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September 24, 2008

Thoughts on the Bailout

Due to time constraints I'm not even going to attempt my usual breezy prose, much less the jokes. I've been reading up on the meltdown for a few days when I have a spare moment. I'd like to offer a few observations from what I've read so far, interspersed with the best of the articles and posts I've seen on the topic.

Hopefully this will be helpful, either as an aid to discussion or to folks like Grim who've indicated they'd like to learn more about the forces at work here.

First of all, how did we get to this point?

My quick synopsis (and feel free to correct or append to it in the comments section - I don't pretend to be an expert on economics):

Beginning in the early 1990's, government sponsored entities like Fannie Mae and Freddie Mac came under increasing pressure to make risky loans to underqualified applicants, all in the name of providing "affordable housing" (a phrase that should cause you to run shrieking into the desert). Thus began a cascading series of events that led to what we just experienced:

1. Lenders like Fannie Mae extended loans to people who, under traditional mortgage underwriting standards, would have been judged likely to default. You may wish to resist the temptation to blame them - at least entirely. Statutory penalties mandated by Congress set a high price for "discrimination" in mortgage lending:

Failure to comply with the Equal Credit Opportunity Act or Regulation B can subject a financial institution to civil liability for actual and punitive damages in individual or class actions. Liability for punitive damages can be as much as $10,000 in individual actions and the lesser of $500,000 or 1 percent of the creditor’s net worth in class actions."

And this was the result:

Consider the following Countrywide tends to follow the most flexible underwriting criteria permitted under [Government Sponsored Enterprises] and FHA guidelines. Because Fannie Mae and Freddie Mac tend to give their best lenders access to the most flexible underwriting criteria, Countrywide benefits from its status as one of the largest originators of mortgage loans and one of the largest participants in the [Government Sponsored Enterprises] programs. When necessary — in cases where applicants have no established credit history, for example — Countrywide uses nontraditional credit, a practice now accepted by the [Government Sponsored Enterprises].

And Bear Sterns:

Credit scores. While credit scores can be an analytical tool with conforming loans, their effectiveness is limited with [Community Reinvestment Act] loans. Unfortunately, [Community Reinvestment Act] loans do not fit neatly into the standard credit score framework… Do we automatically exclude or severely discount … loans [with poor credit scores]? Absolutely not.

Recognize those names? Action, meet reaction.

2. Because so many bad loans were being made, more houses were purchased than would have been in a tighter credit market. This boost to housing demand also boosted home prices (values). As long as home values were rising, the balances on mortgages remained lower than the market value of most homes. In effect, rising home prices "insured" lenders against the risk of making bad loans (after all, banks could always foreclose and sell to cover the note)....

3. ...until the housing market began to contract and home values fell. Suddenly, many homes were worth less than the loan balance, leaving banks with bad debts that had to be written off.

4. To make matters worse, lulled by the strong housing market, lenders had been making more and more of these loans. During the 3-year period from 2003-2006, the percentage of risky loans nearly tripled.

The conditions were ripe for disaster. And that's what happened next:

5. Banks began to fail. Precisely why they failed is quite interesting, especially for those of you who oppose a bailout:

Regulators said the "immediate cause" of IndyMac's failure was a deposit run in recent days that began after a June 26 letter to the OTS and the FDIC from New York Senator Charles Schumer was made public. The letter voiced concerns about IndyMac's soundness. By July 10, depositors had pulled more than $1.3 billion from their accounts, the OTS said in a statement.

It's like something out of your high school history book. A run on the bank, but exacerbated by easy access to financial markets and information made possible by the Internet. Imagine how much more difficult it is to contain investor panic in a wired world? Well, unless you're Chuck Schumer. In that case, you blame the very regulations that make "affordable housing" possible:

"The institution failed today due to a liquidity crisis," said OTS Director John Reich. "Although this institution was already in distress, I am troubled by any interference in the regulatory process."

But Schumer wasn't having it, telling the Wall Street Journal that if OTS "had done its job as regulator and not let IndyMac's poor and loose lending practices continue, we wouldn't be where we are today."

Why do investors panic? Well, there are several reasons.

