euphoria Wall Street displayed upon the announcement by the Bush
Administration that the government’s balance sheet would be used
to park illiquid securities was spectacular. On Thursday and Friday,
the Dow gained approximately 780 points, after losing as much in
the beginning of the week on the news Lehman Brothers was insolvent
and Morgan Stanley and Goldman Sachs were seeking suitors/mergers.
rally over the last two trading days of the week can be appropriately
characterized as irrational exuberance, a term coined by the chief
architect of this credit bubble we are experiencing. To explain
this position, it is essential that we ask three questions: 1) What
measures are being taken; 2) What are the intended consequences;
and 3) How do we protect ourselves from the failure of another rescue
effort by a compromised and beleaguered Administration? Let’s address
these questions seriatim.
What measures are being taken?
Bush Administration will submit a proposal to Congress for authority
to purchase $700 billion in mortgage related securities and bonds.
The Treasury will purchase, if necessary, other assets, after consultation
with the Federal Reserve. Treasury may buy only assets issued or
originated on or before Sept. 17. The Treasury would also have discretion,
after discussions with the Fed, to make non-U.S. financial institutions
eligible under the program. Treasury Secretary Paulson will have
the discretion to act as he deems necessary to hire people, enter
into contracts and issue regulations related to a revival of U.S. mortgage finance. The
Administration is seeking the authority to implement this plan with
insulation from review by the courts. The sunset provision of the
proposal requires most components to expire after two (2) years.
What are the intended consequences?
Treasury will remove worthless mortgage related assets from the
balance sheets of financial entities unable to comply with regulatory
capital requirements. The intent is to restore liquidity and confidence
to the capital markets. First, the premise is faulty. Sec. Paulson
and other economists have incorrectly identified sub-prime mortgages
as the culprit.Unfortunately, the contagion has spread to Alt A,
Option ARMS, and prime mortgages, the so-called agency paper (Fannie
Mae and Freddie Mae). Hence, the GSE Regulator had to place the
two mortgage giants into conservatorship on September 7th.
as recent as last week, stated if we stabilize the housing market,
we can begin to work our way out of this crisis.Sorry Hank, all
classes of assets have been compromised, the exuberance displayed
on Wall Street is irrational. The US
has $12 trillion in outstanding mortgage debt. According to the
Mortgage Bankers Association, at the end of the second quarter of
2008, over 9% of mortgages were 30 days delinquent or in some stage
of foreclosure. Interim reports (Case/Shiller Index, National Association
of Realtors and Commerce Dept.) indicate the market decline has
escalated. Thus the $700 billion may be insufficient to accomplish
what the Administration is attempting.
the delinquent and foreclosed mortgages are just one of the symptoms
of the much broader credit bubble. Commercial mortgages, credit
cards, auto loans, consumer loans, and high yield corporate loans
were underwritten to sub-prime guidelines also. Financial institutions
originating these transactions merely winked at the underwriting
standards because the assets and attendant risk were removed from
their balance sheets by way of securitization. The loans were packaged
into securities called Collateralized Debt Obligations (CDO). Unlike
mortgage-backed securities which have mortgages as underlying assets,
CDO’s underlying collateral typically consists of several asset
classes (a combination of auto loans, mortgages, consumer loans,
corporate loans, etc.) with approximately half of CDO’s having mortgages
as an underlying asset.
to Bloomberg News (March 13, 2008), there are approximately $2 trillion
in CDO’s, that are leveraged beyond the value of all the stocks
in the US (Wall Street Journal, August 18, 2007).The $700 billion
will not cleanup the toxic dump consisting of mortgage-backed securities.
How much will the Administration add to that figure to ease the
fallout from the CDO’s? How will the Administration address the
Synthetic CDO’s and other derivatives with stratospheric notional
values (see International Swaps and Derivative Association)? If
you think that proverbial last shoe has dropped, I am here to tell
you we are dealing with a centipede. The exuberance is irrational.
Administration was aware of what they are telling us now, as far
back as June, 2007, when two Bear Stearns hedge funds collapsed
and certainly by August of 2007, when the markets seized up. To
mollify the public, Bush offered a paltry $100 billion stimulus
package, $300 billion anemic housing bill, and now this $700 billion
bailout - all measures taken are too late and too little, which
leads me to my final question.
How do we protect ourselves from the failure of another rescue effort
by a compromised and beleaguered Administration?
recognizing where we are today, we can decide “where do we go from
here”. The starting point is to unwind our credit positions and
start accumulating cash. On Monday, September 8, 2008, Jim Cramer
(CNBC’s Mad Money) advised his audience to walk away from their
homes if they are upside down. I do not watch the program for several
reasons (until recently, Cramer was promoting investments in the
equity markets and Cramer believed Sarbanes-Oxley would resolve
the transparency issue challenging publicly trade companies) but
my wife is an avid fan and she is aware that I have been an advocate
of deleveraging since February, 2008, so she called me in a state
of shock to announce that Cramer, on national television, encouraged
his audience to walk away from a legally binding contract. This
position was untenable a few weeks ago but so was the idea that
the GSE’s (Fannie, Freddie and the Federal Home Loan Banks) would
require a bailout, AIG would need to raise $85 billion or Merrill
Lynch would be bought for $45 billion in an all-stock transaction.
to some of you might present a moral dilemma. We have been socialized
to believe it is unethical and dishonorable to walk away from our
obligations. It is not immoral for one to free him or herself from
a depraved encumbrance. Employ the line of reasoning in the “clean
hands” doctrine of the law. A person (mortgagee/Wall Street) who
has acted wrongly will not receive assistance from the court when
complaining about the behavior of someone else (mortgagor/homeowner).
Also, if Congress did not intend to provide relief to consumers
from oppressive debt, the Supreme Court would have not held valid
the Bankruptcy Act of 1898. Moreover, it is not economically prudent
to remain in a house that will not accumulate equity for years to
come due to declining values in that community or because of an
inappropriate product used to finance that home.
with mortgage balances greater than the market value of their home
should re-evaluate the market conditions of their neighborhood and
consider whether it is better to rent until the market makes the
proper adjustments and save the difference between the mortgage
payment and rent. In upside-down circumstances, one-half of the
fiscal advantages to homeownership have been eliminated (equity
accumulation) the other half (tax deductions) should be balanced
against the disadvantages of remaining in the home. Seek advice
from a HUD-approved housing counselor or a trained loss-mitigation
specialist before you walk away. The same principle should be applied
to most debt (auto/consumer loans, commercial loans, credit cards,
etc.). Recognize where we are now.
understand some consumers are fearful of what is behind the doors
of foreclosures, bankruptcies and judgments. Many believe they will
not recover if either of those credit events should happen to them.
fears can partly be attributed to a lack of information about the
markets. Do not give up hope, our economy will not be the same in
the future. We can prepare and inform ourselves for the new economy.
Take solace in this historical fact, underwriting guidelines of
today will evolve to accommodate market conditions of the future.
To the extent a fairly large number of consumers will experience
one or more of the above events, investors will adjust their guidelines
to capture that market.
BlackCommentator.com Columnist, Lloyd Wynn, was a consultant in the secondary market. Lloyd is the author of Residential Real Estate Finance: From
Application Through Settlement. Click here
to contact Lloyd Wynn.