Commentary: Bailouts will lead to rough economic ride

Yesterday American International Group's (AIG) stock price took a beating. It dropped 61%. News sources were saying AIG needed cash badly, about $75 billion. I had to dig further to find out why. The market value of AIG's bonds (as borrower) are down significantly and were downgraded by the rating agencies Moody's Investors Service and Standard & Poor. The downgrades likely triggered provisions in many of AIG's derivative agreements -- many probably credit default swaps -- to post additional collateral to cover prospective losses on said agreements. Many of these agreements are not traded on exchanges. The provisions to post collateral are akin to "margin requirements". When one party's position per the agreement deteriorates, it needs to post more collateral to better assure the counterparty can collect. The rating agencies expect greater losses in both AIG's portfolio of residential mortgage-backed securities as well as in insurance products (e.g. credit default swaps) protecting against loss in complex instruments backed by mortgages.

Post 41

Tuesday, September 16, 2008 - 5:11am

Investing in Vodka and Beards
By LENORE SKENAZY | September 16, 2008

Investors, perhaps you are worried. Perhaps you are ready to yank all your money out of the market and stuff it in your mattress — except that you were thinking of selling your mattress on eBay.

Don't. I just checked. There are 5,796 there already, and you're going to want that mattress when you're curled up in a ball, moaning something about Jim Cramer.

Anyway, the good news is that even if the entire financial world seems to be falling apart like your Ikea bookshelf — don't ask, I just know — there's no reason you have to sit there while dictionaries fall on your head. Actually, it's an ideal time to get out and invest.

That's what my broker tells me, anyway. And he would know, right? Although something seems to be wrong with his phone. The only question is: Which stocks can we believe in? Which ones are absolutely recession-proof? Depression-proof? Armageddon-dipped-in-economic-disaster-deep-fried-in-Steinbeck-proof?

Herewith, a professional's picks. Ha ha — I didn't tell you what profession, did I?

INVESTMENTS THAT WON'T GO BELLY UP *

*Because they don't have bellies.

STARBUCKS: Yes, I know you think it's going to go under — who needs $4 coffee when $4 can buy you a state senator? — but watch what happens to what's left of American productivity if it does. The government will step in faster than you can say, "Fannie Mae." Or just "Fannie," because that's more fun.

DAVID BLAINE ... is about to hang upside down for three days. Figure out a way to invest in him, because when the entire market is going down, for him it's going up.

SELTZER: There are only two things everyone needs to live: Water and air. Look who's got 'em both.

VODKA: Of course, sometimes it feels like there's only one thing everyone needs to live. Especially after a day like yesterday....

Post 42

Wednesday, September 17, 2008 - 5:56am

The federal government bails out AIG. Hopefully it won't end up costing taxpayers, and the federal government will actually gain from it. AIG's main problem is liquidity, not solvency at this time. Of course, illiquidity can lead to insolvency. It's analogous to a "run on the bank", except the runners are AIG's counterparties in derivative contracts (many credit default swaps) and AIG is an insurer rather than a bank.

Story from Wall Street Journal

Story from Yahoo! Finance

Edit: I wonder if Fannie and Freddie are AIG counterparties.

(Edited by Merlin Jetton on 9/17, 6:24am)

Post 43

Thursday, September 18, 2008 - 2:35pm

R. Malcom posted the following on another thread. I'm duplicating it here due to its relevance for this thread.

And Tracinski speaks on this -

http://atlasshrugs2000.typepad.com/atlas_shrugs/2008/09/financial-meltd.html

Today there was a surge in the stock market. One of the spurs of the surge was the revelation of a plan to establish a quasi-Resolution Trust Corporation to get shaky mortgage assets off the balance sheets of banks. How well it will work, of course, is in the details and the execution.

Praise of the plan by politicians has already started with Bill Clinton on CNBC. The government will be the "white knight" to solve a crisis caused by "market failure" or "Wall Street greed." What will be completely overlooked by so many people and ignored by politicians is that government was the main cause of the crisis. Tracinski's article, and several of my posts on RoR, name the main cause, but so many people will not get the message.

(Edited by Merlin Jetton on 9/18, 2:58pm)

Post 44

Thursday, September 18, 2008 - 2:48pm

One of the messages I heard, just yesterday, I don't remember whether it was Obama, or McCain, or one of their spokespeople, they are so alike on the financial crisis, was for the creation of new cabinet level post to oversee ALL activities of ALL large financial organizations - like an SEC but not limited to the Securities markets. To keep us safe from corporate greed.

