Stopgap Plan Outlined With Fanfare Ends Without Announcement
By Mary Kane 4/2/09 5:35 PM
A ban on foreclosure sales and evictions from houses owned by mortgage giants Fannie Mae and Freddie Mac, which began as a high-profile effort just before the holidays to keep people in their homes as the government tried to come up with homeowner rescue plans, is over.
Spokesmen for Fannie Mae and Freddie Mac confirmed the ban ended March 31, in a response to an inquiry from TWI. The agencies made a major announcement in November to roll out the ban, garnering headlines and extensive news coverage. Freddie Mac CEO David Moffett issued a statement at the time, saying the ban “provides a new measure of certainty” to families facing foreclosures during the holidays.
But its expiration didn’t seem to merit the same level of fanfare, with some housing advocates caught by surprise, scrambling for information today and Wednesday on listservs and in phone calls.
Danilo Pelletiere, research director for the National Low Income Housing Coalition, said the ban’s eventual expiration wasn’t unexpected - but it also wasn’t clear specifically when it was supposed to end. Some housing attorneys and advocates were confused because they were in the middle of cases that would be affected by the expiration. Fannie and Freddie have repeatedly extended the ban, which was originally expected to expire on Jan. 9.
Fannie Mae said in a brief statement from spokesman Brian Faith that “Fannie Mae’s suspension of foreclosure-related evictions concludes as of March 31, 2009. The company has in place special foreclosure sale requirements that take into account the Making Home Affordable program. A foreclosure sale may not occur on any Fannie Mae loan until the loan servicer verifies that the borrower is ineligible for a Home Affordable Modification and all other foreclosure prevention alternatives have been exhausted.”
Since the ban started, both Fannie and Freddie have developed rental programs to keep tenants from being evicted from foreclosed properties owned by the two agencies.
In addition, the Obama administration in March unveiled its plan to help troubled borrowers either refinance their homes or modify their mortgages.
Housing advocates aren’t exactly cheering about the ban being lifted. But they are hoping the new programs succeed, and plan to keep a close eye on their progress, Pelletiere said.
The lifting of the ban will be a testing ground for the administration’s approach to foreclosures. A bill to allow bankruptcy judges to modify mortgages has stalled in Congress. Money from the Troubled Assets Relief Program has gone to banks and bailout efforts. The ban, enacted as foreclosures soared and the holidays approached, was the government’s first dramatic step to help homeowners. The housing rescue plan was developed and announced only after the Treasury Department first unveiled its plan to buy toxic assets from banks.
“A perpetual moratorium is not a solution to how we do foreclosures in the future,” Pelletiere said. “It’s a holding pattern. We need to break that holding pattern to allow for something else positive to happen.”
Brad German, a spokesman for Freddie Mac, said he was “mystified” as to how anyone could be surprised by the ban’s expiration. The idea behind it was to give the government time to create homeowner rescue plans, and that’s been done, he said. Neither agency also expects a flood of homeowners out on the street because the ban is being lifted, he added.
“For all practical purposes, people will be in their homes for a while,” despite the ban’s expiration, German said. Fannie and Freddie will need time to approach tenants and homeowners and figure out whether they are qualified for help, he said.
Separate programs launched recently by Fannie and Freddie to allow tenants to stay in Real Estate Owned (REO) foreclosed properties owned by the agencies and lease them on a month by month basis at market rents, until they can be sold again, are not affected by the ban’s expiration, German said. Those programs will continue, with no expiration date scheduled. Fannie’s program covers renters of foreclosed properties, while both former owners and renters can qualify for Freddie’s program.
The REO rental programs aim to reach out to those no longer covered by the foreclosure ban and see if they can qualify, German said - which mitigates the effect of the ban being lifted. For example, under Freddie Mac’s program, a homeowner currently facing eviction could stay in his house as a renter until it is sold, if he meets the program’s guidelines.
But with little information to go on today, housing advocates found themselves in confusion and concern over whether the REO program was ending, and whether all renters would be subject to evictions again.
Even when the Fannie and Freddie ban was active, however, it sometimes failed to reach people before they got evicted, said Judith Liben, a senior housing attorney with the Massachusetts Law Reform Institute, a nonprofit legal services advocacy group. Only the District of Columbia and a few states have no-fault eviction laws requiring that a lease survives foreclosure, and that tenants can’t be automatically evicted. And the new REO policy by Fannie and Freddie, while laudable, takes time to reach the neighborhood level, Liben said.
Expanding no-fault eviction laws could be one answer to the problem of renters facing evictions, Liben said. Other states are moving to require more foreclosure notice for tenants.
The vulnerability of tenants to foreclosure evictions, along with falling property values of vacant and foreclosed homes, are prompting Liben and others to question the banking industry’s reluctance so far to move toward allowing people to stay in foreclosed houses and pay rent. Many are hoping the rest of the mortgage industry will follow Fannie and Freddie’s lead in establishing REO rental programs.
“Very few people have reached the stage where they are looking at renters as part of the solution,” Pelletiere said. “There’s almost a resistance to it. Bankers in particular still have this mindset that ‘I need to get those people out and sell the house right away.’ But rental housing really is part of the solution to this crisis.”
An oversupply of housing, combined with a weak economy that often requires people to move to find new jobs - and not tied down to a house they can’t sell - makes renting an especially worthwhile option, Pelletiere added. “Until the economy finds its footing, we don’t want to put pressure on people to settle down,” he said. “In the past we’ve had a very significant bias toward homeownership that has been to the detriment of rental housing. And that has to stop. Housing policy going forward really has to balance out a little more. In the long term, rental housing can be good for communities.”
Problems with bank-owned foreclosed properties that sell for way below market value, for example, could be addressed by keeping renters in the houses.
Community groups last month urged Congress to crack down on the practice of Broker Price Opinions , which are cheaper substitutes for full appraisals and are used to determine a property’s value. BPOs often are performed by real estate agents with minimal training and cost as little as $50, compared to $300 and above for a traditional appraisal. They are increasingly employed by lenders for sales of bank-owned foreclosed properties, known as REOs, or Real Estate Owned properties, and for short sales, in which owners sell their homes for less than they are worth. The bank forgives the difference, and takes a loss.
Using a BPO is illegal in more than 20 states, but the practice has become widespread, said David Berenbaum, executive vice president of the National Community Reinvestment Coalition. The BPOs frequently result in lowball estimates of a property’s value, with lenders using them to unload REOs and short sale properties. Agents who perform BPOs have an inherent conflict of interest, because they are working for lenders who want to quickly dispose of properties. Speculators and other investors scoop them up at the fire sale prices, dragging down property values overall.
“Right now, it’s a race to the bottom,” Berenbaum said. “They’re having a terrible impact on property values.”
Whether or not they use BPOs, banks increasingly are selling off REOs at low prices, even in stronger housing markets. In Temecula, Calif., for example, Citigroup sold a foreclosed house for just $139,000, when comparable houses in the area were going for $240,000 to $260,000, the North County Times reported - meaning the bank left some $100,000 on the table.
In markets where the REOs don’t sell and lenders fail to maintain their properties, other problems persist, with neighborhoods facing a glut of abandoned homes and blight, as TWI has explained. RealtyTrac, an online foreclosure database, predicts a record 1.5 million REOs this year, meaning more trouble ahead.
Given all this, some housing advocates can’t understand why lenders aren’t allowing more former homeowners or current tenants to pay rent and live in foreclosed houses until they can be sold. The new REO rental programs of Fannie Mae and Freddie Mac marked a major step toward that goal. But there’s been no major private industry initiative to move beyond the model of getting owners and tenants out ASAP, Berenbaum noted, despite the obvious benefits of doing so.
“Frankly, if the mortgage industry would allow homeowners facing foreclosure to remain in the properties as tenants, it would stabilize their investments and stabilize the communities,” Berenbaum said.
But bloated REO inventories are proof of how overwhelmed servicers and lenders due to record numbers of foreclosures - and they’ve said repeatedly they don’t want to be in the property management business. They also contend they’re not always the ones responsible for the vacant homes problem. In a magazine published by the Housing Wire mortgage blog, Robert Klein, CEO of Safeguard Properties, a major servicer, put it this way:
“The fact is, as an industry, mortgage servicers spend in excess of $2 billion annually to take care of vacant properties so they don’t become nuisances to neighbors and communities. Unfortunately, servicers who are the ‘good guys’ get lumped in with property flippers and Internet investors whose irresponsible practices have been major contributors to urban blight.”
Despite that blight, lenders and servicers seem to be closing their eyes to the possibility of economic benefits from filling empty houses with renters, said Liben said.
“I think that the mortgage industry and the banking industry are very slow to catch on to why things are different in this particular crisis,” Liben said. “They aren’t even trying to be creative. It’s like “This is the way we’ve always done it. Get people out and sell the house and get new people in and that’s that.’” Or, “We don’t want to be landlords.’” That’s all they ever say. ”
Foreclosed and vacant houses often lose 50 percent of their market value by the time they are sold out of bank REO inventories, Liben said. Those kind of losses should be spurring the industry to at least undertake a cost benefit analysis to figure out whether it might be more financially advantageous to rent out the properties, she said.
“Maybe those properties wouldn’t have declined by 50 percent if they had people in them,” Liben said.
Creating policies to encourage lenders to rent their foreclosed properties remains an uphill battle, said Dean Baker, co-director of the Center for Economic and Policy Research. The mortgage industry just isn’t interested in getting involved in the rental market. And some of the nonprofit development groups that overreached in promoting homeownership during the boom, putting people in houses they couldn’t afford, aren’t taking the lead on initiating rental options, he said.
