Bailout Nation

by Barry Ritholtz

  Figure 21.4 Existing Home Inventory

  SOURCE: Chart courtesy of Calculated Risk, www.calculatedriskblog.com

  Until prices revert back toward historical norms, the excess inventory will not be removed, the foreclosures will not stop, and the total sales will remain depressed. The sooner Washington, D.C., figures this out, the better off the economy and U.S. homeowners will be.

  Real estate is unique. Unlike most goods and services, purchases are not independent from other parties to the sales transaction. Whether you buy 1,000 shares of stock, a used car, or a can of soup, only two parties are involved: the buyer and the seller. But buy a home (85 percent of all sales are existing homes) and you are involved in a transaction chain with four, five, even six or more other buyer/seller pairs.

  Consider the newlywed couple who want to purchase a starter home. Their sellers are a family with a child on the way who want to move to a larger home. The sellers of that house have two teenage daughters driving them crazy, and they want to move to an even bigger house, whose seller is moving to a waterfront property, and so on. It is often a long chain of trade-ups, with increasing size and cost (and property taxes). The rub is that if any one of these sales falls apart, the entire chain collapses.

  And therein lies the problem.

  Go to any suburban neighborhood—even the one you live in. Look at the starter homes that our theoretical newlywed couple might consider: small Cape Cod cottages and two- or three-bedroom ranches. Assume that this couple are in their late 20s or early 30s, and are making decent (but not six-figure) salaries. I’m guessing that describes 80 percent of typical newlywed home buyers.

  Can they afford that starter house? If not, then the real estate chain is partially frozen. What’s left is mostly downsizing, laterals, and moves into different regions. As long as housing remains unaffordable for the majority of first-time buyers, it will significantly reduce total real estate sales.

  House sales peaked in 2007 at well over 7 million units. We are now running about 4.25 million sales per year. A more normalized number would be between 5 and 5.5 million. That’s not going to happen if the starter home market is dead. If the newlyweds cannot afford that first purchase, the entire chain gets bogged down.

  How can we reduce foreclosures and lower home prices?

  The real estate market would be much better off if policy makers recognized three things:1. Falling prices help return the housing market to normalcy.

  2. Those people who cannot afford to be in their houses (underwater, overpriced, too little income) should be helped to move into affordable housing (rental or purchased); keeping people in homes they cannot afford is counterproductive.

  3. Those people who can afford to stay in their homes with a loan modification or workout are the best targets for legitimate foreclosure avoidance.

  If they could, banks would prefer to avoid foreclosure. It’s an expensive, time-consuming process; properties acquired through foreclosure are a messy, money-losing headache. Any intelligent proposal to reasonably avoid preventable foreclosures would give the banks a big incentive to voluntarily participate in loan modifications. I believe this is just such a plan.

  In September 2008, I offered a housing proposal (“Fixing Housing & Finance: 30/20/10 Proposal”8) that provided a way to reduce foreclosures and lower home prices at the same time. Call it the “30/20/10” solution:• 30: Take up to 30 percent of any qualifying delinquent mortgage and separate it from the main mortgage; it becomes a second, interest-free balloon mortgage. It stays on the books of the present mortgage holder, be it the loan originator (bank) or MBS investor.

  • 20: The goal of the 30 percent part of the plan is to save 20 percent of the current delinquent and potential foreclosure properties; of the five million homes that are late in making payments (the first step along the road to delinquency, default, and foreclosure), the process should make 20 percent (one million) homes eligible.

  • 10: The balloon payment comes due in 10 years, and will be treated as a second mortgage, with interest charges accruing only as of September 1, 2019, when it can be refinanced or paid off in full.

  There is no reason why those people who are underwater but current would not qualify for such a program. This plan would allow housing market prices to normalize, keep those loans that are savable from going into default, and avoid moral hazard. Note that this requires little if any taxpayer money. If you really want to motivate the banks to do this, however, Uncle Sam has to either guarantee some portion of the loans or provide low-interest-rate loans to the participating lenders.

  A few other government actions are needed: The interest-free balloon loans should be made tax free; the lenders also need to be able to set aside these loans without taking a markdown immediately. The defaults (if any) wouldn’t hit until 10 years hence. Banks should be permitted to carry these balloon loans not as a liability, but as a current nondelinquent loan (i.e., an asset).

  The mad attempt to avoid any and all foreclosures is counterproductive. The foreclosure process is how an overpriced market returns back to normalcy. That is what is now happening, and excess interference will only slow down the eventual return to a healthy economy.

  Chapter 22

  Casino Capitalism

  Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

  —John Maynard Keynes

  Bear Stearns opened the floodgates. Once the bailouts began, there was no end to them. Citigroup took $25 billion, and came back for another $20 billion, plus $250 billion in guarantees on its toxic assets. Bank of America—its name more appropriate now than ever—was also a three-time supplicant, getting the same $45 billion as Citi, plus $300 billion in guarantees. AIG has been back to the well four times—and counting—for a total of $173 billion of bailout green, so far.