First of all, there is the problem of lack of information. Or perhaps it might be more accurate to say there is almost too much information for individual investors to take in:

It is natural to ask whether there is some specific reason for these events to occur when they did. Can we identify a specific trigger? While we can see something that has happened, as I suggested earlier there has been no fundamental deterioration in economic conditions. In fact, in the United States there was no economic data released on Thursday 9 August 2007. So, it isn’t that people suddenly changed their view of the future.

Instead, what happened was analogous to a bank run. Bank runs can be the result of either real or imagined problems. Here’s what how it works. Most people, even fairly sophisticated investors, are not in a position to assess the quality of the assets on a financial institution’s balance sheet. In fact, most people don’t even know what those assets are. So when we learn that one bank is in trouble, investors begin to worry about all financial institutions and investors start to flee. The inability to accurately value assets leads to a strong shift toward high-quality securities like Treasury bonds.

I cannot emphasize the importance of that last bolded portion enough. Imagine the power of panic, spreading by the Internet, TV, radio, newspapers, email. The fear "goes viral" with frightening speed.

THIS IS WHAT THE BAILOUT IS INTENDED TO ADDRESS. Not "affordable housing", not the horrible tragedy of failed banks (the economy can survive a bank or two going belly up), but investor confidence. I am not entirely sure some people realize how close we came last week to a disaster of monumental proportions:

7. As with the Chuck Schumer incident previously cited, in a nervous market, it's astounding how little it takes to cause a panic:

Money market funds are heavily regulated as to what sort of securities they can buy. These kind of short term debts were widely believed to be as safe as . . . er . . . something other than buying a house.

What happened last week is that one money market firm advertised its entire portfolio, including a large chunk of Lehman paper worth slightly less than 2% of the total fund assets. Spooked investors, who did not want to lose out if the fund "broke the buck" started withdrawing as fast as their little fingers could punch the buttons on their phones.

That's it. That's all it took. And then all hell broke loose:


Now, this money market fund had tens of billions worth of assets; if it started dumping them on the market, it would drive the price down, leaving them even less money to hand back to their shareholders. But there's a reason investors herd in a bank run: the first people out get all their money back. The rest get trampled in the stampede. The fund--incidentally, the same company that founded the money market industry--"broke the buck"; that is, its shares became worth less than a dollar. It's as if the value of your bank account suddenly dropped below the amount you'd put in.

This, by the way, is probably not the only fund this happened to, but it was the only fund that a) advertised its holdings and b) was not attached to an institution large enough to easily make good the loss.

Thus was touched off a general run on money market funds that held money for institutions--the kind that require buy ins of a couple million or more. Institutional managers have a strong incentive to do stupid, destructive things, as long as everyone else is doing them. It's the same reason that IT managers used to buy IBM--not because it was necessarily the best solution, but because as long as you did it, no one could blame you when things went south. "I bought IBM!" troubled CTOs would say when the server crashed. "The whole market is down!" cry money managers when the financial system crashes.

Investors were particularly worried about any exposure to financial paper. So, frankly, were the managers of money market funds. From Lehman, the worries spread to Wachovia, Washington Mutual, and beyond. Suddenly, said one source, no one could sell two-week Wachovia paper at 30% yield-to-maturity--which in layman's terms means they were offering a hell of a discount on a loan that was pretty likelyt o pay off. Some funds bragged they didn't have Wachovia, which only made the others seem ominously silent in comparison. The fund runs started to hit money markets that had no obvious problems (Putnam, BKNY/Mellon, American Beacon) causing them to shut down or redeem the shares in kind. Investors began worrying State Street's massive short-term investment fund complex was holding Lehman, which whipsawed its stock price 50% in one day.

Money market funds are generally designed to be the functional equivalent of a bank account: short-term vehicles where you park cash you aren't using at the moment. Investors are supposed to be able to pull their money out at any time. That meant that all the funds, sound or not, were vulnerable to a run. And virtually any fund that experienced a run would "break the buck" because while these funds are perfectly safe and liquid in normal circumstances, no one could dump a billion dollars worth of securities on the market without seeing the price of those securities plummet. Since funds definitionally try to hold their asset base near a dollar a share, and distribute the yield, there was no gigantic cushion to pad the sales.