“They don’t want to own up to what they did,” Baker said. “They’ve pretty much put their heads in the sand.”
Pelletiere, of the National Low Income Housing Coalition, said the rental issue remains a “tense” one for some nonprofits, because of the bitter controversy over whether the Community Reinvestment Act, an anti-redlining law, played a role in the housing crisis. Conservatives have blamed the CRA and poor and minority borrowers for the foreclosure crisis, saying the government forced lenders to make risky mortgages to them to meet CRA requirements.
Nonprofits fought that campaign by pointing out that most subprime loans were made by independent mortgage brokers and firms not covered by the CRA. Nonetheless, the belief persists, and nonprofits are wary of ceding any ground on the issue by changing their focus to promoting renting, Pelletiere said.
For the lending industry, the issue is far less complicated, Liben charged. The savings and loan crisis should have prepared them to better manage their REOs, she said. “They have no excuses,” she said. “They should have seen this coming.”
In the absence of industry initiatives, economists and housing experts have been floating various rental ideas, including allowing a delinquent homeowner to give the property back to the bank, in return for having his credit wiped clean. Rent-to-own programs, in which a portion of rent goes toward a downpayment, also are being revived in some communities with too many foreclosed homes.
But none of those efforts will gain a foothold until the mindset that renters are a detriment to a neighborhood begins to change, Pelletiere said. Or until renting is seen as one of the answers to the problem of foreclosures and vacant homes. For those reasons, he and others will watch closely as Fannie and Freddie run their REO rental programs, and try to keep people in their homes as a ban on foreclosure sales and evictions finally ends.
Saturday, April 4, 2009
Friday, April 3, 2009
Low Mortgage Rates Spur Buyers
Budget plan for 2010 approved
Barack Obama's $3.5 trillion budget plan was approved by the U.S. congress but not before the Republicans showered it with criticism. John Boehner (R - OH), the House Minority Leader, commenting on the "expansionary" budget that aimed at increasing spending, increasing taxes, and leading to increased public debt, called it "a roadmap to disaster." Incidentally, the fiscal deficit is expected to touch $1.8 trillion in 2009, for anyone still counting. Steny Hoyer (D - MD), the House Majority Leader, said, "Our budget lays the groundwork for a sustained, shared, and job-creating recovery." With all the Republicans voting against the budget, there was no sign of the bipartisanship Obama had hoped for. Obama was pleased with the outcome, calling it "an important step toward rebuilding our struggling economy."
Disclosing information on borrowers
The Federal Reserve, as the lender of the last resort, does not disclose the names of its borrowing banks on account of the concern that there could be a run on them. After all, public confidence could take a beating if it became known that a bank had to go to the Fed to tide over a liquidity situation. If the U.S. Senate has its way though, the Fed will be required to disclose the names of its borrowers in future. As part of an initiative to enhance the quality of regulation of the financial sector, the Senate introduced a budget amendment on April 3, 2009 requiring the Fed to disclose the names of its borrowers. While the Fed is not required by law to make the disclosure, it may not find it easy to ignore the budget amendment, particularly in the current financial crises. Can the Senate's writ be challenged by the Fed, and will the disclosure do more harm than good to the stability of the banking sector? We'll know in the days to come.
U.S. unemployment rate expected to hit a 25-year high
According to a Bloomberg News survey, ahead of the March jobs data to be released by the Labor department, the unemployment rate in the U.S. in March is estimated to be 8.5% (a 25-year high). The total number of job losses since the beginning of 2008 now stands at 5.1 million - 2 million of those in the first 3 months of 2009. Large companies like IBM have announced job cuts in the thousands and the situation is showing no signs of improvement. Given the slump in the manufacturing sector and the likelihood of bankruptcy for General Motors, analysts are talking about a significant increase in the unemployment rate. Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities, estimates that the unemployment rate could reach as high as 11 percent. Will the $3.5 trillion budget rein in job losses or just cause inflation on top of everything else?
Mortgage rates leading to a rebound in the home-loan market?
Freddie Mac announced that the 30-year mortgage (fixed) rate fell to 4.78% (lowest since 1971) in the last week of March. Ben Bernanke, Chairman of the Federal Reserve, in his testimony to the U.S. House of Representatives last November said, "It is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met." The Fed's announcement in March 09 that it would buy $1.25 trillion in home-loan securities in 2009 is a clear sign of Bernanke walking his talk. How effective will the Fed's initiative be? The initial signs are encouraging, with mortgage applications on the rise. According to the National Association of Realtors (NAR), the sale of previously owned homes rose by 5.2% in March over the previous month, and the rise in "affordability index" (released by the NAR) in January indicates that the lower home values and mortgage rates are having an impact on the home market.
CEO Pay Falls
According to an analysis prepared by Hay Group for the Wall Street Journal, median cash salaries and bonuses for chief executives of 200 big U.S. companies fell 8.5 percent in 2008 to $2.24 million. CEO compensation decreased more sharply at banks and brokerages, and median annual cash compensation for CEOs in the financial industry fell 43 percent, to $976,000, while total direct compensation fell 14.2 percent, to a median $7.6 million. The decline was the first in seven years.
Barack Obama's $3.5 trillion budget plan was approved by the U.S. congress but not before the Republicans showered it with criticism. John Boehner (R - OH), the House Minority Leader, commenting on the "expansionary" budget that aimed at increasing spending, increasing taxes, and leading to increased public debt, called it "a roadmap to disaster." Incidentally, the fiscal deficit is expected to touch $1.8 trillion in 2009, for anyone still counting. Steny Hoyer (D - MD), the House Majority Leader, said, "Our budget lays the groundwork for a sustained, shared, and job-creating recovery." With all the Republicans voting against the budget, there was no sign of the bipartisanship Obama had hoped for. Obama was pleased with the outcome, calling it "an important step toward rebuilding our struggling economy."
Disclosing information on borrowers
The Federal Reserve, as the lender of the last resort, does not disclose the names of its borrowing banks on account of the concern that there could be a run on them. After all, public confidence could take a beating if it became known that a bank had to go to the Fed to tide over a liquidity situation. If the U.S. Senate has its way though, the Fed will be required to disclose the names of its borrowers in future. As part of an initiative to enhance the quality of regulation of the financial sector, the Senate introduced a budget amendment on April 3, 2009 requiring the Fed to disclose the names of its borrowers. While the Fed is not required by law to make the disclosure, it may not find it easy to ignore the budget amendment, particularly in the current financial crises. Can the Senate's writ be challenged by the Fed, and will the disclosure do more harm than good to the stability of the banking sector? We'll know in the days to come.
U.S. unemployment rate expected to hit a 25-year high
According to a Bloomberg News survey, ahead of the March jobs data to be released by the Labor department, the unemployment rate in the U.S. in March is estimated to be 8.5% (a 25-year high). The total number of job losses since the beginning of 2008 now stands at 5.1 million - 2 million of those in the first 3 months of 2009. Large companies like IBM have announced job cuts in the thousands and the situation is showing no signs of improvement. Given the slump in the manufacturing sector and the likelihood of bankruptcy for General Motors, analysts are talking about a significant increase in the unemployment rate. Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities, estimates that the unemployment rate could reach as high as 11 percent. Will the $3.5 trillion budget rein in job losses or just cause inflation on top of everything else?
Mortgage rates leading to a rebound in the home-loan market?
Freddie Mac announced that the 30-year mortgage (fixed) rate fell to 4.78% (lowest since 1971) in the last week of March. Ben Bernanke, Chairman of the Federal Reserve, in his testimony to the U.S. House of Representatives last November said, "It is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met." The Fed's announcement in March 09 that it would buy $1.25 trillion in home-loan securities in 2009 is a clear sign of Bernanke walking his talk. How effective will the Fed's initiative be? The initial signs are encouraging, with mortgage applications on the rise. According to the National Association of Realtors (NAR), the sale of previously owned homes rose by 5.2% in March over the previous month, and the rise in "affordability index" (released by the NAR) in January indicates that the lower home values and mortgage rates are having an impact on the home market.
CEO Pay Falls
According to an analysis prepared by Hay Group for the Wall Street Journal, median cash salaries and bonuses for chief executives of 200 big U.S. companies fell 8.5 percent in 2008 to $2.24 million. CEO compensation decreased more sharply at banks and brokerages, and median annual cash compensation for CEOs in the financial industry fell 43 percent, to $976,000, while total direct compensation fell 14.2 percent, to a median $7.6 million. The decline was the first in seven years.
Wednesday, April 1, 2009
Recent data from First American CoreLogic shows that while the 90 day delinquency rates in Myrtle Beach-Conway-North Myrtle Beach (3.3%) have increase
Recent data from First American CoreLogic shows that while the 90 day delinquency rates in Myrtle Beach-Conway-North Myrtle Beach (3.3%) have increased for the month of February over the same period last year, the rate is much less that the US (5%) and SC statewide (3.5%) rates.
Cynthia Stanley, Realty One Grand Strand, has been living and working in real estate most of her career. Stanley says her office has been not handling a lot of foreclosures and even short sales (property selling for less than the mortgage upon them) have been difficult.
“To get one to close out is horrendous,” said Stanley. Buyer, sellers and agents feel like they have been dropped “in a bottomless pit” with no way to climb out. She puts a lot of the blame on the bank’s ‘loss mitigations officers’ with whom all short sales must be processed. Unfortunately, they are all snowed under.
Stanley went on to say, “Foreclosure sales work better because the bank already owns it and wants to get rid of it”
Visitors to North Myrtle Beach Online.com should not be surprised by the positive contrast with other real estate areas. In an article, ‘Myrtle Beach in Healthiest Market in U.S’ Builder online.com ranked this area the 15th most viable market in the U.S.
