Wednesday, January 28, 2009

Good Bank, Bad Bank: Who Cares?

Stocks rallied today as investors cheered reports the government would create a so-called "bad bank" to buy the troubled loans and securities that have rendered much of our financial sytem effectively insolvent. The hope would be to "cure" sick banks so that they can resume lending, allegedly allowing the rest of the economy to rebound. The idea has some credibility because it was used successfully in the U.S. and Sweeden in the 1987-1992 period.

Despite the optimism, I have some doubts, which I discuss in this blog entry. Fortunately, I see several ways the housing problem can be fixed. This article will conclude with specific policy recomendations.

Objection #1: If you create a true market for these toxic assets, the prices will be so low that the value of banks' entire portfolios will be in question. This could cause a panic and further shut down the credit markets.

Imagine you are trying to calm a patient whose femur is protruding from their leg. If they panic and move, it could slice their artery or cause worse injury. Do you tell them: "Wow, cool bone!" .. or do you say "It's okay, everything's going to be alright?" In dealing with any crisis, one major rule is to maintain calm, which means that sometimes ignorance is bliss. This was a theme I raised last year in this blog entry and this one. Just as shock can kill the patient, forcing a major bank to write down its assets by more than 50% can also be fatal.

Recently, people of much greater stature than myself have made similar observations:

"I'm strongly against forming a bad bank... If you have an asset only you own and only you carry, the history has been the banks carry them at inflated values ... If I bought that assert at fair value, you'd have to write that down... It's sort of robbing Peter to pay Paul. I don't think it gets you anywhere."
-Oppenheimer & Co. Banking Analyst Goddess Meredith Whitney on Maria Bartiromo's Wall Street Journal Report, 1/23/09

"I don't like it... I'm not alone. The original toxic relief program was never really implemented because the value of these [assets] is going to be dramatically enhanced by the government's presence. I don't see that as a good thing."
-CNBC bond market reporter Rick Santelli, giving a thumbs down to the "Bad Bank" on CNBC 1/28/09

Objection #2: The problem does not reside in the banks. It results from conditions in the credit market, which I have discussed at great length in previous blog entries such as this one, this one and this one about the decline of the banks.

Objection #3: Even if the "bad bank" successfully quarantines problem assets, that won't fix the problem: Falling home prices. The Case-Shiller Index shows that home prices are down 25% from their peak in July 2006 through November.

The worrisome thing is that the declines are accelerating: From from November 2007 to November 2008, Case-Shiller dropped a record 18%, compared 9-10% annual drops at the start of last year.

Mortgages are secured by houses and so ultimately derive their value from home prices. Most loans are repaid when people sell their homes rather than making monthly payments. When owners are "upside down," and owe more than your house is worth, the mortgage is by definition at risk. If money was lent assuming inflated value for the houses as was common in 2005-2007, the bank is almost certain to take a hit on the principal. If they foreclose on a house, a loss is even more likely.

First confined to some problem regions, home price declines are now becoming systemic. This has never happened on a sustained national scale before. The OFHEO Home Price Index goes back longer than Case-Shiller and looks at the entire country, rather than just 20 key cities, so I will use it for a longer-term view.
Looking at the period between the start of the index in 1975 and the first half of 2007, prices never fell for two consecutive quarters, or more than 0.4% at once.
This changed in the third quarter 2007, when the financial crisis began. Four of the last 5 readings have been negative.

Q3 2007: -0.5%

Q4 2007: +0.4%

Q1 2008: -0.2%

Q2 2008: -1.6%
Q3 2008: -2.7%

Given the lag in reporting, we can be pretty sure that Q4 of 2008 will also be negative. And, unless some kind of miracle transpires, the current quarter ending in March will also be a trainwreck. We're going to have at least five straight negative quarters of worsening losses, so if you think the recession is bad now, you ain't seen nothing yet.

Delving a little deeper into home prices: The OFHEO index rose from a base number of 61.04 in 1975 to a peak of 386.39 at the end of 2007. That's a change of 325.35 points. In technical analysis of price changes, it's common to use so-called Fibonacci retracement numbers. While they are very complicated and somewhat mystical in nature, they can prove uncannily accurate.

