23 September, 2008

Yes. No. Maybe.

I feel bad for Donald Luskin. Two Sundays ago he claimed in a Washington Post op-ed that

Things today just aren't that bad. Sure, there are trouble spots in the economy, as the government takeover of mortgage giants Fannie Mae and Freddie Mac, and jitters about Wall Street firm Lehman Brothers, amply demonstrate. And unemployment figures are up a bit, too.
He then cited an enormous number of statistics to back up his point.

The very next day, the federal government bailed out AIG, and refused to bail out Lehman. The very same day, Bank of America scooped up Merril Lynch at a greatly discounted price. Three days later, the money market a source of safe, short-term loans to businesses froze. What on earth does the money market have to do with bad mortgages? I have no idea, but it scared the administration into doing two things: (1) putting a huge amount of money into the money market, and (2) putting together the $700 billion bailout package. Not a good week for Luskin to claim things were, overall, okay. (I agree with him, but that's another story.)

The sales pitch is that the bailout will buy "bad loans" from banks. This is kind of correct. I'll try to summarize my understanding of what has happened, and I would appreciate correction of any errors!
  1. I buy my house in a middle-class neighborhood on a fixed mortgage, with no money down but with monthly payment that I can afford. Call me Mortgage A; this is somewhat risky.
  2. A university administrator buys a house in the posh Canebrake community down the road a ways. His house is much, much more expensive, but he makes a down payment and again, he can afford his monthly payment. Call the administrator Mortgage B; there's little risk involved here.
  3. Another professor decides to make some money on the side using an "investment property". He buys another house and plans to rent it to university students. He can't actually afford the mortgage on the house, but everyone assumes that, over time, the price of the house will increase. (And in general, this is true.) The bank offers, and the professor accepts, an adjustable rate mortgage where he pays only the interest on the loan for the first two years. He rents the place for two years, earning enough to pay the interest and put a little aside. Call him Mortgage C; this is a very risky loan.
  4. The mortgages are financed through different banks, but ultimately Freddie Mac (FM) is involved. FM's goal is to sell the mortgage to someone else, an investor who has a lot of money and wants it to "work for" him. ("Don't work for your money, make it work for you," they say.)
  5. A while back, someone at Freddie Mac (or maybe Fannie Mae, one of the two) realized that you could package Mortgages A, B, and C together in a bundle (which I might sometimes call a "security", its technical name) and, yes, an investor would buy the thing. Rather than selling just the mortgage on the market the same way stocks and bonds are sold on the market, the bundle could be sold, or even parts of the bundle.
  6. One reason to do this is that, by mixing the three mortgages together, someone would actually buy Mortgage C, because the risk appears to be lessened by the inclusion of Mortgages A and B. Ordinarily the same investor wouldn't touch Mortgage C, but if it's the only way to obtain access to Mortgages A and B, well, fine. There was political pressure to increase home ownership (see below).

This scenario isn't hypothetical. On the one hand, I've read quite a bit about it lately. On the other, I first noticed it almost two years ago, when I read the contract on my home equity loan.
20. Sale of Note; Change of Loan Servicer; Notice of Grievance. The Note or a partial interest in the Note (together with this Security Instrument) can be sold one or more times without prior notice to the Borrower. …
Note the choice of words: a partial interest in the Note. I strongly suspect that the same is true of my first mortgage, but I cannot find any documentation that states this.

This is why I said the scenario painted by the Treasury Secretary is only "kind of" correct: they aren't buying bad mortgages, they're buying bundles that include bad mortgages. The bundles also include good mortgages. It is unlikely, however, that these bundles will earn anywhere near as much as someone at FM pretended when they initially bundled and sold them.

Imagine that a housing "bubble" occurred: home prices increased at a rate where they bore little resemblance to the home's actual value. This was due primarily to demand: (a) the government was pushing to increase home ownership, especially among the economically disadvantaged; (b) a lot of "get rich quick" types were pushing "mortgage flipping" schemes; and (c) a lot of big cities had figured out that gentrification brought new tax dollars, much to the dismay of the poor who used to live in such neighborhoods and could no longer afford the property tax. There were almost certainly more issues involved. Five years ago I read an article where an author remarked that, without any effort on his part, he had become a millionaire, based solely on the apparent equity he had in his house. President Bush boasted at one point (the 2004 election campaign?) that home ownership had reached historic highs. Stocks had proven a bad idea in the dot-com bubble, and real estate was the new fashion.

There's a word I repeat from time to time: apparent value, apparent equity. This wasn't real money.