Post 45

Friday, September 19, 2008 - 5:56am

In addition to the revelation of a plan by Treasury Secretary Hank Paulson to get shaky mortgage assets off the balance sheets of banks, the SEC put a temporary ban on short-selling financial stocks. As a result, the stock market is poised for another big rise today. The futures market signals about a 4% rise in the S&P 500 and a 3+% rise in the Nasdaq. Foreign stock markets have soared. The dollar rose against most other major currencies. Gold prices fell.

The temporary ban on short-selling financial stocks is a CYA, protective move by the government. It doesn't want any more runs on financial companies, especially banks, which is the Fed's perview. "New York Sens. Charles Schumer and Hillary Clinton, who urged Mr. Cox to halt all short-selling for financial stock. They reasoned it was necessary to aid their Wall Street constituents" (source). Somehow or another, they managed to avoid using the words "campaign contributions."

You may wonder what I think about these moves. I don't categorically condemn them given the circumstances, and it was probably better than doing nothing. The basis of that judgment is one fascist policy versus another fascist policy, or between the lesser of two evils. I strongly prefer a free market economy over a fascist one. The action on the stage is a scene about the commanding heights, and a free market economy has only a cameo role. On another thread Michael Marotta recommended Commanding Heights. I strongly second that, if it's the one by Daniel Yergin and Joseph Stanislaw. It was firstly a book. It was a PBS tv show. It's also on videotape and DVD. Some or all may be in your local library. (There is also a DVD with the same title by Ben Stein, Barbara Castle, Paul Volcker, and Tony Benn, which I have not seen.)

(Edited by Merlin Jetton on 9/19, 6:17am)

Post 46

Friday, September 19, 2008 - 6:36am

Who's to blame for the recent torrent?
Mike Bloomberg casts a wide net. The mayor of New York, former Wall Streeter, and founder of financial services company Bloomberg (which made him the 8th richest person in America with a net worth of $20 billion) told reporters Tuesday that, "You can�t just blame the banks, you also can blame the people that took out mortgages ... We were brought up that you first had to put some savings together and then enjoy. But this whole society has gotten to the fact that we�re a �now, give it to me today� kind of society. I think regulation has not been adequate.
"There�s no one person to blame other than all of us," he added. (source)

What's missing?

Post 47

Friday, September 19, 2008 - 9:00am

"What's missing?"

Someone pointing the finger at the politicians?
---------

I've only heard one elected official in Washington, and this is over a period of decades, even talk about monetary policy, as such, in a campaign speech - it is sad that there is but one voice (marginalized as a 'nut case') that has been pointing out the need for a gold standard - or just an intelligent monetary policy.

Post 48

Friday, September 19, 2008 - 9:36am

Someone pointing the finger at the politicians?

That's correct.

Who do you get Atlas points for answering, but I don't get any (yet) for posing the question? Boo-hoo.

Post 49

Sunday, September 21, 2008 - 7:18am

I don't know the extent, but a non-trivial part of mortgage foreclosures are on wealthy people, and many of them on second homes. When home values drop below the outstanding mortgage, it's much easier for people to hand the keys to the lender and walk away from a second home.

This article tells about some of the surprising foreclosure hot spots.

I wonder if the government bailout program will make a distinction between defaulting mortgages on primary residences versus secondary residences versus rental property.

Post 50

Sunday, September 21, 2008 - 12:37pm

I have long suspected that investment purchases account for the majority of the foreclosures. And it is not just the wealthy. There are a lot of people in the middle and even lower-middle income brackets that purchased a small, older, second home, to rent out and as a personal retirement annuity, or to get in on the housing boom. The Democrats may have pushed through the requirements of lenders to create sub-prime mortgages as an aid to minorities and the poor, but everyone and their brother ended up coming through that door after watching the way someone else was making more per year with buying and selling a single house than they took home as a paycheck from work.

