Wednesday, September 24, 2008

Payback's a ......political necessity

Issue Is Payback, Not Bailout - The linked column by David Leonhardt is focused and lucid - not always the hallmarks of the Time's business section. As Good As News always wants you to read, or at least skim, the articles linked at the beginning of each post, but this one is worth reading carefully. Now, here's another view on some of the points made by Mr. Leonhardt. [for a third view, more sophisticated than the one presented below but still readable see Daniel Alpert's mad as hell take on the same issues]

Even if the government spends a full $700 billion buying "toxic" mortgage backed securities, it will get something back when it sells the securities. True. These securities are bundles of mortgage loans. Some of these mortgage loans are not even in default, the homeowner is still making the full monthly payments. Even the defaulted mortgage loans are secured by homes which should, in theory, have a value greater than zero. In a market not driven by panic the value of the securities, the bundled mortgage loans, should reflect this value in the underlying mortgage loans and the homes that secure them. But, many of the underlying loans were made without a serious credit review. Many mortgaged properties are in neighborhoods where nothing is selling. Even if the bailout stops a financial crisis, it won't stop a recession or reverse the decline in real estate values. The government, or anyone else, who ends up dealing with individual mortgages and needs to maintain and sell properties obtained by foreclosure will have a prolonged and very expensive mess on their hands. Who wants to spend $70,000 on property taxes and maintenance over three years waiting for a property's value to bounce back to $60,000? Even if the property value bounces back all the way to $75,000 you still lose, because your recovery is all at the back end of a constant stream of expenses that start on day 1. The bundling and sale of the mortgage loans has also made foreclosure, and workouts to avoid foreclosure, more confusing and expensive than in the old days when a single local bank made the loan and held onto the mortgage. So the "panic" prices for toxic mortgage backed securities (panic being driven by lack of liquidity and fear of the impact of mark-to-market accounting) may actually be closer than we would like to the "rational" market prices we hope will emerge once a buyout plan is in place. In sum, don't get your hopes up too high, a lot of that $700 Billion will not be coming back as cash proceeds from toxic security resales by the government.

The government will likely need to buy toxic mortgage backed securities at prices greater than market value in order to save the financial system and it should get equity in the selling firm each time it does so. Yes and Yes, but watch out for a rough ride. Taking an ownership interest as part of each "rescue" purchase is the simplest and safest way to recover some of the tax money spent on this rescue mission. It will put the government into a messy, conflicted position - (it can let bank x fail and triple the value of its stock in bank y) and require some business smarts outside the government's normal skill set. Witness the pointless shenanigans of the leasing group within the Dept. of Interior, which mimicked all the worst elements of corporate excess without making any good deals. The problems are real, but taking some equity is the taxpayer's best hope. It's worth the risk.

Congress should not spend time right now on side issues like executive compensation. Narrow the focus to two issues - how much does the government spend and how can the taxpayer get pay back - to move a rescue plan through Congress ASAP and avert a disaster. Sounds good, but As Good As News is not sold. There is more than one kind of pay back involved here. The fastest way to get something through Congress is to recognize political reality and deal with it now, not spend weeks convincing Congress the crisis is so urgent they can't spend time on executive compensation. Any company that wants the government to buy its toxic securities should pay a price - limits on exec comp and clawbacks for any bonuses paid based on illusory income from selling toxic mortgage backed securities. The politics of the situation makes this a central issue, not a detail to look at later.

One final detail, which shouldn't stand in the way of a rescue. The American economy's recent growth has been driven by consumer spending, which apparently was driven by an ocean of bad mortgages and shaky credit card debt. One of the first ripples in the coming tidal wave of new (or in many cases, restored) regulation will be accountability for credit evaluation - no more mortgage loans to the unemployed based on a made to order property appraisal, no more applications begging ten year old children to sign up for credit cards. What happens to the economy, already on the brink of recession, once we pull the plug on the creation of bad consumer debt in order to preserve the financial system? Thanks to Reaganomics and the Iraq War the government deficit has reached the point where there's no room left for fiscal stimulus. The Fed is already holding interest rates steady in a crisis, it clearly sees little room for monetary stimulus. Can Americans, with help from a weak dollar, actually start making products that foreigners will want to buy again? Like an invalid's 99th birthday, saving the financial system beats the alternative, but Wall Street and Main Street may both be in for some serious belt tightening.

For an opinionated look at what might have been America's last chance to avoid some of this trainwreck see, Kevin Hassett's (no relation) story for Bloomberg on the Democrat's refusal to rein in Fanny Mae and Freddy Mac in 2005. This Hassett is actually a widely known and respected economist, currently Director of Economic Policy for the American Enterprise Institute formerly a teacher at Columbia B and Fed Reserve economist. That would be a real economist, as opposed to an unknown comic who didn't even stay at a Holiday Inn Express, but knows a little about derivatives and has a few friends in the financial world.

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