“This area caters to retirees and, although they might have lost a lot in the markets, their homes are either paid for or they have a low mortgage,” said Mandy Dunlap, ReMax Southern Shores, explaining why delinquencies and foreclosures were comparatively low in this area.
Agreeing with Stanley that short sales were really difficult to negotiate, Dunlap added, “Short sales are distorting the price point of the market. Short sellers are trying to cut their losses and make a deal before bringing in the banks. Once the banks get involved, buyers tend to be negotiating up, not down and get tied up for months.” Then, Dunlap explains that any other ‘better’ contract that comes in can kick the current negotiator out of the dealing.
Emphasizing that short sales are distorting the market, Dunlap said, “Some agents believe short sales should not be included in the Multiple Listing service.” She believes their inclusion gives a distorted view of the market values of homes in a neighborhood in which they are located and gives a buyer a false sense of values.
Dunlap believes that potential purchasers will find “wonderful buys in the market, where sellers are pricing to sell and willing to negotiate.”
Getting financing is “more difficult than two years ago” added Dunlap, “but if the purchase is for a primary home, the buyer has 10% down, above average credit rating and an acceptable debt ratio, they can close within 4 – 5 weeks.”
Second homes are a little more difficult requiring 20% down and if the property is Ocean Front in a complex with a lot of rentals, banks may require as much as 30 to 40% down.
Foreclosure data for First American CoreLogic is reported based on the actual number of active mortgage loans rather than the total number of households in a given area, which provides more accurate results by removing paid-in-full mortgages from the equation.
Cynthia Stanley, Realty One Grand Strand, has been living and working in real estate most of her career. Stanley says her office has been not handling a lot of foreclosures and even short sales (property selling for less than the mortgage upon them) have been difficult.
“To get one to close out is horrendous,” said Stanley. Buyer, sellers and agents feel like they have been dropped “in a bottomless pit” with no way to climb out. She puts a lot of the blame on the bank’s ‘loss mitigations officers’ with whom all short sales must be processed. Unfortunately, they are all snowed under.
Stanley went on to say, “Foreclosure sales work better because the bank already owns it and wants to get rid of it”
Visitors to North Myrtle Beach Online.com should not be surprised by the positive contrast with other real estate areas. In an article, ‘Myrtle Beach in Healthiest Market in U.S’ Builder online.com ranked this area the 15th most viable market in the U.S.
“This area caters to retirees and, although they might have lost a lot in the markets, their homes are either paid for or they have a low mortgage,” said Mandy Dunlap, ReMax Southern Shores, explaining why delinquencies and foreclosures were comparatively low in this area.
Agreeing with Stanley that short sales were really difficult to negotiate, Dunlap added, “Short sales are distorting the price point of the market. Short sellers are trying to cut their losses and make a deal before bringing in the banks. Once the banks get involved, buyers tend to be negotiating up, not down and get tied up for months.” Then, Dunlap explains that any other ‘better’ contract that comes in can kick the current negotiator out of the dealing.
Emphasizing that short sales are distorting the market, Dunlap said, “Some agents believe short sales should not be included in the Multiple Listing service.” She believes their inclusion gives a distorted view of the market values of homes in a neighborhood in which they are located and gives a buyer a false sense of values.
Dunlap believes that potential purchasers will find “wonderful buys in the market, where sellers are pricing to sell and willing to negotiate.”
Getting financing is “more difficult than two years ago” added Dunlap, “but if the purchase is for a primary home, the buyer has 10% down, above average credit rating and an acceptable debt ratio, they can close within 4 – 5 weeks.”
Second homes are a little more difficult requiring 20% down and if the property is Ocean Front in a complex with a lot of rentals, banks may require as much as 30 to 40% down.
Foreclosure data for First American CoreLogic is reported based on the actual number of active mortgage loans rather than the total number of households in a given area, which provides more accurate results by removing paid-in-full mortgages from the equation.
Monday, March 30, 2009
On the Urgency of Restructuring Bank and Mortgage Debt,
John P. Hussman, Ph.D.
Note - Regular readers of these weekly comments will recognize many elements of the following analysis from published remarks over the past year. They are summarized here to provide a clear picture of the current situation, outlook, and the options available to Congress. To the extent that this discussion is consistent with your own views, please forward it to others, particularly to your representatives in the House and Senate. There is far too little debate about alternative responses to this crisis. – JPH
Last week, the U.S. Treasury Secretary advanced two proposals; one was a call for regulatory reform that is absolutely essential to the resolution of the current financial crisis. The other was a recipe for the insolvency of the FDIC, which would squander public funds to subsidize private speculation in troubled mortgage securities.
To begin this discussion, it is important to consider the balance sheet of a typical leveraged financial institution. The example below is similar to the one I presented last year in You Can't Rescue the Financial System if You Can't Read a Balance Sheet, but makes allowance for the fact that assets continue to be impaired due to policy failures, and that deposit banks such as Citigroup use more bond financing than investment banks. At the beginning of the recent crisis, the condition of U.S. financial institutions was much like the following:
Good Assets: $90
Questionable Assets: $10
TOTAL ASSETS: $100
Liabilities to Customers: $65
Debt to Bondholders: $30
Shareholder Equity: $5
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100
Now suppose there are losses in those questionable assets - not all the way to zero, but to $4:
Good Assets: $90
Questionable Assets: $4
TOTAL ASSETS: $94
Liabilities to Customers: $65
Debt to Bondholders: $30
Shareholder Equity: $-1
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $94
The above institution is insolvent. There are several ways to address this situation.
Direct Capital Infusions
The first possible response is to provide public capital directly to the banks, which is what the Treasury did last year by purchasing newly issued preferred stock of banking institutions. A capital infusion increases the asset side of the balance sheet (cash on hand) and increases the shareholder equity side of the balance sheet by the same amount. The difficulty is that without clear restrictions on the use of that capital, banks have the freedom to continue business as usual, including using the public capital to finance bonus payments and other expenditures. Absent explicit restrictions, there is also no assurance that the public funds will be lent out. To some extent, financing additional loans is not the purpose of capital infusions. The purpose is to replace the cushion of equity (“Tier 1 capital”) that stands between the bank's customers and bankruptcy.
Capital infusions are certainly a viable option to respond to the immediate threat of insolvency. These infusions were largely responsible for reducing the immediate threat to the U.S. financial system in late 2008. However, in the face of large and increasing losses, capital infusions are not sustainable. The public stands to lose the entire amount of funding if the institution fails, unless the infusions can be provided as a senior claim ahead of bondholders in the event of bankruptcy, and still be counted as “Tier 1 capital” otherwise. There are currently no legal or regulatory provisions to accomplish this.
Note that gross private debt currently stands at about 350% of GDP, about double the historical norm. Meanwhile, many of the assets underlying this debt are being marked down in value by 20-30% or more. Given that GDP itself is about $14 trillion, a continued policy of bailouts will eventually require a commitment of public funds amounting to a significant fraction of $14 trillion. The “real” burden of the mounting federal debt will have to be devalued through inflation, or it will place an onerous claim on the nation's future production and capital investment (which might otherwise be able to provide for the needs of an aging population).
Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. As noted below, this can be achieved without customer losses or a disorganized Lehman-style unwinding.
Toxic Asset Purchases
The Treasury's proposal to address insolvency is to finance the purchase of impaired assets from the banks, primarily using taxpayer funds. But note that if the questionable assets are taken off of the bank's books at their actual value ($4 in the example above), there is absolutely no change on the liability side of the balance sheet. The bank's capital position does not improve. The “toxic asset sale” simply replaces the bad assets with cash. While this might improve the “quality” of the bank's balance sheet, it does not make the institution solvent.
Indeed, the only way for the toxic asset sale to increase shareholder equity is if the buyer overpays for the asset. To accomplish this, the Geithner plan creates a speculative incentive for private investors, by effectively offering them a “put option,” whereby taxpayers would absorb all losses in excess of 3-7% of the purchase amount. This is essentially a recipe for the insolvency of the Federal Deposit Insurance Corporation itself, which would provide the bulk of the “6-to-1 leverage.” To the extent that it is not acceptable for the FDIC to fail, the Geithner plan implies an end-run around Congress, and would ultimately force the provision of funds to cover probable losses.
An equal concern is that there is no link between removing “toxic assets” from bank balance sheets and avoiding large-scale home foreclosures and loan defaults. All the transaction accomplishes is to take the assets out of the bank's hands, to offer half of any speculative gains to private “investors,” and to leave the public at risk for 93-97% of the probable losses. What the plan emphatically does not do is to affect the payment obligations of homeowners in a way that would reduce the likelihood of foreclosure. Moreover, the last thing that a bank would do with the proceeds would be to refinance such mortgages, because that would provide full repayment to the original lenders while taking on the risk of the newly refinanced loans.
If part of the intent of Congress is to increase lending, this could be done directly by providing funds to GSEs or by broadly providing capital to solvent regional banks. This would be a much more effective way of increasing the volume of lending in the U.S. economy without putting taxpayers at risk of major losses. There is no need for the public to purchase impared assets in order to increase lending activity.
Remember that the “toxic assets” held by banks represent pools of mortgages that have been cut up into dozens of individual pieces; the higher grade pieces having first claim to payments made on the underlying mortgages, and the lower grade pieces having claims to less likely payments. It is improbable that banks will be interested in selling off the better “tranches,” and yet there is no benefit (aside from rank speculation) to owning the lower tranches unless the underlying mortgages can be restructured.