Here is the big problem: If they bail out any of the foreclosure victims, can they do it in a way that lets the marketplace reset the price of the houses in short order. Until the prices bottom out in the market, there is no correction and the problem stays alive. The longer it stays alive, the more it spreads through the economy and the more public angst. Every time the price of houses drop, there are going to be new foreclosures. And just the passing of time, inflation, unemployment, recession - these will throw new people into hard times and leaving them without the money to make payments and create more foreclosures. What is needed is for the marketplace to see that the next wave of foreclosures will be the end and that it represents the bottom of the housing market and then, even if very slowly, the prices will start going up. Then people can start buying again.

It isn't so much about preventing the prices from going down - that must happen. It is more about getting them to drop in a short time, but with the public perception that this is a good thing - just the necessary medicine that is needed.

Something similar needs to be seen for Wall Street - that the institutions are going belly up, but that just serves up the assets at bargain prices - that for the dollar decline in the stock of company A there will be a dollar increase in the stock of company B that picks up assets for pennies on the dollar. Sure it means some serious loses but far less than trying create an escape from reality where there are no loses.

Post 51

Sunday, September 21, 2008 - 1:12pm

With a hat tip to Robert Bidinotto: Rein In Fannie, Freddie?

Excerpts:

"During the Clinton years, Treasury Secretary Larry Summers and Treasury official Gary Gensler both spoke out on the issue of Fannie and Freddie's investment portfolios, which had already begun to resemble hedge funds with risky holdings. Nor were others silent: As chairman of the Federal Reserve, Alan Greenspan regularly warned about the risks posed by Fannie and Freddie's holdings."

"During this period, Sen. Richard Shelby led a small group of legislators favoring reform, including fellow Republican Sens. John Sununu, Chuck Hagel and Elizabeth Dole. Meanwhile, Dodd � who along with Democratic Sens. John Kerry, Barack Obama and Hillary Clinton were the top four recipients of Fannie and Freddie campaign contributions from 1988 to 2008 � actively opposed such measures and further weakened existing regulation."

I read two articles in today's Chicago Tribune casting blame for the mortgage crisis. Amazingly, neither author could find any blame for Fannie Mae or Freddie Mac.

Enough blame for all to share

Who to blame? Wall Street

I also found the following about the accounting scandal at Fannie Mae.
Study Finds 'Extensive' Fraud at Fannie Mae

(Edited by Merlin Jetton on 9/21, 1:41pm)

Post 52

Tuesday, September 23, 2008 - 6:58am

http://biz.yahoo.com/ap/080923/financial_meltdown.html

The above is from Yahoo! Finance. The following is by me.

The Mortgage Morass

How the bailout might be best engineered strikes me as a daunting task. Mortgagees and the parties to whom mortgage payments and the consequence of defaults ultimately flow are "worlds apart." The initial lender who deals with the mortgagees bundles together many such mortgages into a "pool" and sells the pool. The pool is transformed into a mortgage-backed security (MBS). Then the MBS is often carved up and repackaged into collateralized mortgage obligations (CMOs) or collateralized debt obligations (CDOs). MBSs, CMOs and CDOs are widely held, many of the investors in them being retail or investment banks. In addition some investors in the MBSs, CMOs and CDOs attempt to insulate ("hedge") themselves from default risk by entering a credit default swap.

Where does the intervention take place? The proposal by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke focuses on the investor end, for their main concern is the stability of the banking system. Some congressmen want more focus on the mortgagee end, such as by allowing judges to rewrite bankrupt homeowners' mortgages so they could avoid foreclosure. (If a judge does so, that's still a partial default on the original mortgage that must ultimately flow to an investor. Or in many cases it will flow to the guarantors Fannie Mae and Freddie Mac, i.e. the federal government.)

Paulson and Bernanke propose to buy MBSs, CMOs and CDOs with a lot of default risk. Assume this is handled by a new entity called the "Resolution Trust Corporation" (RTC). If the party the RTC buys from has credit default swaps to hedge their exposure, does the RTC take them, too? If no, then the seller possibly retains a lucrative asset. If yes, then the RTC likely pays more. In either case, the RTC, or its parent federal government, has a dilemma. The counter-party to many credit default swaps is AIG, which the federal government has loaned $85 billion dollars and has an equity stake in (with warrants). If no, the federal government is on the hook indirectly for payments under the credit default swap via its relationship to AIG. If yes, the federal government is to some extent simply moving money from one pocket to another (although there may be timing differences).

