not-So-Bad Bank (NSBB).
This has to be done by Congress passing a law creating the bank and giving the bank certain privileges and responsibilities, one of which is the ability to buy-up CMOs, not one bond coupon at a time, but as entire offerings, which would be recaptured and redeemed en masse. Congress can require this by passing a law, but of course the issue is still what price to offer for those typical $100 million (at issuance) CMO deals. The banks want the price to be $100 million. The free market says the CMOs are worth maybe $20 million. Let’s split the difference and have the NSBB pay $60 million.
This price accomplishes three important things. First, it finally sets a price so the secondary CMO market can get moving again. The price is set high enough that though CMO investors lose something they don’t lose everything. It’s high enough, too, that insurance companies don’t have to pay so much to cover those CDS’s. Everyone hurts a bit but nobody dies.
Now we have an entire CMO offering held by the NSBB at a value of $60 million. This type of transaction would be done over and over again, buying-up deal after deal, though it wouldn’t have to be done for all CMOs because the secondary market would have been unfrozen through this government action and private trading of CMOs resumed with a noticeable firming of house prices as a result.
Let’s assume that the NSBB uses $50 billion or more tax dollars to buy-up CMOs at 60 cents on the dollar, which reflects less the market value of the securities and more the market value of the underlying assets or collateral, the homes.
With a normal bad bank now would begin the painfully slow process of waiting for people to sell their houses or refinance so the government can get paid back and eventually even make a profit on its $50 billion investment. Remember this process took the RTC about 15 years to complete.
But we don’t have a bad bank, we have the Not-So-Bad-Bank, which operates differently. Relying on another clause in the law passed to establish the NSBB, the bank has the right to call all the mortgage loans connected to its CMO portfolio, forcing them to be refinanced all at the same time. No waiting for people to sell their homes or refinance on their schedule, in this case the government says to do it NOW.
Using as an example this one CMO deal for 10,000 mortgages, that would mean 10,000 refis all at the same time. Is that bad or good?
Well it turns out to be very good for at least a couple reasons. There’s an opportunity here for economies of scale and for mortgage arbitrage. Doing the numbers we can see that the NSBB owns the CMO deal for $60 million or 60 cents on the dollar. So the NSBB turns around and forces all the homeowners to refinance at 70 cents on the dollar, the difference between those two numbers being the NSBB’s gross profit.
We’ve already given the banks and insurance companies a survivable level of pain by redeeming the CMOs at 60 cents. Now we give the homeowners a break, too, by forcing them to refinance at 70 cents. If they owed $100,000 on their old mortgage, on the new one they’ll only owe $70,000. Most loans that were under water will be dragged to dry ground by this action because it affects only the loan balance, NOT the value of the house. People will owe less, their houses will be worth the same or more, so their equity — which may have been negative — will now suddenly be positive, making it easier to qualify for Fannie, Freddie, Gennie, VA, or FHA refinance loans. And because those loan balances are all 30 percent lower, the payments will be 30 percent lower, too, making the homes more affordable to own. That’s homeowner relief.
Lower payments and higher equity will lead to lower default rates, avoiding the current mortgage restructuring problems that appear not to improve default rates at all.
The best part about this process from the standpoint of the NSBB is that those mortgages can be then resold in the secondary market or aggregated by outfits like Fannie Mae or Freddie Mac, freeing up the NSBB capital to be reused immediately to buy and retire more CMOs and refinance more mortgages.
Running on a 90 day buy-call-refinance cycle, the NSBB could reuse its capital four times per year and within a couple years (not 15) be out of business, having shown a substantial profit that would go back into the Treasury.
The Not-So-Bad-Bank would work better than a Bad Bank. It costs less money, helps firm house prices, gives relief to homeowners, and tempers the distress of banks and insurance companies. The only real count against it is that it isn’t Ben Bernanke’s, Tim Geithner’s, or Larry Summers’ idea.
Why not give it a try, Mr. Obama?
This is the third of three columns on human behavior and systemic problems. The first column covered in general how our complacency allows us to be taken advantage of, especially when information technology is involved. The second column, based in part on my friend Ralph’s mortgage problems, showed one example of how a class of investors has been able to keep millions of Americans trapped in high cost mortgages, creating a sort of economic time machine that benefits one group at the expense of the other and the nation. This third column, addressed to President Obama, is about a cure for that specific mortgage problem — a cure that would also create a huge, and very cost-effective, boost for the economy.
This is the second of what now appear to be three columns about how we as a people allow ourselves to be victimized, whether by unscrupulous computer hackers or unscrupulous computer bankers. This part is about the bankers — the guys whose bonuses were too big to be discontinued. Part three will present a possible solution to this specific systems problem…