As a result, the only point in the public having anything to do with these securitized mortgages is if all of the tranches of a given issue can be purchased simultaneously, so that the underlying payment obligations of the homeowners can be restructured. That is, if the entire issue could be purchased at 50% of the original face amount, the underlying mortgages could be written down by the same proportion. Those mortgages would then be far more likely to be repaid, and as a result, the restructured debt could be sold back into the financial markets without the need for taxpayers to hold it to maturity. There is no “all or none” mechanism in the Treasury's toxic assets plan to accomplish this.
While the U.S. equity market advanced strongly on the day the Treasury plan was announced, most market indices were lower by the end of the week, and credit spreads (indicators of bondholder concerns about default risk) did not budge. It is far from clear that the Wall Street has confidence in the plan, beyond the fact that a trillion dollars to speculate on mortgage securities at taxpayer expense was not immediately rejected.
Debt Restructuring
From the beginning of the recent crisis, starting with Bear Stearns, I have emphasized that nearly all of the financial institutions at risk of insolvency have enough liabilities to their own bondholders to fully absorb all probable losses without any loss to customers or the American public. The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense.
Note that in the example balance sheet above, 30% of the liabilities of the institution represent debt to the company's own bondholders. It is these individuals – not homeowners, not the American public – that are being defended by the promise of trillions of dollars in public money.
For example, while Citigroup has approximately $2 trillion in assets, those assets are financed not only by customer deposits, but also by nearly $600 billion in debt to Citigroup's own bondholders. It is these private bondholders who provided the funds for Citigroup to acquire questionable assets.
The bondholders of distressed financial institutions – not the American public – should bear responsibility for the losses of those institutions. This can be accomplished, without harm to customers or the broader financial system, in one of two ways:
1) The bondholders could voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps , preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Alternatively;
2) The U.S. government could take receivership of the financial institution, defend the customer assets, change the management, wipe out the stockholders and a chunk of the bondholders claims entirely, continue the operation of the institution in receivership, and eventually sell or reissue the company to private ownership, leaving the bondholders with the residual. Indeed, this is how the largest bank failure in history – Washington Mutual – was handled so seamlessly last year that it was almost forgettable. This is not Argentina-style “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. This would fully protect all of the customers and depositors at no probable expense to the public.
What should not be done is what was allowed in the case of Lehman Brothers – a disorderly failure, by which the company was allowed to fail with no conservatorship of the existing business. It was not the failure of Lehman per se, but the disorder resulting from its piecemeal liquidation, that caused distress to the financial markets.
That said, it is true that the bondholders of major banks include pension funds, insurance companies, mutual funds, foreign investors and other holders that would be adversely affected by a writedown in bond values. But this is part of the contract – when one lends money to a financial institution, one also assumes the risk and responsibility of bearing the losses. Congress always has the ability to mitigate the losses of some parties, such as pension funds, if it is agreed that this is in the public interest. But to defend all bondholders of financial institutions at public expense is to commit the future economic output of innocent citizens to cover the losses of mismanaged financial institutions. As a result of the intervention by the Federal Reserve and the U.S. Treasury, even the bondholders of Bear Stearns stand to receive 100% repayment of both interest and principal on their bond investments. This is absurd.
Needed Legislation
1) Enable receivership of distressed bank and non-bank financial institutions (including bank holding companies), encouraging voluntary debt-equity swaps as an alternative to the seizure of insolvent institutions.
2) Allow “toxic asset” purchases using public funds only to the extent that entire issues of these securitized mortgages can be purchased “all or none” at a moderate percentage of face value, thereby allowing the underlying mortgages to be written down to the same percentage of face.
3) Establish a Treasury conduit to administer (but not guarantee) property appreciation rights on restructured mortgages, again encouraging voluntary restructuring, using the Treasury conduit as a coordinating mechanism (additional details below).
4) Allow bankruptcy judges to substitute a portion of foreclosed mortgage obligations with equivalent claims on subsequent property appreciation. “Push-down” of mortgage principal without offsetting compensation rights to lenders should be emphatically avoided.
Receivership Provisions
More than a year ago, in a March 24, 2008 comment (Why is Bear Stearns Trading at $6 instead of $2?), I emphasized the need for immediate authority to take distressed financial institutions into receivership in order to cut away the stockholder and bondholder obligations, while preserving the ongoing business, as well as its obligations to customers and counterparties:
“At what point will investors figure out that the liquidity problems are nothing but the precursors of insolvency problems? At what point will investors stop begging the government to save private companies and recognize that the losses should be taken by the stock and bondholders of the offending financial institutions? If the Fed and the Treasury are smart, they will act quickly to figure out how to respond to multiple events like we've seen in recent days, to expedite turnover in ownership and quickly settle the residual claims of bondholders, without the kind of malfeasance reflected in the Bear Stearns rescue.”
It is essential for regulators to have the ability to take distressed institutions into receivership, so that customers and counterparties of insolvent financial companies can be fully protected. Ideally, this determination should be made not by the Treasury, but by the FDIC, which has a clearer regulatory role. The objective of receivership provisions would be to allow the failing institution to be partitioned into an operating entity (including whatever questionable loans are on the books), while cutting away the obligations to the stockholders and bondholders of that institution. Upon the sale, liquidation, or re-privatization of the institution, the bondholders would receive the portion of the proceeds that are not required as regulatory capital.
To reduce the indirect effects of such receivership on other institutions, it would be helpful to legislate a restriction on the use of credit default swaps (essentially insurance contracts against the failure of a company's bonds), requiring that such swaps may be used for bona-fide hedging purposes only. That is, a credit default swap could not be entered for purely speculative purposes, but only to offset the default risk of the same or similar bonds held by the investor.
Foreclosure Abatement
Although trillions of dollars have been promised or committed in hope of resolving the current financial crisis, the simple fact is that virtually nothing has been done to reduce the incidence of foreclosures. Even if the plan to remove toxic assets from bank balance sheets is successful (however “success” might be defined), the rate of foreclosure will be unaffected, because no change in the payment obligations of homeowners will result.
As with financial institutions, insolvent mortgages would best be addressed by a) voluntarily swapping debt for equity, or failing that; b) technical default and restructuring of the debt obligation.
From the standpoint of homeowners, a debt-equity swap is equivalent to writing down the mortgage principal, while at the same time giving the lender an equal and offsetting claim on the future appreciation of the home. As I noted in The Economy Needs Coordination, Not Money, From the Government,
“The most useful feature of government in resolving the foreclosure crisis is not its ability to squander taxpayer money, but its ability to provide coordinated action. I still believe that the best approach to foreclosure abatement would be for the Treasury to set up a special “conduit” fund to administer “property appreciation rights” or what I've called PARs.
“Suppose a $300,000 mortgage is in foreclosure (or the homeowner and lender can agree to the following arrangement outside of foreclosure court). A reasonable mortgage restructuring might be to cut the principal of the mortgage to $200,000, and to create a $100,000 property appreciation right. The homeowner would agree to pay off the PAR to the Treasury (and administered through the IRS) out of future price appreciation on the existing home or subsequent property. The homeowner would be excluded from taking on any home equity loans or executing any “cash out” refinancings until the PAR was satisfied. The maximum PAR obligation accepted by the Treasury would be based on the value of the home and the income of the homeowner.
“The lender would receive not a direct claim on that homeowner, but a participation in the Treasury's “PAR fund” which would pay out proportionately from all PAR proceeds received by the Treasury (technically, new shares in the PAR fund would be assigned based on a ratio reflecting the extent to which existing shareholders have already been paid off, so earlier shareholders don't receive more than they have coming to them).
“Importantly, the Treasury would not guarantee repayment, but would simply serve as a conduit. There would be no “free lunch” at taxpayer expense. If the homeowner was to eventually sell the home and not purchase another, the obligation would become a low-interest loan obligation and would eventually be a claim on the estate of the homeowner, but with an initial exclusion at low income and a progressive recovery rate based on the size of the estate. The PARs would be tradeable, since they would be based on a single pool of cash flows, though they would almost certainly trade at a discount to face value. Assuming that the PAR obligations are fixed and don't increase at some rate of interest, then even if home prices were expected to take about 15 years to recover, the PARs would still trade at more than 50% of face. Given that recovery rates in foreclosure are running at only about 50% of the entire loan, it is clear that this sort of approach would be preferable to foreclosure in most cases. If this sort of mechanism were available, lenders might agree to outright principal reductions as well in preference a costly foreclosure process.
“This sort of approach would reduce foreclosures without relying on free money from the government, or violating contract law. The PARs would provide a legally enforceable, diversified stream of cash flows at far lower cost than individual lenders would have to spend to collect from individual homeowners. Since home sales are taxable events, the IRS would be in an ideal position to enforce these obligations.”
The Danger of Inaction
If there is any good news at present, it is that the capital infusions of late-2008 have temporarily stabilized the banking system, and that the U.S. economy is presently enjoying a brief and modest reprieve from the financial crisis. This is largely the result of an ebbing in the rate of sub-prime mortgage resets, which reached their peak in mid-2008, with corresponding mortgage losses and foreclosures a few months later. Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures.
As a foreshadowing of the probable foreclosures ahead, the following is what the Federal Reserve, FDIC, and the Office of Thrift Supervision noted about option-ARMs and other loans in a colorful little booklet entitled “Interest-Only Mortgage Payments and Payment-Option ARMs: Are They For You?” , published in November 2006:
“Owning a home is part of the American dream. But high home prices may make the dream seem out of reach. To make monthly mortgage payments more affordable, many lenders offer home loans that allow you to (1) pay only the interest on the loan during the first few years of the loan term or (2) make only a specified minimum payment that could be less than the monthly interest on the loan.
"Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment (an I-O mortgage)--or an adjustable-rate mortgage (ARM) with the option to make a minimum payment (a payment-option ARM)--is right for you. Lenders have a variety of names for these loans, but keep in mind that with I-O mortgages and payment-option ARMs, you could face
* "payment shock." Your payments may go up a lot--as much as double or triple--after the interest-only period or when the payments adjust.
"In addition, with payment-option ARMs you could face
* negative amortization. Your payments may not cover all of the interest owed. The unpaid interest is added to your mortgage balance so that you owe more on your mortgage than you originally borrowed.
"Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast ) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment.
"Lenders end the option payments if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made minimum payments on your $180,000 mortgage and had negative amortization. If the balance grew to $225,000 (125% of $180,000), the option payments would end. Your loan would be recalculated and you would pay back principal and interest based on the remaining term of your loan. It is likely that your payments would go up significantly.
"Be sure you understand the loan terms and the risks you face. And be realistic about whether you can handle future payment increases. If you're not comfortable with these risks, ask about another loan product.”
Judging from the reset schedule above, it is clear that more than a few borrowers ignored this advice.
Market Climate
As of last week, the Market Climate for stocks was characterized by reasonable valuations – moderate undervaluation on earnings-based measures that assume a reversion to above-average profit margins in the future, but continued overvaluation on measures that do not rely on future profit margins being above historical norms.
This is an important distinction, because much of my constructive perspective about valuations late last year was based on the expectation of something of a “writedown recession” whereby our policy focus would have been on properly defending customers through greater use of the receivership process – demonstrating that the financial system itself could remain sound even while allowing the writedown and restructuring of debt. I believed, as I wrote a year ago, that “The U.S. economy will get through this without the requirement of massive public bailouts. What is required, however, is that the stock and bondholders of financial companies take due losses. Customers and counterparties need not, and I expect will not, be harmed.” My optimism that our policy-makers would see clearly enough to follow this course was mistaken (fortunately, we are within 5% of where we stood at the beginning of this bear market).
The misguided policy of defending bondholders against losses with public funds has increased uncertainty, crowded out private investment, harmed consumer confidence, and prompted defensive saving against possible adversity. We observe this as a plunge in gross domestic investment that is much broader than just construction and real estate, and a corresponding but misleading “improvement” in the current account deficit as domestic investment plunges.
Aside from a few Nobel economists such as Joseph Stiglitz (who characterized the Treasury policy last week as “robbery of the American people”) and Paul Krugman (who called it "a plan to rearrange the deck chairs and hope that that keeps us from hitting the iceberg"), the recognition that this problem can be addressed without a massive waste of public funds (and that it is both dangerous and wrong to do so) is not even on the radar.
In short, attempting to avoid the need for debt restructuring by wasting trillions in public funds increases the likelihood that the current economic downturn will be prolonged, places a massive claim on our future production in order to transfer our nation's wealth to the bondholders of mismanaged financial companies, and raises the likelihood that any nascent recovery will be cut short by inflation pressures. We are nowhere near the completion of this deleveraging cycle.
To the extent that we continue to force add-on effects in the form of declining employment and capital investment, we also reduce the likelihood that profit margins and returns on equity will recover to the historically above-average levels which have prevailed in recent years.
The advance of the past few weeks has cleared the prior oversold condition and the market is now overbought in a generally negative Climate. As should be clear from last year's decline, the market can be severely oversold and only become more oversold, so an oversold condition is not a timing tool. That said, oversold conditions in clearly favorable Market Climates are often followed by strong advances, and overbought conditions in clearly unfavorable Market Climates are often followed by spectacular declines. At the recent market low, the Market Climate could certainly not be characterized as favorable, but at the present overbought level, there is considerable risk of a fresh plunge.
Thus far, the recent advance has been focused on low-quality and distressed sectors such as financials, insurance and homebuilders. If the current advance is durable, we would expect to observe stronger market internals, greater participation among higher quality sectors, and a clear easing of credit spreads, which remain near their highs despite the advance in equities. On sufficient improvement in market internals, we would be inclined to establish call option positions that would gradually take us to a significantly less hedged position on persistent market strength, but we do not expect to eliminate our put option defenses until the combination of valuations and market action becomes clearly favorable, or until it is reasonable to expect a sustained economic recovery within a quarter or two. Nothing in our analysis of valuations, market action, or economic conditions compels us that removing downside protection is reasonable at present.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively neutral yield pressures. The yields on Treasury Inflation Protected Securities have declined further in recent sessions, with inflation-adjusted yields on some issues dropping below 1%. I expect that a further decline in real yields would prompt us to reduce our holdings modestly, as it is doubtful that persistent inflation surprises will be a near-term outcome. I continue to view the U.S. dollar as vulnerable to depreciation given the rapid expansion in government liabilities, so the Strategic Total Return Fund continues to hold about 20% of assets in precious metals shares and foreign currencies, with a few percent in utility shares on the basis of longer-term total return prospects.
Note - Regular readers of these weekly comments will recognize many elements of the following analysis from published remarks over the past year. They are summarized here to provide a clear picture of the current situation, outlook, and the options available to Congress. To the extent that this discussion is consistent with your own views, please forward it to others, particularly to your representatives in the House and Senate. There is far too little debate about alternative responses to this crisis. – JPH
Last week, the U.S. Treasury Secretary advanced two proposals; one was a call for regulatory reform that is absolutely essential to the resolution of the current financial crisis. The other was a recipe for the insolvency of the FDIC, which would squander public funds to subsidize private speculation in troubled mortgage securities.
To begin this discussion, it is important to consider the balance sheet of a typical leveraged financial institution. The example below is similar to the one I presented last year in You Can't Rescue the Financial System if You Can't Read a Balance Sheet, but makes allowance for the fact that assets continue to be impaired due to policy failures, and that deposit banks such as Citigroup use more bond financing than investment banks. At the beginning of the recent crisis, the condition of U.S. financial institutions was much like the following:
Good Assets: $90
Questionable Assets: $10
TOTAL ASSETS: $100
Liabilities to Customers: $65
Debt to Bondholders: $30
Shareholder Equity: $5
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100
Now suppose there are losses in those questionable assets - not all the way to zero, but to $4:
Good Assets: $90
Questionable Assets: $4
TOTAL ASSETS: $94
Liabilities to Customers: $65
Debt to Bondholders: $30
Shareholder Equity: $-1
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $94
The above institution is insolvent. There are several ways to address this situation.
Direct Capital Infusions
The first possible response is to provide public capital directly to the banks, which is what the Treasury did last year by purchasing newly issued preferred stock of banking institutions. A capital infusion increases the asset side of the balance sheet (cash on hand) and increases the shareholder equity side of the balance sheet by the same amount. The difficulty is that without clear restrictions on the use of that capital, banks have the freedom to continue business as usual, including using the public capital to finance bonus payments and other expenditures. Absent explicit restrictions, there is also no assurance that the public funds will be lent out. To some extent, financing additional loans is not the purpose of capital infusions. The purpose is to replace the cushion of equity (“Tier 1 capital”) that stands between the bank's customers and bankruptcy.
Capital infusions are certainly a viable option to respond to the immediate threat of insolvency. These infusions were largely responsible for reducing the immediate threat to the U.S. financial system in late 2008. However, in the face of large and increasing losses, capital infusions are not sustainable. The public stands to lose the entire amount of funding if the institution fails, unless the infusions can be provided as a senior claim ahead of bondholders in the event of bankruptcy, and still be counted as “Tier 1 capital” otherwise. There are currently no legal or regulatory provisions to accomplish this.
Note that gross private debt currently stands at about 350% of GDP, about double the historical norm. Meanwhile, many of the assets underlying this debt are being marked down in value by 20-30% or more. Given that GDP itself is about $14 trillion, a continued policy of bailouts will eventually require a commitment of public funds amounting to a significant fraction of $14 trillion. The “real” burden of the mounting federal debt will have to be devalued through inflation, or it will place an onerous claim on the nation's future production and capital investment (which might otherwise be able to provide for the needs of an aging population).
Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. As noted below, this can be achieved without customer losses or a disorganized Lehman-style unwinding.
Toxic Asset Purchases
The Treasury's proposal to address insolvency is to finance the purchase of impaired assets from the banks, primarily using taxpayer funds. But note that if the questionable assets are taken off of the bank's books at their actual value ($4 in the example above), there is absolutely no change on the liability side of the balance sheet. The bank's capital position does not improve. The “toxic asset sale” simply replaces the bad assets with cash. While this might improve the “quality” of the bank's balance sheet, it does not make the institution solvent.
Indeed, the only way for the toxic asset sale to increase shareholder equity is if the buyer overpays for the asset. To accomplish this, the Geithner plan creates a speculative incentive for private investors, by effectively offering them a “put option,” whereby taxpayers would absorb all losses in excess of 3-7% of the purchase amount. This is essentially a recipe for the insolvency of the Federal Deposit Insurance Corporation itself, which would provide the bulk of the “6-to-1 leverage.” To the extent that it is not acceptable for the FDIC to fail, the Geithner plan implies an end-run around Congress, and would ultimately force the provision of funds to cover probable losses.
An equal concern is that there is no link between removing “toxic assets” from bank balance sheets and avoiding large-scale home foreclosures and loan defaults. All the transaction accomplishes is to take the assets out of the bank's hands, to offer half of any speculative gains to private “investors,” and to leave the public at risk for 93-97% of the probable losses. What the plan emphatically does not do is to affect the payment obligations of homeowners in a way that would reduce the likelihood of foreclosure. Moreover, the last thing that a bank would do with the proceeds would be to refinance such mortgages, because that would provide full repayment to the original lenders while taking on the risk of the newly refinanced loans.