How much should the government pay for these "illiquid assets"? If the government buys these "illiquid assets" at a high enough price to give troubled financial companies relief, taxpayers would see no profit in reselling them. And if the government drives a hard bargain on price, the financial firms will have bigger write-offs, worsening their balance sheets and diminishing capital.

(Edited by Merlin Jetton on 9/23, 10:03am)

Post 53

Tuesday, September 23, 2008 - 9:17am

Here is one of the sentences that jumped out at me, "Despite the bipartisan unhappiness, the prospects for legislation seemed strong, with lawmakers eager to adjourn this week or next for the elections."

That tells so much of the story - "700 billion, 700 smillion, who cares, we have to start campaigning!"

Foreclosures are mother natures way of saying, "you paid too much," and the difference between the old loan value and the realized sales amount from the foreclosure is the amount of diminished value in any of mortgage backed securities (MBS) made from that foreclosed house's sale. This is more complex but just the same, in principle, as a company making bad decisions and going bankrupt and the holders of various kinds of paper for that company (loans, bonds, stock) wanting the government to come in and prop it up.

The only clean solution, and the one with the least pain in the long run, is to educate the public on this issue, describe the turmoil that will appear in the market place, let the foreclosures take place, the diminished values will become specific amounts and ripple through the markets, and then, at a new place, we have stability and move on - the housing market and the credit market can resume. Let the broken shells of Freddie Mac and Fanny Mae be purchased in the market place and operate as true private enterprise organizations - no special rates available, no special regulations, no government guarantees.

Post 54

Tuesday, September 23, 2008 - 11:27am

Steve, I think we pretty much agree, but will make one comment.

A problem with the "clean solution" you present that is relevant to the current situation is accounting rules. I'm no expert on them, but as I understand them, MBSs, CMOs and CDOs held by banks must be "marked to market." Many of the securities are thinly traded and there is a lack of willing buyers. "Mark-to-market" value can be much less than what a holder might regard as a "fair value" based on what he/she regards as the discounted cash flows, even allowing for expected defaults and foreclosures. (In the ongoing hearings the former has been called "fire sale" value and the latter has been called "hold to maturity.") If like you say, "foreclosures take place, the diminished values will become specific amounts and ripple through the markets", it isn't clear to me if you mean mark-to-market value or hold-to-maturity value. Do you regard any excess of hold-to-maturity value over mark-to-market value as simply a wish for the government to come in and prop it up?

Time to Exempt Mortgage Securities from Mark-to-Market Rules

In connection with this I will make a point about history. When interest rates soared in the late 1970's and early 1980's, if life insurance companies had been required to mark-to-market the bonds they held (as lender), then much of the industry would have been insolvent.

(Edited by Merlin Jetton on 9/23, 12:36pm)

Post 55

Tuesday, September 23, 2008 - 11:58am

http://www.cnn.com/2008/POLITICS/09/23/paul.bailout/index.html

Commentary: Bailouts will lead to rough economic ride

By Ron Paul
Special to CNN

<SCRIPT type=text/javascript _extended="true">document.write(cnnRenderTimeStamp(1222174306109,['September 23, 2008 -- Updated 1251 GMT (2051 HKT)','updated 8:51 a.m. EDT, Tue September 23, 2008']));

updated 8:51 a.m. EDT, Tue September 23, 2008

Editor's note: Ron Paul is a Republican congressman from Texas who ran for his party's nomination for president this year. He is a doctor who specializes in obstetrics/gynecology and says he has delivered more than 4,000 babies. He served in Congress in the late 1970s and early 1980s and was elected again to Congress in 1996. Rep. Paul serves on the House Financial Services Committee.

Rep. Ron Paul says the government's solution to the crisis is the same as the cause of it -- too much government.

(CNN) -- Many Americans today are asking themselves how the economy got to be in such a bad spot.

For years they thought the economy was booming, growth was up, job numbers and productivity were increasing. Yet now we find ourselves in what is shaping up to be one of the most severe economic downturns since the Great Depression.

Unfortunately, the government's preferred solution to the crisis is the very thing that got us into this mess in the first place: government intervention.

Ever since the 1930s, the federal government has involved itself deeply in housing policy and developed numerous programs to encourage homebuilding and homeownership.

Government-sponsored enterprises Fannie Mae and Freddie Mac were able to obtain a monopoly position in the mortgage market, especially the mortgage-backed securities market, because of the advantages bestowed upon them by the federal government.

