Monthly Archives: September 2008

While Rome Burned….Bailout Negotiations in Disarray

The same free market de-regulation ideology that got us into this financial crisis is now blocking the road to a solution.  As the Wall Street Journal explains House Republicans appeared to be those most responsible for the debacle that unfolded at the White House today.
These Republicans naively think the Paulson plan is a “bail out” of Wall Street with government money.  This is wrong.  The Paulson plan is a revolving line of credit extended to the Department of Treasury by the American taxpayer allowing the Treasury to enter the financial markets to buy assets like mortgage backed securities or MBS’s.  
What Paulson is attempting to do is “make a market” for these securities, much like the service provided by the New York Stock Exchange or the Nasdaq.  Since these securities usually trade in the off exchange environment, what some call dark matter, they are not easily priced even in ordinary times.  But in an environment of great uncertainty only an institution with very substantial resources like the federal government can make a market for such complex instruments.
These MBS’s are now priced well below their long term value because of fear and uncertainty in the markets.  Thus there is room for Treasury to purchase billions in those assets at above current prices yet below their fair value and over time to resell those assets at a profit for the taxpayers.
We did the very same thing in the 1930s when the Reconstruction Finance Corporation entered into the market for mortgages and restarted the frozen market for those bonds.  And we did not take preferred share positions in the companies that sold us those bonds, as some mistakenly argue.  Soon other players followed and prices started to rise off the bottom.
The aversion to federal action by the Republicans is certainly repugnant, but it did not help matters today to see Maxine Waters more worried about cutting in women and minority owned businesses on the action in the Treasury plan than actually making sure that the federal government is first allowed to stop the financial bleeding.
The disadvantages of our atomized political culture are coming into full view as the far right and left attempt to weigh down a triage operation proposed by Bernanke and Paulson with all sorts of politically opportunistic amendments.  One particularly disappointing turn of events: left wing economists like Michael Reich and Jamie Galbraith joining with right wing anti-union and anti-regulatory ideologues from the University of Chicago to oppose the plan.
Take one concern: CEO pay.  Most of the CEOs who got us into this mess are already out of a job.  Those who are left will be earning far less than they did before given the very different economic and regulatory landscape they will be operating in.  
And what prevents us from re-visiting this and a host of other issues once the illiquidity issue is addressed?
It is unfortunate that the broader public does not understand how deep the problems we now face really are.  
Perhaps the collapse today of WaMu, the largest bank failure in US history, will wake people up.
But here is one helpful anecdote from the unfolding crisis:
Goodyear Tire & Rubber was forced today to draw down an expensive $600 million reserve line of credit because it was not allowed to withdraw money from its money market mutual fund. That mutual fund is supposed to be composed of what accountants call “cash equivalents” because they are invested in “commercial paper,” the most secure financial instruments we have next to actual dollars.
But the commercial paper market is now itself being deeply impacted by the unfolding crisis.  Industrial grade companies like Goodyear depend on commercial paper – loans for 30 or 45 days – to finance their working capital.  But of late the interest rate on CP is skyrocketing.  IBM is now facing triple its ordinary interest rate on CP in order to finance its operations. IBM thus applied for, and received, protection against short sales.
In other words, the real economy – Main Street in today’s phony parlance – is being directly impacted by the unfolding crisis.
The right solution is to let Paulson do his job.

Bailout Negotiations in Disarray –

Why the Left Should Back Paulson….

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….

Ground Control to Major Tom: New York to Regulate Some Credit Default Swaps

The massive struggle to bring the value of derivatives down to earth is underway. The latest move is by the state of New York, a leading center of regulation of the insurance industry.  The yelps heard from derivatives industry representatives is a sign of the emerging political fault lines.
They are, finally, re-classifying credit default swaps where the protected bond is actually held by the buyer of protection as “insurance” (duh) and thus subject to the requirements that the seller hold sufficient regulatory capital to back up the insurance protection offered.
A brief summary of how CDS’s work: 
  • 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.
This may strike most followers of this issue as a bit like closing the barn door after the horse has fled the barn.  There is something like 60 trillion dollars of notional value of CDS’s out there and only a fraction are written to protect someone who actually holds the underlying.  
A much larger market is made by selling CDS’s that reference a bond issued by a third party like GM but where the purchaser of the protection has not actually bought the bond.  They simply want to bet on the possibility of a default – in this case they would get up to $10 million without ever having actually had to purchase the bond.
Nonetheless, this is the kind of move that is likely to change the dynamics of this asset class in important ways – namely, to slow it down and possibly alter its shape and impact for many years to come.

naked capitalism: New York to Regulate Some Credit Default Swaps