If part of the intent of Congress is to increase lending, this could be done directly by providing funds to GSEs or by broadly providing capital to solvent regional banks. This would be a much more effective way of increasing the volume of lending in the U.S. economy without putting taxpayers at risk of major losses. There is no need for the public to purchase impared assets in order to increase lending activity.
Remember that the “toxic assets” held by banks represent pools of mortgages that have been cut up into dozens of individual pieces; the higher grade pieces having first claim to payments made on the underlying mortgages, and the lower grade pieces having claims to less likely payments. It is improbable that banks will be interested in selling off the better “tranches,” and yet there is no benefit (aside from rank speculation) to owning the lower tranches unless the underlying mortgages can be restructured.
As a result, the only point in the public having anything to do with these securitized mortgages is if all of the tranches of a given issue can be purchased simultaneously, so that the underlying payment obligations of the homeowners can be restructured. That is, if the entire issue could be purchased at 50% of the original face amount, the underlying mortgages could be written down by the same proportion. Those mortgages would then be far more likely to be repaid, and as a result, the restructured debt could be sold back into the financial markets without the need for taxpayers to hold it to maturity. There is no “all or none” mechanism in the Treasury's toxic assets plan to accomplish this.
While the U.S. equity market advanced strongly on the day the Treasury plan was announced, most market indices were lower by the end of the week, and credit spreads (indicators of bondholder concerns about default risk) did not budge. It is far from clear that the Wall Street has confidence in the plan, beyond the fact that a trillion dollars to speculate on mortgage securities at taxpayer expense was not immediately rejected.
Debt Restructuring
From the beginning of the recent crisis, starting with Bear Stearns, I have emphasized that nearly all of the financial institutions at risk of insolvency have enough liabilities to their own bondholders to fully absorb all probable losses without any loss to customers or the American public. The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense.
Note that in the example balance sheet above, 30% of the liabilities of the institution represent debt to the company's own bondholders. It is these individuals – not homeowners, not the American public – that are being defended by the promise of trillions of dollars in public money.
For example, while Citigroup has approximately $2 trillion in assets, those assets are financed not only by customer deposits, but also by nearly $600 billion in debt to Citigroup's own bondholders. It is these private bondholders who provided the funds for Citigroup to acquire questionable assets.
The bondholders of distressed financial institutions – not the American public – should bear responsibility for the losses of those institutions. This can be accomplished, without harm to customers or the broader financial system, in one of two ways:
1) The bondholders could voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps , preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like). Alternatively;
2) The U.S. government could take receivership of the financial institution, defend the customer assets, change the management, wipe out the stockholders and a chunk of the bondholders claims entirely, continue the operation of the institution in receivership, and eventually sell or reissue the company to private ownership, leaving the bondholders with the residual. Indeed, this is how the largest bank failure in history – Washington Mutual – was handled so seamlessly last year that it was almost forgettable. This is not Argentina-style “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. This would fully protect all of the customers and depositors at no probable expense to the public.
What should not be done is what was allowed in the case of Lehman Brothers – a disorderly failure, by which the company was allowed to fail with no conservatorship of the existing business. It was not the failure of Lehman per se, but the disorder resulting from its piecemeal liquidation, that caused distress to the financial markets.
That said, it is true that the bondholders of major banks include pension funds, insurance companies, mutual funds, foreign investors and other holders that would be adversely affected by a writedown in bond values. But this is part of the contract – when one lends money to a financial institution, one also assumes the risk and responsibility of bearing the losses. Congress always has the ability to mitigate the losses of some parties, such as pension funds, if it is agreed that this is in the public interest. But to defend all bondholders of financial institutions at public expense is to commit the future economic output of innocent citizens to cover the losses of mismanaged financial institutions. As a result of the intervention by the Federal Reserve and the U.S. Treasury, even the bondholders of Bear Stearns stand to receive 100% repayment of both interest and principal on their bond investments. This is absurd.
Needed Legislation
1) Enable receivership of distressed bank and non-bank financial institutions (including bank holding companies), encouraging voluntary debt-equity swaps as an alternative to the seizure of insolvent institutions.
2) Allow “toxic asset” purchases using public funds only to the extent that entire issues of these securitized mortgages can be purchased “all or none” at a moderate percentage of face value, thereby allowing the underlying mortgages to be written down to the same percentage of face.
3) Establish a Treasury conduit to administer (but not guarantee) property appreciation rights on restructured mortgages, again encouraging voluntary restructuring, using the Treasury conduit as a coordinating mechanism (additional details below).
4) Allow bankruptcy judges to substitute a portion of foreclosed mortgage obligations with equivalent claims on subsequent property appreciation. “Push-down” of mortgage principal without offsetting compensation rights to lenders should be emphatically avoided.
Receivership Provisions
More than a year ago, in a March 24, 2008 comment (Why is Bear Stearns Trading at $6 instead of $2?), I emphasized the need for immediate authority to take distressed financial institutions into receivership in order to cut away the stockholder and bondholder obligations, while preserving the ongoing business, as well as its obligations to customers and counterparties:
“At what point will investors figure out that the liquidity problems are nothing but the precursors of insolvency problems? At what point will investors stop begging the government to save private companies and recognize that the losses should be taken by the stock and bondholders of the offending financial institutions? If the Fed and the Treasury are smart, they will act quickly to figure out how to respond to multiple events like we've seen in recent days, to expedite turnover in ownership and quickly settle the residual claims of bondholders, without the kind of malfeasance reflected in the Bear Stearns rescue.”
It is essential for regulators to have the ability to take distressed institutions into receivership, so that customers and counterparties of insolvent financial companies can be fully protected. Ideally, this determination should be made not by the Treasury, but by the FDIC, which has a clearer regulatory role. The objective of receivership provisions would be to allow the failing institution to be partitioned into an operating entity (including whatever questionable loans are on the books), while cutting away the obligations to the stockholders and bondholders of that institution. Upon the sale, liquidation, or re-privatization of the institution, the bondholders would receive the portion of the proceeds that are not required as regulatory capital.
To reduce the indirect effects of such receivership on other institutions, it would be helpful to legislate a restriction on the use of credit default swaps (essentially insurance contracts against the failure of a company's bonds), requiring that such swaps may be used for bona-fide hedging purposes only. That is, a credit default swap could not be entered for purely speculative purposes, but only to offset the default risk of the same or similar bonds held by the investor.
Foreclosure Abatement
Although trillions of dollars have been promised or committed in hope of resolving the current financial crisis, the simple fact is that virtually nothing has been done to reduce the incidence of foreclosures. Even if the plan to remove toxic assets from bank balance sheets is successful (however “success” might be defined), the rate of foreclosure will be unaffected, because no change in the payment obligations of homeowners will result.
As with financial institutions, insolvent mortgages would best be addressed by a) voluntarily swapping debt for equity, or failing that; b) technical default and restructuring of the debt obligation.
From the standpoint of homeowners, a debt-equity swap is equivalent to writing down the mortgage principal, while at the same time giving the lender an equal and offsetting claim on the future appreciation of the home. As I noted in The Economy Needs Coordination, Not Money, From the Government,
“The most useful feature of government in resolving the foreclosure crisis is not its ability to squander taxpayer money, but its ability to provide coordinated action. I still believe that the best approach to foreclosure abatement would be for the Treasury to set up a special “conduit” fund to administer “property appreciation rights” or what I've called PARs.
“Suppose a $300,000 mortgage is in foreclosure (or the homeowner and lender can agree to the following arrangement outside of foreclosure court). A reasonable mortgage restructuring might be to cut the principal of the mortgage to $200,000, and to create a $100,000 property appreciation right. The homeowner would agree to pay off the PAR to the Treasury (and administered through the IRS) out of future price appreciation on the existing home or subsequent property. The homeowner would be excluded from taking on any home equity loans or executing any “cash out” refinancings until the PAR was satisfied. The maximum PAR obligation accepted by the Treasury would be based on the value of the home and the income of the homeowner.
“The lender would receive not a direct claim on that homeowner, but a participation in the Treasury's “PAR fund” which would pay out proportionately from all PAR proceeds received by the Treasury (technically, new shares in the PAR fund would be assigned based on a ratio reflecting the extent to which existing shareholders have already been paid off, so earlier shareholders don't receive more than they have coming to them).
“Importantly, the Treasury would not guarantee repayment, but would simply serve as a conduit. There would be no “free lunch” at taxpayer expense. If the homeowner was to eventually sell the home and not purchase another, the obligation would become a low-interest loan obligation and would eventually be a claim on the estate of the homeowner, but with an initial exclusion at low income and a progressive recovery rate based on the size of the estate. The PARs would be tradeable, since they would be based on a single pool of cash flows, though they would almost certainly trade at a discount to face value. Assuming that the PAR obligations are fixed and don't increase at some rate of interest, then even if home prices were expected to take about 15 years to recover, the PARs would still trade at more than 50% of face. Given that recovery rates in foreclosure are running at only about 50% of the entire loan, it is clear that this sort of approach would be preferable to foreclosure in most cases. If this sort of mechanism were available, lenders might agree to outright principal reductions as well in preference a costly foreclosure process.
“This sort of approach would reduce foreclosures without relying on free money from the government, or violating contract law. The PARs would provide a legally enforceable, diversified stream of cash flows at far lower cost than individual lenders would have to spend to collect from individual homeowners. Since home sales are taxable events, the IRS would be in an ideal position to enforce these obligations.”