  Another hard lesson learned: Once executives get a taste of corporate welfare, they want more. Do you have any idea how hard it is to earn $30 billion in a year? Flying commercial—or even driving—to Washington, D.C., for an afternoon of hostile Q&A is a lot easier than having your company make $30 billion. The return on investment (ROI) on the day trip is fantastic.

  The queen of corporate welfare is AIG. In addition to its multiple bailouts, it more or less threatened to blow up the rest of the world if more money wasn’t forthcoming. In a special report to the Treasury Department titled AIG: Is the Risk Systemic?, AIG claimed that without a fourth bailout it would collapse, triggering a “chain reaction of enormous proportions” that would likely “bankrupt the entire system.” Oh, and if you don’t give us more money, we won’t able repay the $135 billion we already owe the U.S. taxpayer.

  It is casino capitalism at its finest. Heads, we win; tails, you lose.

  The endless maw that the Treasury Department keeps feeding appears insatiable. First under Hank Paulson, now under Tim Geithner, the trillions in bailout monies paid out is beyond absurd—it is asinine.

  With the conditions at the country’s biggest banks deteriorating rapidly, the nation needs to move beyond the half trillion dollars paid out to the 10 largest banks so far. The money already dumped into the black holes of just the two largest financial institutions far exceeds their net worth. And in exchange for this foolish investment, taxpayers have received a small stake in each: at first, 6 percent of Bank of America and 7.8 percent of Citigroup (eventually converted into 36 percent). How an investment of 120 percent of a company’s market capitalization yields only a minor ownership stake is simply beyond my comprehension.

  There has to be a faster, fairer, cheaper, more efficient way out of the current credit and financial mess. There is, and it is called receivership—but you may know it under its more common name, nationalization.

  The solution to the banks’ problems, as well a
s this ridiculous investment posture, is relatively simple: Identify the banks that are insolvent, and temporarily nationalize them. Appoint new management, and give them six months to spin out 10 percent of each of the separate viable pieces, with the taxpayer retaining the rest as passive investors. Bank of America can spin out five major pieces: BoA, Merrill, Countrywide, a toxic holding company, and the rest of its holdings. The toxic assets put into the toxic holding section get wiped off the bank’s balance sheet.

  The derivatives exposure gets wound down (counterparties are unsecured creditors—except, for unfathomable reasons, in the case of AIG).

  Stockholders get wiped out, as that is what occurs when you invest in a company that goes bankrupt. Bondholders take a haircut, and end up owning a piece of the new firm. Perhaps in exchange for fresh capital, they can have a preferred position in buying the new firms’ bonds. As opposed to the small pro-rata share they would have gotten in liquidation, they get a convertible preferred in the new debt-free firm, as well as an opportunity to lend to the new banks at a generous convertible rate.

  In January 2009, Adam S. Posen, deputy director of the Peterson Institute for International Economics, noted:

  The case for full nationalization is far stronger now than it was a few months ago. If you don’t own the majority, you don’t get to fire the management, to wipe out the shareholders, to declare that you are just going to take the losses and start over. It’s the mistake the Japanese made in the ’90s.1

  It seems to be the least onerous, least offensive way to halt the downward spiral of America’s largest financial institutions.

  The current bailouts have shown themselves to be expensive, ineffective, and replete with moral hazard. Not only are we wasting vast sums of money, but we also are rewarding the incompetent management teams that created the mess in the first place. As this book was going to press, Treasury was forced to intervene to prevent AIG from giving out nearly $450 million in bonuses to “pay executives in the business unit that brought the company to the brink of collapse last year,” according to the Wall Street Journal.2

  How is it possible that the same collection of financial nincompoops who caused this problem not only are still in the employ of AIG, but somehow think they are entitled to performance bonuses?

  P erhaps we should be looking to Sweden. Lars Jonung served as chief economic adviser to Swedish Prime Minister Carl Bildt from 1992 to 1994. That was when “the Swedish solution” was implemented.

  The former professor at the Stockholm School of Economics sees the United States as having two options: go Swedish or turn Japanese:

  Banks all over the world are in deep trouble. This has created an interest in the successful bank resolution policy adopted in Sweden in the early 1990s. But can the Swedish model of yesterday be applied in other countries today?

  When Sweden was hit by a financial crisis in 1991-93, its response comprised a unique combination of seven distinctive features:1. swift policy action,

  2. political unity,

  3. a blanket government guarantee of all bank liabilities (including deposits but excluding shareholder capital),

  4. an appropriate legal framework based on open-ended government funding,

  5. complete information disclosure by banks asking for government support,

  6. a differentiated resolution policy by which banks were classified according to their financial strength and treated accordingly, and

  7. an overall monetary and fiscal policy that facilitated the bank resolution policy.