The runs meant that all the money market funds were in the same boat: everyone wanted to sell and hoard cash in case of a run. No one wanted to buy. Once busted funds had gotten rid of their very short paper, they were stuck with the weeks/months maturities, which were virtually unsaleable. Unless the parent institutions make your investors whole the only thing you can do in that situation is distribute the assets in kind, to investors who can't sell them any more than you could.

Let me emphasize the bolded portions in the excerpt above:

IT'S NOT JUST "WEAK" FUNDS OR COMPANIES WHO ARE AT RISK. IT'S THE ENTIRE DECK OF CARDS.

So while many of you may find the proposed bailout "unpalatable", I heartily invite you to contemplate the alternative:

If investors lose confidence in the safety of money market funds, mutual funds, demand deposit accounts and the other storehouses of value in the modern economy, we would have a problem that would make somewhat higher taxes and moral hazard seem like child’s play. Trust me — you do not want to experience a full-scale bank run in contemporary America. I’m not sure how many people realize how close we were to the wheels coming off at about noon yesterday, as major commercial-paper processing banks like State Street lost 30% – 60% of their value in about 2 hours. Want evidence: When was the last time you heard of the U.S. government identifying a problem, developing a multi-hundred-billion-dollar program and announcing it within about 48 hours?

Finally, this is intended to be a high level summary, not an in depth analysis. As you may have gathered, I am in favor of doing something because this problem is not going away. I also find that despite my extreme unhappiness at both plans being proposed, I am in general agreement with this analysis.

If after all this, you are somehow trusting in the rationality of your fellow citizens, may I direct your attention to lemming-like behavior in the face of a non-crisis which nearly brought our entire financial system to its knees and this utterly inexplicable reaction.

Your fellow voters are about to vote you more "affordable housing". It's like deja vu all over again.

Posted by Cassandra at September 24, 2008 05:27 PM

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Comments

Cass,

I think that you have a pretty decent summary of the major pieces in this mess. If I were king for a day, I would make all reporters, editors, television anchors, and especially Members of Congress read and study this until they could pass a test on its contents at the level of a junior in a good university. That would undoubtedly lead to many job openings, but it's time this conversation got more serious and professional.

Many times in the past 15 years, my wife has asked why we seem to 'have' so much less than many neighbors, friends, acquaintances. I replied that if you were willing to borrow the money to entertain yourself, the sky was the limit. She responded that it couldn't be true that this 'lifestyle' was financed on credit (or at least by not saving at all). It seemed impossible to her that we were so different.

Tonight, while I grilled hamburgers for dinner out back, she came out and said the words I so rarely here: "You were right." It wasn't really that I was so right about this as this reflected her Depression-era mentality that you borrowed money for houses and maybe for cars, but certainly not for travel, entertainment, etc. If you borrowed to buy a house, you didn't buy a house beyond your ability to pay. Start small and work your way up from there. She couldn't fathom that people would borrow their way into financial oblivion and that bad loans could create the financial mess that we have now, but the evidence for this analysis was overwhelming.

Therein lies the other sad truth. Many of our fellow Americans have played a small, individual role in this disaster. My message to them is to get their own house in order and not to ask me or the government to bail them out of their messes. Time to grow up and act like an adult. Oh, and Congress critters, don't ask me to recognize a 'right to credit.' There is no such thing............

Posted by: Bob at September 24, 2008 07:39 PM

Well, I left a lot out in the interest of not making it incomprehensible, but some (if not all) of the things I wanted to discuss are in the linked articles.

I don't know if I am crazy, but it just strikes me that so much of the stock market is at heart illogical. I hate even thinking about it. I can't help but find it infuriating that I'm being asked to rescue people who took dumb risks based on the expectation that they could unload at a profit to some poor schmuck down the line. But then I guess there's a reason it's called the bigger fool theory :p

If it's any comfort, I'm married to a conservative guy when it comes to risk. We know military folks who own 2 or 3 houses, but we've always lived w/in our means. He's smart enough to see where he could be making lots of money b/c he has a far better grasp of finance than I do, but he has never been willing to risk our security, and for that I'm grateful.