The Danger of Inaction
If there is any good news at present, it is that the capital infusions of late-2008 have temporarily stabilized the banking system, and that the U.S. economy is presently enjoying a brief and modest reprieve from the financial crisis. This is largely the result of an ebbing in the rate of sub-prime mortgage resets, which reached their peak in mid-2008, with corresponding mortgage losses and foreclosures a few months later. Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures.
As a foreshadowing of the probable foreclosures ahead, the following is what the Federal Reserve, FDIC, and the Office of Thrift Supervision noted about option-ARMs and other loans in a colorful little booklet entitled “Interest-Only Mortgage Payments and Payment-Option ARMs: Are They For You?” , published in November 2006:
“Owning a home is part of the American dream. But high home prices may make the dream seem out of reach. To make monthly mortgage payments more affordable, many lenders offer home loans that allow you to (1) pay only the interest on the loan during the first few years of the loan term or (2) make only a specified minimum payment that could be less than the monthly interest on the loan.
"Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment (an I-O mortgage)--or an adjustable-rate mortgage (ARM) with the option to make a minimum payment (a payment-option ARM)--is right for you. Lenders have a variety of names for these loans, but keep in mind that with I-O mortgages and payment-option ARMs, you could face
* "payment shock." Your payments may go up a lot--as much as double or triple--after the interest-only period or when the payments adjust.
"In addition, with payment-option ARMs you could face
* negative amortization. Your payments may not cover all of the interest owed. The unpaid interest is added to your mortgage balance so that you owe more on your mortgage than you originally borrowed.
"Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast ) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment.
"Lenders end the option payments if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made minimum payments on your $180,000 mortgage and had negative amortization. If the balance grew to $225,000 (125% of $180,000), the option payments would end. Your loan would be recalculated and you would pay back principal and interest based on the remaining term of your loan. It is likely that your payments would go up significantly.
"Be sure you understand the loan terms and the risks you face. And be realistic about whether you can handle future payment increases. If you're not comfortable with these risks, ask about another loan product.”
Judging from the reset schedule above, it is clear that more than a few borrowers ignored this advice.
Market Climate
As of last week, the Market Climate for stocks was characterized by reasonable valuations – moderate undervaluation on earnings-based measures that assume a reversion to above-average profit margins in the future, but continued overvaluation on measures that do not rely on future profit margins being above historical norms.
This is an important distinction, because much of my constructive perspective about valuations late last year was based on the expectation of something of a “writedown recession” whereby our policy focus would have been on properly defending customers through greater use of the receivership process – demonstrating that the financial system itself could remain sound even while allowing the writedown and restructuring of debt. I believed, as I wrote a year ago, that “The U.S. economy will get through this without the requirement of massive public bailouts. What is required, however, is that the stock and bondholders of financial companies take due losses. Customers and counterparties need not, and I expect will not, be harmed.” My optimism that our policy-makers would see clearly enough to follow this course was mistaken (fortunately, we are within 5% of where we stood at the beginning of this bear market).
The misguided policy of defending bondholders against losses with public funds has increased uncertainty, crowded out private investment, harmed consumer confidence, and prompted defensive saving against possible adversity. We observe this as a plunge in gross domestic investment that is much broader than just construction and real estate, and a corresponding but misleading “improvement” in the current account deficit as domestic investment plunges.
Aside from a few Nobel economists such as Joseph Stiglitz (who characterized the Treasury policy last week as “robbery of the American people”) and Paul Krugman (who called it "a plan to rearrange the deck chairs and hope that that keeps us from hitting the iceberg"), the recognition that this problem can be addressed without a massive waste of public funds (and that it is both dangerous and wrong to do so) is not even on the radar.
In short, attempting to avoid the need for debt restructuring by wasting trillions in public funds increases the likelihood that the current economic downturn will be prolonged, places a massive claim on our future production in order to transfer our nation's wealth to the bondholders of mismanaged financial companies, and raises the likelihood that any nascent recovery will be cut short by inflation pressures. We are nowhere near the completion of this deleveraging cycle.
To the extent that we continue to force add-on effects in the form of declining employment and capital investment, we also reduce the likelihood that profit margins and returns on equity will recover to the historically above-average levels which have prevailed in recent years.
The advance of the past few weeks has cleared the prior oversold condition and the market is now overbought in a generally negative Climate. As should be clear from last year's decline, the market can be severely oversold and only become more oversold, so an oversold condition is not a timing tool. That said, oversold conditions in clearly favorable Market Climates are often followed by strong advances, and overbought conditions in clearly unfavorable Market Climates are often followed by spectacular declines. At the recent market low, the Market Climate could certainly not be characterized as favorable, but at the present overbought level, there is considerable risk of a fresh plunge.
Thus far, the recent advance has been focused on low-quality and distressed sectors such as financials, insurance and homebuilders. If the current advance is durable, we would expect to observe stronger market internals, greater participation among higher quality sectors, and a clear easing of credit spreads, which remain near their highs despite the advance in equities. On sufficient improvement in market internals, we would be inclined to establish call option positions that would gradually take us to a significantly less hedged position on persistent market strength, but we do not expect to eliminate our put option defenses until the combination of valuations and market action becomes clearly favorable, or until it is reasonable to expect a sustained economic recovery within a quarter or two. Nothing in our analysis of valuations, market action, or economic conditions compels us that removing downside protection is reasonable at present.
In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively neutral yield pressures. The yields on Treasury Inflation Protected Securities have declined further in recent sessions, with inflation-adjusted yields on some issues dropping below 1%. I expect that a further decline in real yields would prompt us to reduce our holdings modestly, as it is doubtful that persistent inflation surprises will be a near-term outcome. I continue to view the U.S. dollar as vulnerable to depreciation given the rapid expansion in government liabilities, so the Strategic Total Return Fund continues to hold about 20% of assets in precious metals shares and foreign currencies, with a few percent in utility shares on the basis of longer-term total return prospects.
Mortgage Crisis Over? Please, It's Just Beginning
Now that all those sub-prime loans have defaulted and folks who couldn't afford their houses have been evicted, the foreclosure crisis is over, right?
Wrong.
Why?
Because subprime loans aren't the only loans that began with a couple of years of fantastic teaser rates that made houses seem affordable. And over the next few years, all of those other loans will reset.
Now that interest rates are low, the folks who still have jobs and equity in their houses will refinance. Others, however, will be stuck paying higher rates--or they'll walk away from their houses.
Fund manager John Hussman of the Hussman Funds explains:
If there is any good news at present, it is that the capital infusions of late-2008 have temporarily stabilized the banking system, and that the U.S. economy is presently enjoying a brief and modest reprieve from the financial crisis. This is largely the result of an ebbing in the rate of sub-prime mortgage resets, which reached their peak in mid-2008, with corresponding mortgage losses and foreclosures a few months later. Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures.
Unfortunately, the reset schedule above depicts only sub-prime mortgages. As the recent housing bubble progressed, the profile of mortgage originations changed, so that at the very peak of the housing bubble, new originations took the form of Alt-As (low or no requirement to document income) and Option-ARMs (teaser rates, with no required principal repayments).
A broader profile of mortgage resets is presented below (though even this chart does not include the full range of adjustable mortgage products).
This reset profile is of great concern, because the majority of resets are still ahead. Moreover, the mortgages to which these resets will apply are primarily those originated late in the housing bubble, at the highest prices, and therefore having the largest probable loss. Though many of these mortgages are tied to LIBOR, and therefore benefit from low LIBOR rates, the interest rates on the mortgages are typically reset to a significant spread above LIBOR, and this spread remains constant as interest rates change. Undoubtedly, some Alt-A and option-ARM foreclosures have already occurred, but the likelihood is that major additional foreclosures and mortgage losses lie ahead. If we fail to address foreclosure abatement during the current window of opportunity (early to mid-2009), there may not be time for legislative efforts to contain the resulting fallout.
Wrong.
Why?
Because subprime loans aren't the only loans that began with a couple of years of fantastic teaser rates that made houses seem affordable. And over the next few years, all of those other loans will reset.
Now that interest rates are low, the folks who still have jobs and equity in their houses will refinance. Others, however, will be stuck paying higher rates--or they'll walk away from their houses.
Fund manager John Hussman of the Hussman Funds explains:
If there is any good news at present, it is that the capital infusions of late-2008 have temporarily stabilized the banking system, and that the U.S. economy is presently enjoying a brief and modest reprieve from the financial crisis. This is largely the result of an ebbing in the rate of sub-prime mortgage resets, which reached their peak in mid-2008, with corresponding mortgage losses and foreclosures a few months later. Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures.
Unfortunately, the reset schedule above depicts only sub-prime mortgages. As the recent housing bubble progressed, the profile of mortgage originations changed, so that at the very peak of the housing bubble, new originations took the form of Alt-As (low or no requirement to document income) and Option-ARMs (teaser rates, with no required principal repayments).
A broader profile of mortgage resets is presented below (though even this chart does not include the full range of adjustable mortgage products).
This reset profile is of great concern, because the majority of resets are still ahead. Moreover, the mortgages to which these resets will apply are primarily those originated late in the housing bubble, at the highest prices, and therefore having the largest probable loss. Though many of these mortgages are tied to LIBOR, and therefore benefit from low LIBOR rates, the interest rates on the mortgages are typically reset to a significant spread above LIBOR, and this spread remains constant as interest rates change. Undoubtedly, some Alt-A and option-ARM foreclosures have already occurred, but the likelihood is that major additional foreclosures and mortgage losses lie ahead. If we fail to address foreclosure abatement during the current window of opportunity (early to mid-2009), there may not be time for legislative efforts to contain the resulting fallout.