Fibonacci analysis expects that once a period of appreciation ends, prices should retrace either 23.6% or 38.2% of the move higher. (The latter number is more common.) This would suggest the OFHEO index needs to drop to 309.61 or 262.11, or 17-29%, from the level at the end of September. That would represent another $3.4 trillion to $6.2 trillion or so of wealth losses for U.S. households, and surely deepen the banks' financial crisis. This is why it's so important to arrest the declines, and why people need to consider the solutions I propose below.
I should highlight that Fibonacci is not normally used for this kind of pricing because we're not talking about a traded security like currencies and stocks. But it's still worth thinking about.

Home-price depreciation is becoming a national crisis. Everyone blithely thinks they will just stabilize at some point on their own. Aside from the Fibonacci analysis above, there are many other reasons to doubt things will just "get better."

First, home prices have risen dramatically for decades, outpacing inflation. This resulted from a self-reinforcing feedback loop of suburbanization, household formation, mass consumption and financial speculation. It also formed against the backdrop of a three-decade bull market in U.S. fixed-income assets, which had its own origins.

Source: Ofheo, BLS

Basically, the Fed's defeat of inflation in the early 1980s allowed it to cut interest rates steadily from a peak over 14%. This occured in a market dominated by so-called Bond Vigilantes, who were paranoid about inflation because of their experiences in the 1970s. Then came the 1980s, with falling oil prices, rising productivity, stagnant wages and cheap imports. As the inflation beast was tamed, vigilantes became believers. Just like in religion, converted bears become more zealous than those born bullish (usually because they are under-own the asset in question and must buy to catch up.) There was also a growing U.S. trade deficit, which left foreigners with huge stockpiles of dollars that were recycled into the U.S. bond market. Over time, these factors caused one of the greatest -- yet least appreciated -- bull markets in the history of financial markets. It channeled trillions of dollars of leverage into the U.S. economy, much of which found its way into the mortgage market. See this posting for more details. This bull market in fixed income has been coming undone over the past year or so, as I explain in this posting.

While I am a big fan of Reagan's tax cuts, their importance paled in comparison to the bull market in bonds unleased by the Fed's defeat of inflation. In many ways, the supply-siders owe more to the heroic actions of Paul Volcker, the Democrat appointed to run the Fed by Jimmy Carter, than to the Gipper himself.

Other things combined to drive home prices steadily higher in the decades following WWII, such as the baby-boom and suburbanization. The government promoted homeownership as a means of economic growth, giving tax subsidies, paying for roads and sewers, providing water to dry places like California and flood insurance for wet places like Florida. And, don't forget about institutions like Fannie Mae, Freddie Mac and the Federal Housing Authority (FHA), which built the modern-day mortgage industry. For instance, banks never dared to offer 30-year mortgages before the government was willing to back them.

Another major factor that drove the housing boom for decades was white flight from cities and a general decline of urban centers, especially as jobs exited en masse and drugs and crime arrived.

This process is now reversing itself and suburban areas are increasingly prone to crime -- especially as foreclosed homes invite squatters and troublemakers. This is only in its earliest stages, but a Google News search already turns up several stories across the country such as this one and this.

This reversal in the crime situation, while cities like New York continue to attract new people, highlights the severity of what's going on: A myriad of reasons combined to cause the homeowning boom of the last 60 years. It was systemic and self-reinforcing, making it hard to pin down a single cause.

But because the factors all fed into each other, many of those causes are now combining to move in the opposite direction. This is common in many kinds of human behavior -- especially after a bubble breaks. For instance, after the tech bubble burst in 2000, investors suddenly went mad for "real economy" companies like banks, retailers and homebuilders. (We know how that wound up.) After a bubble breaks, the bubble asset always becomes toxic. If it happened to tulips and tech stocks, it can also happen to townhouses.

So, even if government creates a "bad bank", it would only treat a symptom, and not the true disease. The reality is that the country is drowning in houses, and many of them poorly built at that. We need to accept they will never be purchased, or if they are, it will be at terribly depressed levels.