I don't begrudge anyone who is willing to live with risk their profit if the gamble pays off. What galls me is being asked to pay for their losing bet.

Posted by: Cass at September 24, 2008 08:05 PM

A right to credit, now there is a scary thought.

Anyone who thinks there should be one (Barney Frank maybe?)should open up their wallet and starting loaning their own money.

Excellent post Cass darlin'.

Posted by: Pile On at September 24, 2008 08:05 PM

Good summary..
though the roots go back to Carter in 77 with the community reinvestment act...

Posted by: artfldgr at September 24, 2008 09:07 PM

I think the roots go back to when Cain slew Abel, because he coveted something that he didn't earn.

But I could be wrong about that one.

All I know is that my mortgage is held by Washington Mutual, and I keep wondering what happens when/if they go belly up.

May we all live in interesting times.

Posted by: Don Brouhaha at September 24, 2008 09:28 PM

Question:

I keep hearing about how Clinton, in an effort to encourage minority and low-income home ownership, repealed part of the 1933 Glass-Steagal Act.

Is that what forced the lenders to accept loans that weren't financially sound?

I'm all for more minority and low-income home ownership but not through the lowering of standards.

I don't know about the rest of you but I am really struggling understanding all of this - parts make sense and parts don't.

d.

Posted by: d. at September 24, 2008 09:45 PM

Glass-Steagall had nothing to do with forcing lenders to do anything.

Glass - Steagall prevented commerical banks from getting into other types of investment businesses, such as insurance and brokering stocks.
Actually, the banks that have taken advantage of the end of Glass -Steagall (JPMorgan-Chase, Citibank) are doing ok right now. It't the other banks that haven't broadened their business model that are struggling.

Posted by: Don Brouhaha at September 24, 2008 10:01 PM

It is my very shaky understanding that the repeal of Glass-Steagall did two things, one bad and one good:

1. It allowed bands to diversify their investments. Before the repeal, banks were prohibited from mixing commercial and investment banking. and that left their portfolios shallow. But there was a downside to this.

2. When commercial banks moved into investment banking, that meant competition. Investment bankers began originating and trading derivative securities. This was a new and riskier form of investment that wasn't well regulated.

So there was no "force" except in the sense of market forces operating to encourage newer, riskier investments where they had once been prohibited. They made the commercial banks more diversified (and therefore more stable) but had the unintended effect of driving investment banks into riskier investments.

Posted by: Cass at September 24, 2008 10:47 PM

JPMorgan-Chase came out of the merger of JP Morgan and Chase Bank.
Chase Bank was primarily Bank One, the result of merging Bank One and First Chicago.
Living where I live, I know and have known quite a few people that worked for Bank One. One of the things they were heavily into in the '90's was ....derivatives.
I actually think the mergers helped them because it diluted the presence of derivatives in their portfolio of investments.

There is now only one independent investment bank left, I think. Goldman-Sachs, now that Lehman and Merril Lynch have respectively gone under and been bought out. And Bear-Stearns went under last spring.
So what does that mean? I dunno.

Posted by: Don Brouhaha at September 24, 2008 11:19 PM

It was some other Congressional legislation that mandated the lowering of credit standard to get minorities into homes. And banks, not wanting to hold this high-risk paper, sold them to Fannie Mae/Freddie Mac. Then, Congress let Fannie Mae/Freddie Mac buy more and more of these high-risk mortgage-backed securities. And Fannie & Freddie was cooking the books to inflate their income in order to hit bonus benchmarks for upper management. And those upper management people? Democrats. And the people who tried to reform Freddie & Fannie? Republicans (McCain co-sponsored legislation 3 years ago, then, of course, the attempts my the Bush Admin that Cass has mentioned). Who stopped it? Democrats. Like Dodd, who got a sweetheart deal from Countrywide and is the biggest recipient of campaign money from Freddie & Fannie. Oh, and Obama, too, who is #2 on that list, even though he's only been in the Senate not even 4 full years...