Foreclosures spike again in February
It was starting to look like the problem was easing before January, when foreclosure starts declined to 69,000 in November from 77,000 in October and then dropped again to 56,000 in December. But in January the number of started foreclosures jumped to 217,000, and now February's numbers have leaped up again to 243,000. 87,000 homes were repossessed (foreclosures completed) by banks during February, a 28% jump from the 68,000 foreclosures completed in January. Since the mortgage meltdown hit in July 2007, 1,395,044 homes have been lost. In February, nearly 250,000 homeowners received either mortgage modifications or repayment plans from their lenders, according to Hope Now, the coalition of lenders, investors, and community advocacy groups put together by the Obama administration's foreclosure prevention initiative.
AIG back in the news
American International Group (AIG) has cut or delayed payments to some of its real-estate ventures, potentially leaving the developers and their bankers in the lurch. AIG had previously been sued by Mitchell L Morgan Management Inc for missed and delayed payments, and the latest victim is Alabama shopping-center developer Alex Baker. The action puts 15 banks at risk of exposure to soured loans. AIG Global Real Estate, an arm of the insurance company, has interests totaling more than $23 billion across 53 million square feet of real estate. The Federal Reserve is monitoring AIG's spending closely after committing $180 billion in bailout funds, but whether that's helping or harming is still anyone's guess.
Detroit failed
The Obama administration gave General Motors and Chrysler LLC failing grades Monday for their turnaround efforts. It promised a sweeping overhaul of the troubled companies, but also threatened a "structured bankruptcy." Prior to the announcement, CEO Rick Wagoner announced his resignation, saying it came at the request of the Obama administration. GM will get 60 more days and Chrysler 30 more days in which to make a final push toward proving they can run viable businesses. If Chrysler succeeds -- probably by merging with Fiat -- it will receive a $6 billion loan. In GM's case, the officials would not specify how much the carmaker might receive, but we can all guess it'll be a lot.
Stocks slide on banking troubles
Bad news from the auto sector was bad enough, but Treasury Secretary Tim Geithner's announcement that more banks would need help caused stocks to tumble, with the Dow opening 202 points lower, the S&P 500 index lost 21 points, and the Nasdaq composite lost 39 points. As Art Hogan, chief market strategist at Jefferies & Co put it, "We were starting to see some light at the end of the tunnel, but it's beginning to look oddly like a train." That pretty much captures investor sentiment this am. Would it be an understatement to say the week isn't off to a good start? Especially if you own auto or banking stocks.
Now on to our real estate investing education section...
Understanding the Time Value of Money - Why Short Sales Still Make Sense
Deflation or Inflation? Chances are whichever side of the debate you happen to be standing on at the moment you are in good company. The government experts are readily printing money out of thin air...and actually admitted as much in recent weeks...while financial analysts, other governments around the globe and those with fixed incomes fear the rise of inflationary pressures. How could so many smart people have such a strong disagreement? It comes down to the time value of money. A topic of such importance it will have profound implications on the way you structure investments throughout your lifetime.
There are two primary methods used to determine the time value of money - Present Value and Future Value. Present value is what a dollar today is worth rather than the value compared to receiving it as some point in the future. For example, let's assume you have an option to sell or hold a modest property purchased via short sale. To keep the calculations and comparisons simple, we will further assume the property is paid in full. You are reasonable positive you could pocket $100,000 by selling the property outright but wanted to know if this was your best option.
Typically, future dollars are worth less than present dollars due to inflationary pressures. The entire purpose of the Federal Reserve is to assure a steady supply of funds including controlled inflation (defined in the 1-3 percent range). So for example, if the rate of inflation was rising at 3 percent annually the value of $100,000 would be only $74,400 in only ten years. Wait 20 years and that same $100,000 is only valued at $55,000. Bump up the rate of inflation to 5 percent and $100,000 drops to only $61,000 in ten years and only $37,000 in 20...now you know why lottery ticket discount so much if you take the lump sum payment up front! Ditto for insurance companies.
Short sale investors should immediately realize money printing combined with the ability to use leverage in the form of loans can dramatically increase the ability to generate cash today - not ten or twenty years into the future. In fact, the more excess cash (above what is needed to pay your bills and service debts) you generate today, the better especially during times of inflation. If inflationary pressures hit the levels seen in the 70's take a look at what happens...$100,000 turns into $42,000 within ten years and only $14,000 by year 20. What originally would pay for a modest home will eventually only be enough to buy a used car without taking steps to preserve your wealth.
Rarely, a reversal takes place where future dollars may become more valuable than current dollars as is sometimes seen during a deflationary cycle. That is what the government fears most since it would make it more costly to pay back all the loans and debt obligations - a cost so high it could jeopardize the foundation of the nation. However, the current deflationary concern is a temporary one at best. The Federal Reserve has repeatedly stated they expect the deflationary aspect of this current crisis to cool by the end of 2009 to 2010...listen carefully - unlike what many "think" they hear...the government and Fed Reserve is not claiming the pain will be over...only that the current deflationary spiral will come to an end. The lack of investment grade returns is unlikely to resume its former hay-day for quite some time while employment continues to lag. Both add up to very real pain as Americans are unable to make a profitable investment or keep pace with their standard of l
iving from lagging wages.
AIG back in the news
American International Group (AIG) has cut or delayed payments to some of its real-estate ventures, potentially leaving the developers and their bankers in the lurch. AIG had previously been sued by Mitchell L Morgan Management Inc for missed and delayed payments, and the latest victim is Alabama shopping-center developer Alex Baker. The action puts 15 banks at risk of exposure to soured loans. AIG Global Real Estate, an arm of the insurance company, has interests totaling more than $23 billion across 53 million square feet of real estate. The Federal Reserve is monitoring AIG's spending closely after committing $180 billion in bailout funds, but whether that's helping or harming is still anyone's guess.
Detroit failed
The Obama administration gave General Motors and Chrysler LLC failing grades Monday for their turnaround efforts. It promised a sweeping overhaul of the troubled companies, but also threatened a "structured bankruptcy." Prior to the announcement, CEO Rick Wagoner announced his resignation, saying it came at the request of the Obama administration. GM will get 60 more days and Chrysler 30 more days in which to make a final push toward proving they can run viable businesses. If Chrysler succeeds -- probably by merging with Fiat -- it will receive a $6 billion loan. In GM's case, the officials would not specify how much the carmaker might receive, but we can all guess it'll be a lot.
Stocks slide on banking troubles
Bad news from the auto sector was bad enough, but Treasury Secretary Tim Geithner's announcement that more banks would need help caused stocks to tumble, with the Dow opening 202 points lower, the S&P 500 index lost 21 points, and the Nasdaq composite lost 39 points. As Art Hogan, chief market strategist at Jefferies & Co put it, "We were starting to see some light at the end of the tunnel, but it's beginning to look oddly like a train." That pretty much captures investor sentiment this am. Would it be an understatement to say the week isn't off to a good start? Especially if you own auto or banking stocks.
Now on to our real estate investing education section...
Understanding the Time Value of Money - Why Short Sales Still Make Sense
Deflation or Inflation? Chances are whichever side of the debate you happen to be standing on at the moment you are in good company. The government experts are readily printing money out of thin air...and actually admitted as much in recent weeks...while financial analysts, other governments around the globe and those with fixed incomes fear the rise of inflationary pressures. How could so many smart people have such a strong disagreement? It comes down to the time value of money. A topic of such importance it will have profound implications on the way you structure investments throughout your lifetime.
There are two primary methods used to determine the time value of money - Present Value and Future Value. Present value is what a dollar today is worth rather than the value compared to receiving it as some point in the future. For example, let's assume you have an option to sell or hold a modest property purchased via short sale. To keep the calculations and comparisons simple, we will further assume the property is paid in full. You are reasonable positive you could pocket $100,000 by selling the property outright but wanted to know if this was your best option.
Typically, future dollars are worth less than present dollars due to inflationary pressures. The entire purpose of the Federal Reserve is to assure a steady supply of funds including controlled inflation (defined in the 1-3 percent range). So for example, if the rate of inflation was rising at 3 percent annually the value of $100,000 would be only $74,400 in only ten years. Wait 20 years and that same $100,000 is only valued at $55,000. Bump up the rate of inflation to 5 percent and $100,000 drops to only $61,000 in ten years and only $37,000 in 20...now you know why lottery ticket discount so much if you take the lump sum payment up front! Ditto for insurance companies.
Short sale investors should immediately realize money printing combined with the ability to use leverage in the form of loans can dramatically increase the ability to generate cash today - not ten or twenty years into the future. In fact, the more excess cash (above what is needed to pay your bills and service debts) you generate today, the better especially during times of inflation. If inflationary pressures hit the levels seen in the 70's take a look at what happens...$100,000 turns into $42,000 within ten years and only $14,000 by year 20. What originally would pay for a modest home will eventually only be enough to buy a used car without taking steps to preserve your wealth.
Rarely, a reversal takes place where future dollars may become more valuable than current dollars as is sometimes seen during a deflationary cycle. That is what the government fears most since it would make it more costly to pay back all the loans and debt obligations - a cost so high it could jeopardize the foundation of the nation. However, the current deflationary concern is a temporary one at best. The Federal Reserve has repeatedly stated they expect the deflationary aspect of this current crisis to cool by the end of 2009 to 2010...listen carefully - unlike what many "think" they hear...the government and Fed Reserve is not claiming the pain will be over...only that the current deflationary spiral will come to an end. The lack of investment grade returns is unlikely to resume its former hay-day for quite some time while employment continues to lag. Both add up to very real pain as Americans are unable to make a profitable investment or keep pace with their standard of l
iving from lagging wages.
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