Some people realized this. Others didn't. Certain economists argued that the slide of American households into a negative rate of savings was nothing to worry about since it didn't include home equity. Never mind that Americans had learned from their government, and were now spending more than they earned. With the magic of home equity, the true source of wealth for most American households, there was no reason to worry! Real estate always increases in value, right?

As I say, it wasn't real money, whatever that is. Recently, one of the stock market swings produced a remarkable headline in the post: $700 billion in shareholder value just disappeared. I wasn't sympathetic; instead, I remembered Sam Walton's remark in the days following the stock market crash of 1987, when he personally lost one billion dollars of net worth. "It's just paper," he shrugged, and in the following years earned another two billion. Unfortunately, the moguls controlling the financial sector don't seem to have such an optimistic view.

Back to the point. That bundle of Mortgages A, B, and C was divided into many parts (another brilliant idea from the guys at Freddie Mac, or Fannie Mae). Each part of the bundle was sold two years ago to investors both in the States and abroad. For a while, the bundle made those investors money. All was good.

Recently, however, the two-year term on the ARM expired, and the interest rate on Mortgage C is going to increase a half-percent or something. On a $200,000 mortgage, that amount to $1000/yr, nearly $100/month. The owner of the investment property can't afford that new bill. (Doubt me? Okay, increase the mortgage amount to the "jumbo" mortgages that are failing in New York, DC, Florida, etc: $500,000 and up. Now a half-percent increase amounts to $2,500/yr, more than $200/month.)

Why did the professor take out such a dumb deal? He didn't actually expect this to happen. The original plan (as sold to him by the bank) was that, after two years, he could refinance the loan into a better one, with a lower, fixed rate.

Why could he do so in the future, but not at the time of the original loan? The value of a house usually increases over time due to "market forces", say from $100,000 to $120,000. The amount he owed on the loan, by contrast, would remain constant. Now he could refinance, and the difference between higher value ($120,000) and the same cost of the loan ($100,000) amounts to a substantial down payment, even though the professor has no hard cash ("liquid") for such a down payment. The mere difference in equity (value of house - principal = $20,000) would have made a new loan a "less" risky deal. The bank would on that merit be happy to award him a fixed-rate loan that he could afford.

For several years, this scheme worked. About a year and a half ago, it stopped working. The unrealistic increase in home values in certain areas (New York, Washington, DC, Florida, etc.) slowed, stopped, and reversed. The investment property is now worth maybe $90,000, while the professor still owes $100,000 on the mortgage. He can't refinance, because he has negative equity on the loan. The higher interest rate on the ARM means he can no longer afford the mortgage; he has trouble making payments. Mortgage C defaults.

Recall that Mortgage C was bundled with Mortgages A and B. It was then sliced into many pieces, each of which was sold to different investors. Not only is Mortgage C losing money, the bundle can possibly be losing money—or at least not making as much profit as needed to satisfy the contract made with the investors that own each part of the bundle. Not only does the entire bundle look bad, each part of the bundle looks bad. It doesn't matter that Mortgages A and B are still paying their share; they were bundled with Mortgage C, and the entire bundle looks bad. The investor is losing money on the deal, and no one wants to buy it. Like the houses in many parts of the country, the bundle isn't worth its price.

When this first started to look bad, everyone said "Encourage the banks to renegotiate the terms of these bad loans. Surely that would be better than a wave of foreclosures." True. Unfortunately, the banks don't have a free hand. Mortgage C is part of a bundle, remember. That bundle was been divided into parts (thank Freddie Mac again) and sold to different investors all over the world. Even if the bank could find all those investors (I'm not sure they can), many would refuse to go along with a new mortgage at a lower rate. Their point of view is: I paid for this contract, and have every intention of profiting from my investment. Why should I suffer and lose money, while the guy on the other end gets off scot-free? Let him suffer a while; not all of these delinquentcies lead to foreclosure. I may still do better.

The banks who hold these mortgage bundles face another problem as well: they're earning less money than they expected. Investors in the banks are disappointed by diminishing returns, and start to withdraw their money, looking for better investments elsewhere. New mortgage bundles can't be sold, so the banks have trouble finding ways to raise new money for additional loans (mortgages, short-term loans, etc).

In addition, bank customers are withdrawing money. Some customers have to pay their debts. Others fear a run on the banks, and walk over to withdraw what they can. That "walk" fuels a "run"; rumors of a run on the bank tend to grow into a self-fulfilling prophecy. (I've read that this is what happened to both Bears and Stearns and Lehman Brothers.) Constant claims in the media for the past five or six years that we've been in a recession haven't helped.