Posted by: Miss Ladybug at September 25, 2008 01:10 AM

Forgive me for my ignorance but I need to ask a question. If the government were NOT to step in and the "disaster of monumental proportions" were to actually occur, what would that mean for MY LIFE?

How would this collapse affect me and my family? Keep in mind we do not own (we rent but the house is owned outright by the homeowner) our own home and MacGyver's job is relatively secure. We have some consumer debt but nothing that we couldn't pay off in a year (sooner if we HAD to).

Posted by: HomefrontSix at September 25, 2008 03:48 AM

Heh. Good one, Don :)

If you really want to hear something amusing, my mortgage is held by Countrywide. Yee ha.

Posted by: Cass at September 25, 2008 10:00 AM

Countrywide tends to follow the most flexible underwriting criteria permitted under [Government Sponsored Enterprises] and FHA guidelines. Because Fannie Mae and Freddie Mac tend to give their best lenders access to the most flexible underwriting criteria, Countrywide benefits from its status as one of the largest originators of mortgage loans and one of the largest participants in the [Government Sponsored Enterprises] programs. When necessary — in cases where applicants have no established credit history, for example — Countrywide uses nontraditional credit, a practice now accepted by the [Government Sponsored Enterprises].

Don't make me laugh!

Remember how much trouble my sisters and I had getting the mortgage on the house in Wyoming? Yep - Countrywide.

As you know, Cass, I am a US citizen living outside the country with a very good 6-figure salary and in an executive position with a subsidiary of a US company. Under current tax laws in my country of residence, I pay 53% income tax. In addition, I also pay US income tax on earnings over $75k per annum.

My two sisters and I applied together for a mortgage in the amount of $80k for the house in Wyoming, making a down payment of $245k cash. Both sisters are US citizens, employed and living in the US, with good credit histories.

Although I alone had more than enough money in cash and securities to purchase the entire property OUTRIGHT, my credit information, together with 3 years' income tax statements from BOTH the US and my country of residence was not considered acceptable documentation to obtain a mortgage.

My long-time bank in my country of residence (a well-known multinational bank with whom I have a 15-year relationship) wrote a letter of recommendation stating I had an unlimted credit line with them. All to no avail.

I was frustrated at the time, but now I am outraged.

To make a long story short, I did eventually "establish" credit. I took out a very small loan with a small, local US bank and after only 3 months of making payments I was considered a good enough credit risk for Countrywide.

And now THEY want ME to bail them out? F§$% them!!

I hear what you're saying in today's post about the letting everything go under, and I know I'm being emotional, but I think there's a lot of people like me out there who are just fed up with this crap!

Posted by: MaryAnn at September 25, 2008 12:35 PM

MaryAnn, I totally understand.

My husband and I built a small home in 2001. It is far smaller than what we can afford on our two incomes, but we did not want to put ourselves in jeopardy when he retired from the Marine Corps, so we relied solely on his projected retirement income.

Now we are - or were - ready to build our real retirement home. Fat chance. The truth is, even with a sterling credit rating, we had to jump through hoops to buy our last home. The problem is that we aren't minorities, or disadvantaged, and we pay our bills on time. Oh.

And since my husband is military, we can be asked to "prove" every cent we make. And so we are.

I look at people who leverage every last cent and are in debt up to their eyeballs and don't get it. And now I don't know if I'll ever get to move. So I sympathize.

But that doesn't blind me to the consequences of inaction, and also those loans won't be easier to get in a recession.

Posted by: Cass at September 25, 2008 12:47 PM

Couple of points of clarification, which also serve to show how common the misperceptions are.

In dealing with mortgage markets, with the exceptions of a few banks, almost everytime you've used 'Bank' or 'Lender' you really should have used 'Investor'.

As I said, with a few notable exceptions, banks do not own your loan. They only service your loan. When you default, the bank doesn't take a loss. The investment firm/mutual fund/etc. that owns it does, not the bank.

But because people *perceive' banks as the owners and thus the one in trouble, they make a run on the bank instead of the investment firm/mutual fund/etc. The fund managers who do understand the relationships short sale the investment firms and so both sectors get hit, even though only one has a problem.


