Foreclosure Moratoriums

You can look at the mess in the mortgage banking industry, and the current foreclosure moratorium, from two different directions. Looked at from one side, it a mess of terrible complexity and ambiguity. Uncertainty clouds the outlook. Looked at from the other side, there are no issues, and everything is as clear as a summer’s day.

The current moratorium is being imposed by the banks that process mortgage payments. In almost every case, these banks do not actually own the mortgage in question. The bank may not even have been the original lending institution for the mortgage. In today’s housing market, most mortgages are resold shortly after the real estate closing. Thousands of mortgages are pooled together into securities, which are then sold and resold. What the bank is doing is servicing the mortgage on behalf of the investors who actually own it. So in a foreclosure, the bank has to submit paperwork to prove that it has standing to foreclose on an individual. That is complication number one.

The systems for processing mortgage payments are highly automated, which keeps the cost down. Because almost all of the work is done by computer, it only takes a few people to handle thousands of mortgages. But the legal system is not automated at all. In a foreclosure proceeding, paper documents have to be submitted for every case, covering every aspect of the procedure. That is complication number two.

In the past, only a few mortgages were in foreclosure at any one time, compared to the number of mortgages outstanding. After all, is the borrower couldn’t make the payments, they were encouraged to sell the house to get out from under the mortgage. As long as home prices were rising, this worked. With the collapse of the housing bubble, millions of homeowners are underwater, owing more on their house than it can be sold for. Combined with high levels of unemployment, that means the number of houses being foreclosed upon has grown by leaps and bounds. There are vastly more houses in foreclosure than just a couple of years ago. That is complication number three.

In a foreclosure proceeding, the bank has to submit paperwork to back up their position. In the absence of the original loan documents, bank employees sign affidavits attesting that they have reviewed all of the documents connected with a case. It turns out that, faced with a crushing backlog, some of the document signers were filing up to 400 packages a day. They could not possibly have been reading all of the documents to ensure accuracy.

Now that this has come to light, some attorneys who represent homeowners facing foreclosure are arguing that not only are current foreclosure proceedings invalid, but that many past foreclosures are also questionable. That’s the background for the current moratorium. Lots of heat, not much light and clarity.

But as I mentioned before, there are two sides to the story. The other way to look is at the homeowners. These are people who borrowed the money to buy houses, and aren’t paying it back. I think even the attorneys representing them will admit that these guys have stopped paying the mortgage, sometimes years ago.

To me, this seems pretty simple. You stop making payments, you get your butt thrown out onto the street.

Right now, the squatters keep possession of the house until the bank can prove it has right of ownership. All of the delays are on the bank side of the equation. But it strikes me as unjust, that some people can get away with not paying back a loan without consequences. My solution: throw the deadbeats out, but don’t allow the bank to resell the property until they can catch up on the appropriate paperwork. In the meantime, the bank has to pay to maintain the properties, which they have to do anyway, until they can find a buyer.

This way, the squatters don’t get to make chumps out of the majority of homeowners who continue to pay their mortgage every month. At the same time, the banks have a powerful incentive to get their paperwork straightened up. Case closed.

Getting your stories straight

USA Today ran two finance stories today with sharply contradictory messages. On the front page, the headline above the fold reads BANKS GET STINGY ON CREDIT. The story reported is that for the first four months of this year the number of new credit cards issued declined 38% compared with the same four months in 2008. Also, credit limits are slightly lower on the new cards that are issued. The average credit limit of $4594 is 3% lower than last year.

The tone of this story is that the new restraint on the part of credit card issuers is a bad thing. Spending pumps up the economy. Easy access to credit leads to spending. Therefore limiting access to credit delays the economic recovery.

In the Money section of the same paper, there is a related story with a completely different slant. Here the headline is US DEBT SHRINKING AT GLACIAL PACE. Total household debt peaked at $13.9 trillion in the third quarter of 2008, almost doubling since 2007. It has declined to $13.8 trillion during the first quarter of 2009, about a 1% drop.

This story points out that the US has just begun to deleverage. In the mid-80’s, household debt was 65% of disposable income. At the peak in 2007, household debt was 133% of disposable income. The perspective underlying this story is that until a lot more debt is either paid off or written off, consumers will not have the available income to resume spending in a way that will lift the economy.

So which is it? Is more debt good for the economy, or bad for the economy? From my perspective, it is an obvious answer. The economy came crashing down because of excessive debt. People paid way too much for houses they couldn’t afford. Then, to furnish those houses, they maxed out their credit cards. This was followed by tapping home equity lines of credit to pay off credit cards, which were then run up to the limit again.