What I find significant is the fact that CNN presented this at all. It is too easy to complain that "the media" is controlled by your enemies, whoever they are. Ask a serious green and they will tell you that the mass media serve the capitalist ruling class that is polluting the planet. A psychological need is at work when Objectivists and Libertarians complain about the liberal/statist/mystic/whatever bias of the media.

Post 56

Tuesday, September 23, 2008 - 2:28pm

Merlin,

I'm sure that I know much less in this arcane area than you do... so take these opinions with at least a grain of salt.

When you have a foreclosure, that mortgage is history - if it is owned by a bank, let say, that bank no longer has a mark-to-market or a hold-to-maturity value. It is closed out on the books. Most of the time there will be a loss taken. Not a total loss, but the return from the foreclosure sale is presumably less than the present value of the stream of payments that had been expected when the mortgage was made. (Which is why they should NEVER have made low or zero down payment loans, but that is a horse long since out of the barn) (additional thought: If I were a bank, I'd have my present value calculator adjusted to account for the massive increase in inflation if this bail-out is done, hence a decline in present value for all long term income streams - and further, to increase the risk of foreclosure in highly inflationary times)

Now, if that mortgage had been, in effect, pledged as collateral for a loan (i.e., bundled up with lots of other mortgages and their projected stream of income being pledged as a guarantee should the instrument they back fails), then the credit worthiness and presumably the market price of the instrument they are the backing for will decline. Because that instrument represents assets on some organizations books, there may be companies made insolvent, and because that companies stock is held as assets by yet other organizations, this will ripple through the market. But it shouldn't be major because it is more a matter of the credit worthiness of an instrument's collateral and not the risk to the primary aspect of that instrument.

When the instrument being discussed IS that stream of income (from the bundled mortgages being sold as if it were a bond or note) then the present value, mark-to-market and the hold-to-maturity values take an immediate and measurable decline directly proportional to the loss from those bundled mortgages that went into foreclosure. The good news is that mark-to-market value of this last kind of instrument will become known and stable. This is compared to now, where it cannot be anything but extremely low or totally unrealistic estimate since there has been no bail-out decision made and therefore no way to even guess the worth. This is really just the same as the loss from the simple situation where a lender has a mortgage and has to foreclose. The bundling gives diversification - some of those tranches will be gone, others won't.

In all cases it is the difference between the price paid for a house to start with and what it is sold for at foreclosure that is the maximum loss - summed up across time and geography for all such houses. And adjusted to account for the added cost of the foreclosure sale, and the loss reduced by any principal already paid down, any profits made from loan servicing, any points collected, and any down payment amount.

I think that covers - in a crude fashion - the three ways that the mortgages are handled: they are held, individually, by the originating lender, or by someone who purchased them. Or, the mortgage's income stream is used as collateral (usually in a bundled form), or they are bundled and sold as an income stream bearing entity, which in turn can be pledged as collateral).

Once the decision are made to not bail-out mortgage holders and to allow the foreclosures to happen, there would be a flood of initial foreclosures and they would diminish over time - letting investors project the estimated foreclosures coming in future years and know what the future risk increases in the collateral form of mortgage bundles would be and the diminished income stream would be from the other kind of bundles. And banks and others would be using the existing models to measure the expected future foreclosures.

The only proper role I see for government is to ensure that the assets leaving organizations that go belly up are released into the marketplace in a fashion that brings the best market price as opposed to a panic-driven, fire-sale price, or the behind the scenes sudden sale to a crony for pennies on the dollar. Left alone all these instruments will have a healthy market where their prices go up and down in a normal fashion based upon the portion of value lost due to foreclosed mortgages.

Post 57

Tuesday, September 23, 2008 - 2:34pm

Michael,

You said, "What I find significant is the fact that CNN presented this at all. It is too easy to complain that "the media" is controlled by your enemies, whoever they are. Ask a serious green and they will tell you that the mass media serve the capitalist ruling class that is polluting the planet. A psychological need is at work when Objectivists and Libertarians complain about the liberal/statist/mystic/whatever bias of the media."

I would agree with your view on those extreme complaints that "the media is controlled by ones enemies," but that isn't the same as pointing out a specific and measurable bias in this or that outlet. Looking at NBC or the NY Times, for example, claims of bias aren't psychology, they are facts.

Post 58

Wednesday, September 24, 2008 - 6:44am