The Paulson Plan is not well understood. It is not a bail-out of failing Wall Street companies. Those companies are being destroyed as we speak. Lehman, Bear Stearns, Merrill Lynch – all are gone now. The problem is that the housing debt they created lives on after them and hangs over the heads of ordinary Americans.
Without establishing a new market for those loans growing default rates could threaten, in fact have already threatened, the real economy. The Paulson Plan enables the federal government to step in and “make a market” for real estate where the broken private sector will not dare tread.
Very few Americans seem to understand what is at stake. If the market for mortgage and other asset backed securities is not stabilized by a very large financially sound player, the risk is that it will cause financial markets that ordinarily are very safe to totter. For example, a key market is the commercial paper market. This is a market for short term loans to very sound large businesses like GE, IBM and GM. They borrow billions through their finance arms to fund their working capital. They sell commercial paper to money market funds.
If those funds sell off their CP or refuse to buy newly issued CP then those large industrial companies lose their working capital. Last week, this was happening to a small group of money market funds. As a result, in one example, IBM’s cost of borrowing tripled in a matter of days. To make this even more clear, one of the large players in commercial paper markets are power plants that use CP to finance their purchases of fuel for power plants.
It is conceivable if the CP market fails that power plants could run out of fuel and the lights would start going out.
Fortunately, we have solved this kind of problem before – in the New Deal that rescued the country from the Great Depression. A key institution was the Reconstruction Finance Corporation that pumped money into a moribund mortgage market to lead the way for private capital, in pension funds and elsewhere, to step back in. By renegotiating mortgage payments, by being willing to stand behind the ability of ordinary Americans to pay their mortgages countless homes and businesses were saved by public intervention where the free market had failed the country.
What Paulson and Bernanke propose is very similar to the efforts of the New Dealers.
Here is a description of how that effort worked from someone who was there, Jesse H. Jones:
Lessons from the New Deal
Reviving the Real Estate Mortgage Market
From Fifty Billion Dollars – My Thirteen Years with the RFC by Jesse H. Jones
What is the largest single type of investment in which the American people put their money? It isn’t the railroads or highways or insurance policies or savings accounts or corporate stocks and bonds. It is the mortgage on real estate. From the ten-acre farm to the tallest skyscraper, almost every piece of property in the country has carried a mortgage at one time or another. Mortgages have financed the construction of nearly every home, factory, store, or office building in this country
During the depression the almost measureless market for mortgages went into total eclipse. The RFC [Reconstruction Finance Corporation] helped to bring it back into the light of day – and also into the light of reason.
That accomplishment required a good many years of hard work. Even after the banking structure had been made sound and agriculture was again moderately prospering, and most of the water had been wrung out of railroad finances, the real estate mortgage market remained immobile, congealed with fear. The part taken by the RFC in its recuperation was accomplished without cost to the taxpayer, although we used millions to put life into it. We got the money back and made a small profit for the government. Better still, we helped restore faith and confidence in the orderly financing of real estate.
When the RFC went directly into the mortgage business in 1934 countless mortgage loans were in default throughout the country. Thousands of costly, useful buildings, such as apartment houses, hotels, offices, stores, warehouses, and factories put up by corporations and covered by mortgage bonds, had gone into receivership. At that time real estate mortgages on urban loans alone – all farm and rural properties being out of consideration – aggregated more than thirty five billion dollars.
Of that sum about nine billion dollars in mortgages was held by commercial banks and trust companies and mutual savings banks, seven billions by building and loan associations, and six billions by life insurance companies. Five more billion dollars was in real estate mortgage bonds held by the public. The remainder was held by trustees, educational and charitable institutions, fire and casualty companies, and individuals.
Many of the properties then in default could have been safely reorganized both in the interest of the bondholders and equity owners and without loss to the new money. But there was no new money available in the real estate field – none for retirement of maturing mortgages, none for new construction except, in spots, from one of the more prosperous life insurance companies….
In the booming 1920’s many of our larger cities had been overbuilt or at least expanded in advance of requirements by optimistic promoters.
The mortgage bond houses which financed these promotions not only charged excessive interest rates but, to make matters worse, required amortization payments much beyond the earning power of the properties even in prosperous times.
But this was not a valid reason for forever condemning real estate or real estate securities….the whole real estate market couldn’t remain in collapse….Having convinced ourselves that there was no mortgage money available to save the situation, we asked Congress in 1934 for authority to buy preferred stocks in mortgage companies, much as we had been doing in banks…But we were never able to get anyone to start a mortgage company. Times were so pessimistic that no one would put up money for common stock in such an enterprise….
So, in the spring of 1935, we started the RFC Mortgage Company with a capital of $10,000,000 which later was raised to $25,000,000. The company did a lot of good, and it made some money for the government.
We bought and sold…mortgages to make a market and encourage financial institutions to buy them. We wanted to prove that the mortgages were good and then withdraw from the field….
We immediately offered to buy…mortgage[s]…at 99 per cent of the face value of the mortgage and to sell it at par. We soon had insurance companies and other big investors interested. Then we raised our price, paying par for the mortgages and selling them at a slight premium. They finally became a popular investment with fiduciaries and trust companies.
[Over time this effort resulted in] profitable enterprises for the government as well as a great help to the public….
- An investor like a pension fund may buy a bond (C: “Credit” – the reference ) issued by GM that is worth $10 million.
- If the pension fund is worried (about GM, no, come on, really?) that the issuer of the bond will default (D: “Default”), they can sell (S: “Swap”) the risk to a counter-party, a seller of a CDS, for a fee (typically, 2% of the value of the bond, so, in this case, $200,000) payable each year during the life of the bond.
- If the issuer, GM, defaults, the seller of the CDS will have to pay the pension fund the outstanding value of the bond. AIG is a giant issuer of CDS’s like this.