It was like the financial equivalent of a giant game of musical chairs. Eventually the music stopped. Only in this game, all of the chairs had been pulled away. The good news is that the savings rate has increased from a negative number to 6.9%. This is a sign that people have stopped digging themselves into ever deeper holes of debt. But backfilling those holes will take time. The last thing we need to do is go back onto a credit fueled spending spree. That only starts the digging process all over again.

What was most surprising to me about these two stories is how they could have such different slants on the situation, coming out on the same day in the same paper. Don’t the editors read what the reporters are writing?

Is it safe to go back in the water?

Last week Wells Fargo announced record earnings for the first quarter of 2009. The stock market soared on the news, and reports started to circulate that the worst was over for this recession.

No so fast!

Wells Fargo’s results were driven by fees from a wave of refinancing. The refi boom came about because the Fed has dropped interest rates to the floor. Mortgage rates have followed. As a result, people who could have been refinancing existing mortgages to take advantage of the lower rates.

Everyone who refinances has to pay fees to the bank for handling the transaction. This is great for the bank, but it is a short term phenomena. Mortgage rates are sitting at about 4.5% right now. They aren’t going to go much lower, if any. We’ve got about one quarter more of refinancing, then everyone who wants to take advantage of the new lower rates will have done so, and the fee income is going to dry up again.

The real issue is whether Wells Fargo has finished writing off all the bad loans in their real estate portfolio. Since real estate prices are continuing to fall, I’m guessing that more bad news is going to come out. After all, WF posted a loss in the 4th quarter of last year almost equal to what they earned this quarter.

We’re not out of the woods yet.

We Bring Good Things to Light?

GE stock has fallen precipitously in value over the last year. It was trading at a little over $6 per share last week, having come down from a high of $40+ in 2007. This is the same GE that builds both jet engines and refrigerators, light bulbs and MRI scanners. GE even owns NBC and Universal Studios. They are a leader in globalization, noted for having a deep management bench and the ability to develop talent. GE is one of the few American companies with AAA bond rating. The bluest of the blue chips.

And yet, panic selling drove the price down 45% in one month. This, despite the fact that the company was profitable last year. What gives?

The problem is that GE has xx in assets, but has yy in liabilities. If GE has problems paying back those liabilities, that spells real trouble for the stockholders. In corporate finance, the owners of the liabilities (bondholders) always get paid before the owners of the equity (stockholders). The reason the stock price has fallen so far is that the judgement of the market is that GE’s liabilities won’t be paid back.

You may think “What’s the problem? They’ve got a lot more assets than liabilities.” Well, maybe yes, and maybe no.

GE is really two companies. There is General Electric, which is the collection of industrial businesses that makes all the stuff. They have twice as many assets as liabilities. Then there is GE Capital. GE Capital provided half of GE’s profits for 2007. The problems are in GE Capital portfolio. In the 2007 annual report, GE Capital had $646 billion in assets, and $587 billion in liabilities. If the assets are worth only 10% less than what GE said they were worth a year ago, that would be enough of a fall in value to wipe out GE Capital’s equity, forcing the company to put more cash into the business.

GE Capital uses the AAA rating to borrow money cheaply. They then use that money to make loans. A lot of the loans are equipment leases. You want to lease a jet engine or MRI scanner, GE Capital will help you do that. But they make a lot of other types of loans as well. For a financing company, the money borrowed is a liability, and the loans made are the assets.

The market is concerned about writedowns hidden in the loan portfolio. Another way of saying that is that the assets are worth a lot less than what GE has been saying, and GE will have to ‘fess up soon.

I decided to go looking through the annual report to see if I could spot any potential problems. In corporate annual reports, the pesky details that can cause trouble are usually buried in the notes that follow the financial statements at the back of the report. Opening up the report almost at random, I found Note 12: GECS Financing Receivables.

Inside Note 12 was a line item for a division called GE Money, listing Non-US Residential Mortgages: $73.759 billion. So GE owns a mortgage company that is holding almost $74 billion in mortgages. I’m guessing that most of the mortgages are in the UK.

Attached to the line items was a reference to subnote (A). In little, tiny print, subnote (A) included the following statement: “approximately 26% of this portfolio comprised loans with introductory, below market rates that are scheduled to adjust at future dates; with high loan-to-value ratios at inception; whose terms permitted interest-only payments; or whose terms resulted in negative amortization.”

Yikes. Let me translate that for you: “GE holds over $19 billion dollars of toxic subprime mortgages in a collapsing real estate market.” After those UK homeowners stop paying, GE will foreclose, and then sell the houses for half. My back of the envelope calculation is that GE will have to write down that sliver of their portfolio by about $10 billion dollars. The total reserve for losses in their Financing Receivables is only $4.3 billion.