This isn't to say that banks are squeaky clean. They still have their GSE 'Pipeline' to deal with. When the GSEs stopped buying loans, they also declined loans that were already in process. At this point the bank has a couple of options. Turn the customer away, losing that customer and everyone he tells (not to mention the possible Equal Opportunity lawsuit) or put the loan on their own balance sheet. Basically, the bank is SOL either way.

Posted by: Yu-Ain Gonnano at September 25, 2008 01:03 PM

Mary Ann,

Credit scores. While credit scores can be an analytical tool with conforming loans, their effectiveness is limited with [Community Reinvestment Act] loans

Putting down 30% on an $80k loan with your income is pretty much going to put you into the "conforming" category. At that point, credit score is King. And a non-existent credit history is going to be a problem for any lender absent a credit union or community bank.

It ain't fair, but that's how it is.

Posted by: Yu-Ain Gonnano at September 25, 2008 01:11 PM

This is why I love the Internet :)

It's educational!

Posted by: Cass at September 25, 2008 01:42 PM

Y-A G,

We paid $325k for the home, put down $245k, and wanted to borrow $80k between the 3 of us.

My sisters would have gotten the loan without me. As soon as I was on it, we were refused.

I didn't have a US credit score because my US credit cards were up to date (no debt). I hold US securities with a US broker. I have a US checking account. (in addition to all of my local, non-US accounts)

Now remember this line: "When necessary — in cases where applicants have no established credit history, for example — Countrywide uses nontraditional credit... "

Well, let me tell you a little about that. I worked for MONTHS with Countrywide's underwriters (Radian Guaranty) as well as LandSafe who supposedly "work" on international credit information (i.e., their "job").

They know more about me than anyone else in the universe - years of income tax returns from 2 countries, all bank accounts (US and non-US), securities (US and non-US), 12 months' payment histories with my landlord, my cell phone carriers, my 4 local credit card companies, my utility companies, my employer - I can't even remember all the documentation they received.

And once we finally were aproved (because of a pittance of a loan with a 3-month history), we actually ended up having to sign the mortgage papers FOUR times becaue of who-knows-what. Each time everything had to be notarized (expensive here) and FedEx'd (more money down the drain).

It was nothing but a load of shenanigans with one person more incompetent than the next. A total clusterf*ck.

I have never, ever experienced anything like it.

I run a business, and if I ran mine like they run theirs, I'd be bankrupt. Which is what they should be.

Geez, if you keep me going on this I'm going to end up on Countrywide's doorstep with a shotgun!

Posted by: MaryAnn at September 25, 2008 01:52 PM

Hey, I already said it wasn't fair :-)

Posted by: Yu-Ain Gonnano at September 25, 2008 03:34 PM

But I am sorry about the confusion on the numbers. When you said you wanted to borrow 80K with 245k down, I assumed you had meant 24.5k down as a 25% LTV isn't common.

But, as I said, stuff like your example is stupid, but adherance to incomprehensible regulatory requirements always trumps credit risk.

Posted by: Yu-Ain Gonnano at September 25, 2008 03:42 PM

...adherance to incomprehensible regulatory legislative requirements for "affordable housing" always trumps credit risk.

Fixed that for ya.

In all seriousness though, I do get what you're saying.

Posted by: MaryAnn at September 25, 2008 04:04 PM

Hmmm... guess my html strikethrough tags didn't work on the word "regulatory".

Posted by: MaryAnn at September 25, 2008 04:05 PM

I'm fine with bailout but I need about a couple of hundred heads for the sacrificial lamb thing. That's the deal with me. Bailing people out of problems they caused, like the Sunnis, is a okay with me. So long as we get to kill enough of the people that caused the problem in the first place so it won't ever ever happen again: this generation at least.

Posted by: Ymarsakar at September 25, 2008 04:06 PM

7. As with the Chuck Schumer incident previously cited, in a nervous market, it's astounding how little it takes to cause a panic:

Given how the un free press of the MSM has propagandized Iraq to the American people, that's not so difficult to believe. Once you get your grips on people's psyche in one sphere of things, it's not too hard to cross over unto a new area to induce an emotional state change.

Posted by: Ymarsakar at September 25, 2008 04:09 PM

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