  Two major banks were taken over by the government. Their assets were split into a good bank and a bad bank, the “toxic” assets of the latter being dealt with by asset-management companies (AMCs) which focused solely on the task of disposing of them. When transferring assets from the banks to the AMCs, cautious market values were applied, thus putting a floor under the valuation of such assets, mostly real estate. This restored demand and liquidity, and thus put a break on falling asset prices.3

  The alternative is the Japanese model. When that country’s economy crashed and its real estate bubble burst in 1989, Japan allowed banks to carry the bad assets on their books for years. They failed to take the painful write-downs or raise appropriate capital. The subsequent period is known as Japan’s lost decade.

  Perhaps the word nationalization scares some people, as if that is what would turn the United States into a banana republic. Why don’t we call it by a more user-friendly name? How about “FDIC-mandated, prepackaged, government-funded Chapter 11 reorganization”?

  That is an accurate description of what occurred with Washington Mutual (WaMu), now part of JPMorgan Chase, and with Wachovia, now part of Wells Fargo. The FDIC steps in and seamlessly transfers control of the assets to a new owner, while simultaneously wiping out the debt and the shareholders, and giving a big haircut to the bondholders.

  Let’s look at what these terms mean:• FDIC-mandated: By law, the FDIC is required to handle the liquidation or reorganization of insolvent banking institutions. We have prevented that process from taking place by lending trillions of dollars in bailout monies.

  • Prepackaged: The entire process is mapped out in advance so as to make it fast and seamless. Washington Mutual depositors did not notice a single change over the weekend their FDIC-mandated, prepackaged Chapter 11 workout, government-funded reorganization occurred. The only observable difference to WaMu customers was they were no longer charged a fee when they went to Chase ATMs.

  • Government-funded Chapter 11: The full bankruptcy protection applies—meaning employees still get paid, secured creditors suffer the least, and debtor in possession (DIP) financing is available to the bank; Uncle Sam is the source of the DIP funding.

  • Reorganization: This is just what it sounds like—a new board of directors is brought in, management transitions out to a new team, the company is recapitalized, bad debt is taken off of the books, and toxic assets are spun out.

  What emerges is a clean, debt-free bank, well capitalized, without deadly toxic assets on its books. Why would anyone find this state of affairs objectionable?

  If our choice is between going Swedish or turning Japanese, you can call me Inga.

  In reality, the nationalization issue is moot. Miller Tabak’s market strategist, Peter Boockvar, notes that the debate over nationalization is now mere wordplay:

  The raging debate over whether to nationalize Citigroup and/or Bank of America is semantics at this point. With politicians in Washington DC dictating executive pay, marketing expenses, employee trips, dividend policy, etc.... and the guarantee of almost a half trillion dollars’ worth of assets, both are already wards of the state.

  But whatever step the government may or may not take, healing the banks directly is still only dealing with the symptoms and not the disease. That disease is “an overleveraged consumer and falling home prices”—when it’s cured, it will heal the symptom that is a troubled bank sector. Shifting bad assets from the banks to the government is just a shell game, as we’ll ultimately pay for it one way or another. The $64k question is what will happen to bond holders. . . . 4

  And it could get worse. If the recession intensifies, we should expect increased layoffs, weaker retail sales—and more foreclosures. As of this writing, the United States has had five consecutive monthly Non-Farm Payrolls releases of about 600,000 job losses or worse. If that number doesn’t improve soon, foreclosures are going to increase. With most of the toxic paper banks hold primarily consisting of mortgage-backed securities, the need for more bailout money may be inevitable.

  T o get a handle on just how absurd the results of our casino capitalism have become, let’s take a closer look at AIG. The bailouts of the insurance giant raise a disturbing question: Why are the taxpayers making good on hedge fund trades gone bad?

  AIG was essentially two companies jammed under one roof. One was a highly regulated, state-supervised life insurance company—in fact, the biggest such firm in the world. It had a lon
g history of steady growth, profitability, and excellent management, and made money (as the commercial goes) the old-fashioned way: They earned it.

  This half of the company held the most important insurance in many families’ financial lives: their life insurance. When an AIG policyholder passed away, the company paid off the policy, providing monies that were used to pay the mortgage, kids’ college educations, and the surviving spouse’s lifetime living expenses. Given the importance of this payment, one can see why the state has a vested interest in making sure there are sufficient reserves to pay off the life insurance policies. The actuarial tables used are conservative, the accounting transparent. The policy payoffs are rock solid, utterly reliable.

  AIG, this insurance company, was well run. It made a steady income and provided a valuable service to its clients. It was also solvent, and had no need for a bailout.

  The other half of the AIG firm was an unregulated structured finance firm, specializing in credit default swaps and other derivatives. Most people did not learn of the darker half of the firm until AIG faltered. This structured finance half was nothing that the life insurer was. Neither regulated nor transparent, it existed only in the shadow banking world, a nether region in the financial universe. This part of the company engaged in trading with hedge funds, banks, speculators, and gamblers from around the world. Huge derivative bets were placed, with billions of dollars riding on the outcome. Other than a legal pursuit of profit, it served no societal function.