In this situation, banks start to run low on "liquid reserves". What are these? I took a class on Money & Banking in college. If memory serves, certain laws regulate how much "liquid reserves" banks must keep in proportion to their obligations. If I remember correctly, the ratio is 1%, or maybe 10%. (Some small number like that.) Okay, so the shortage of liquid reserves means that banks are drawing dangerously close to the threshold. By law (and by common sense) they cannot lend much more money. They have to become hyper-choosy in their loans.

The easiest thing to do is to make fewer loans, preserving liquid assets. Risky mortgage loans are the first to be cut off, and less risky mortgage loans follow shortly. Eventually banks have trouble finding money even for the money market, and as I understand it, shortly after noon on Thursday of last week banks simply quit lending money.

This situation is what scared the government into a renewed series of bailouts, an injection of liquidity into the money market, and this rush to devise a plan to buy $700 billion of bad mortgage securities. The government fears more runs on banks, requiring other bailouts.

Let's assume this is a correct understanding of the situation. (I'm not sure that it is.) My reactions are as follows.

(a) Okay, I can see the problem. The near-shutdown of the money market last week certainly drives the point home. Yes, we should avoid that scenario altogether, if it is a real problem. If so, $700 billion is a lot less than I expected. In addition, while the government might pay that amount (or more) for the mortgage bundles, most of the bundles should remain profitable, so the government could actually earn money in the long run. But probably not, since they are likely to relieve the banks of the worst bundles. Once the panic passes, if we're lucky, some of those bundles will still be profitable, and the government can sell them anew.

If I understand this correctly, the Treasury Secretary is telling the truth. It isn't a bailout of "Wall Street"; it's a bailout of the entire economy. If banks stop lending money, the economy will shut down. Companies won't make payroll; new companies won't start up; established businesses will fail.

Even if we suppose a milder scenario, where only a few "big" banks fail, the conseqeuences to ordinary Americans are still immense. A substantial number of Americans have invested in mutual funds that would take big hits from those losses, threatening things like retirement, college education, etc. (You might want to read your prospectus sometime, and see if you used to own part of Bear Stearns or Lehman.) Mutual fund companies could fail if their investors panicked. Unlike a bank account, mutual fund investment are not insured.

(b) On the other hand, that's a big if. One of my credit unions swears that it's having no trouble at all. ("No housing crisis here!" they proclaimed for a while on their website.) I recently contacted them and they said that their money market is doing just fine.

I'm planning to refinance my home equity line in a month. That loan is held by a different credit union, and I'd be interested in knowing whether they'll build a new loan for me. (I've made the monthly payments, plus extra.) In addition, several banks seem to have no qualms about offering me and my wife additional credit cards, or checks for credit card advances, etc., so many banks appear to have plenty of liquidity. In addition, a lot of names that I read & respect are opposed to this particular solution. Coming from the same administration that thought "deficits don't matter" and had no qualms about adding trillions of dollars to the national debt, there's a trust gap involved.

I wonder if this is merely a crisis that, while real, is localized to certain regions of the country that are highly influential in the media and the federal government. To wit: the Treasury Secretary used to run Goldman Sachs. The chair of the Banking Committee is a Senator from New York. Lobbyists live in the Washington, DC region. Do the dots conenct? I don't know. I've read (see Luskin, but also others) that in most parts of the country the housing market is just fine. The local newspaper claimed earlier this year that home prices increased 3% in Hattiesburg from last year.

(c) Is no one talking about putting an end to these securities that bundle bad loans together with good ones? Wouldn't the best idea be to forbid that practice?

When I was young, deficit hawks used joke, "A billion here, a billion there, sooner or later you're talking about real money." Here we are: $700 billion finally classifies as enough "real money" to prompt a discussion in Congress about the national debt. This is why the federal government should not routinely run a deficit. When a real crisis comes along, you need money.

Again, I welcome correction! I want to understand!

Update: The credit union holding my home equity line claims they're having no trouble writing loans.


Clemens said...

Excellent Jack. I am not sure if it is accurate either, but it has the great advantage of being understandable.

For the moment, I am just happy that both Carmen and I are cheapskates who have always lived below our means.

Now, if I could just understand why the western part of North Carolina has run out of gasaline....

jack perry said...

There was a report Friday (?) on All Things Considered that said many things similar to what I wrote. There were a few differences though. You can read it online here.

My wife and I would like to live below our means, and for the most part we are, but several "optional" expenses make it difficult: (a) a new baby last year; (b) braces for our son; (c) private school.

If I really had to, I have no idea which one I'd drop. After watching last night's debate, that puts me in the same boat as the candidates, since neither of them was willing to say which of their proposals they'd drop.

I was hoping McCain would say "tax cuts" and Obama would say "health care" but McCain said "spending freeze" (which isn't dropping any of his priorities) and Obama ducked the question completely as I recall.