This is a disaster because it victimizes people who "didn't do anything wrong." Someone might have put down 20% and never used their home as an ATM, but that won't save them when other houses on their street lose value. It won't help their business get a needed loan from ailing firms like Bank of America. It won't prevent their town from raising property taxes to deal with revenue lost when neighbors are foreclosed on. It won't keep their insurance rates low when crime spreads in the neighborhood.

That person who did nothing wrong might get frustrated and decide they don't care about their house anymore and plan to leave the area, putting yet another house on the market. The next thing you know, it's South Chicago circa 1955. The schools will run into trouble and no one will ever want to live there again. This is how slums happen.

The problem could be even worse than in old industrial cities, where many people were tenants. When they left for "a better life" in the suburbs, their net worth didn't take a hit. They walked away and grew richer. This time, real harm will be done to their underlying personal wealth.

One final problem is that household formation could very well slow because it appears that large numbers of Latinos, who were driving much of the population boom, are leaving the country.

So to wrap it all up, George Soros spoke to Maria Bartiromo today in Davos. Speaking of the $100 billion or so being considered to finance this "bad bank":

"It will not be enough to turn it around."
George Soros on CNBC 1/28/09, referring to the "Bad Bank"

One final objection of mine to the Bad Bank idea is that it keeps the truly bad banks up and running. I would rather see the government and Fed encourage the creation of new banks, with new managements. The only justification for helping the big banks is that letting them fail would hurt the bigger economy. Why not allow new players emerge who could take their place, so they can die a just death?


So how to solve the problem?

1-Stop foreclosures. It might sound like a cavalier and simplistic idea, but foreclosure is a legal process requiring action by the local sheriff. Jim Traficant made a name for himself after refusing to kick people out of their homes in the early 1980s. More recently, at least one sheriff in Illinois took similar action. I know it's not as simple as I make it sound, but it would hardly be impossible if state governors and attorneys general put their minds to it.

2-Convert owners into tenants. Create a system whereby delinquent homeowners could remain in houses and pay rent. Even if they lose ownership of the home, they would be encouraged to remain in it.

3-Encourage investors rather than homeowners. The law is massively skewed in favor of owner-occupied houses. This sounds nice, but has caused many people to possess houses they never had the wherewithal to own. (If they had, banks never would have invented no-income verification loans.) The tax law and lending standards still favor owners. For instance, say I wanted to buy a house I think is cheap and try to rent it out. I would pay at least 1-2 percentage points more on the mortgage than if I lived in the home. In fact, I might not even be able to get a mortgage, which would be considered "Alt-A." This situation is the opposite of what you want to do if your intention is to get the market moving again. When there is too much supply, you should be trying to stimulate demand.

4-End the tax penalty for debt forgiveness. People talk willy-nilly about "reducing principal" on mortgages, but don't realize this can trigger a tax event. If your loan is reduced from $200,000 to $150,000, the government considers the $50,000 difference as taxable income. Not only do you lose your downpayment on the house and trash your credit score -- you also wind up owing income tax on the deal!

5-Identify certain areas that need to be condemned and dismantle the houses. Leave the roads and sewers so it can be restored later. It's key to get rid of extra inventory at this point, and would provide jobs.

6-Encourage investors in distressed mortgage debt. Why make the government buy these things when ordinary people can? I would suggest something like a deferment or outright elimination of income tax on certain kinds of securities. People know much of this stuff is worthless, but they'd be more willing to buy it if it's tax free. While it might sound like a giveaway, many of the parties who currently own this stuff, such as banks, probably would never pay any income tax on it anyway because they are bleeding red ink out of every orafice.

7-Have a government program to rebuild the securitization market. The government should say it will buy mortgage bonds that meet certain high standards, and provide specific price ranges. This would put a floor under the market and make private investors willing to buy. Obama should tap the knowledge and expertise of people like Janet Tavakoli, Meredith Whitney, Sean Egan -- all of whom were on the right side of this credit boondoggle. The rating agencies, partially responsible for this mess, should play only a small role in the new system -- at least in the beginning.

Under the Bad Bank paradigm, the government is forced to lick the wounds of the banks and inherit their lousy assets. Under my idea, including point #6 above, private investors would serve that role. That would restore the government to its rightful place as a leader, rather than nurse or nanny who must clean up after a spoiled child.

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