GE recently eliminated 70% of their dividend. This contributed mightily to the free fall in the stock price, but it will free up $9 billion a year in cash to apply to other uses, like writing off foreclosed mortgages. I have a feeling that they are going to need the cash.

The 2008 annual report is due any day now. I can’t wait to read it.

Happy New Year!

At the beginning of the New Year, I like many others, make resolutions for the coming twelve months. Sometimes these resolutions actually come to fruition (2008: start a blog), sometimes the hard realities of December bear no resemblance to the wishful thinking of January (2008: increase the value of my portfolio by 15%). Nonetheless, I find value in the exercise of goal setting. It helps define my priorities for the coming year.

Sometimes as you take stock at the end of one year, and you review progress against your goals, it becomes an exercise in shoulda, woulda, coulda. For example, I sure wish I'd gotten 100% into cash in the first half of 2008. Ah well. I'll just keep telling myself that I'm investing for the long haul. That makes it feel okay. Really, it does.

Anyway, I've decided that my financial theme for 2009 is deleverageing. My spell check doesn't like the term, so maybe deleverageing isn't in the dictionary yet. By the term the current financial crisis is in the history books, it will be.

In financial terms, leverage is a way of expressing the ratio of debt to equity. For example, if you buy a house with a 20% down payment, and take out a mortgage for the other 80%, you have leveraged your equity four to one. As you make your mortgage payments, your reduce the leverage as you build equity. This happens very slowly in the first years of the mortgage, than picks up speed as a larger and larger percentage of your mortgage payment is focused on paying down the principle balance.

The current crisis in the financial markets was brought on by excessive leverage during the housing bubble, both by consumers and institutions. Consumers bought houses with no money down (essentially infinite leverage), or they extracted all of the equity from their houses through home equity lines of credit. After all, if the value of housing had kept going up, they would have created equity out of thin air. Why not borrow against that? It seemed like a good idea at the time.

On the institutional side, banks were dumb enough to make those loans. The investment banks on Wall Street were dumb enough to repackage those loans and resell them, and institutional investors like insurance companies and pension funds were dumb enough to buy them. After all, if the home owners stopped paying their mortgages, the collateral (the houses) would be worth more than the original loans. Why not loan against that? It seemed like a good idea at the time.

It seemed like such a good idea that the Wall Street investment banks borrowed hundreds of billions of dollars to amplify the returns on the firm's capital. After all, bonuses were paid based on returns on capital. These guys were capitalists, says so right on the brochure. So when the housing market started to turn downward, a lot of the banks and investment banks were highly leveraged, 20 to 1 or even 30 to 1.

The upside of leverage is that when you are making gains, those gains are amplified by the amount of leverage. The downside of leverage is that when you are taking losses, the losses hit your capital by the same degree that gains boost it. So if you are leveraged 20 to 1, that means you have 20 dollars of debt for every dollar of equity. A 5% loss on the value of your assets is enough wipe out your equity.

Picture a bank holding most of it's assets in residential mortages. Foreclosure rates have more than doubled since 2007, and housing prices have dropped an average of 18% in the last year. Banks are taking losses of way more than 5% on their loan portfolios. When your debt is greater than the combination of your assets and your equity, that is the technical definition of insolvency, also known as bankruptcy. Ouch.

Financial institutions have spent the last year trying to raise capital, either by selling shares of preferred stock or by selling assets or by raising cash by cutting expenses like dividend payments. If leverage is the ratio of debt to equity, having more capital lowers leverage. For consumers, leverage is also being reduced. When you mail the keys to your house back to the bank, and move into a rental, you have reduced your personal leverage by the amount of your mortgage loan.

The bottom line is that when you reduce debt, you deleverage your financial position. So the process of reducing debt is deleverageing, however you spell it.

The thing about deleverageing is that it is a lot less painful when you do it willingly, before circumstances force you into it. It is a lot easier to tighten one's belt and build your rainy day fund, than it is to deal with foreclosure, or even escalating late payments because you missed a credit card payment.

Having established the theme of deleverageing for 2009, the next question is whether it is better to pay down debt or build up cash. I'll take up that issue in another post.

It's the Leverage, Stupid!

It has been an amazing couple of weeks in the financial markets. Fannie Mae and Freddie Mac: nationalized. Lehman Brothers: bankrupt. Merrill Lynch: acquired by Bank of America. Insurance company AIG: 80% owned by the Federal government. Last week’s news is that commercial bank Washington Mutual and investment bank Morgan Stanley are both searching for buyers to acquire them before they go the way of Lehman Brothers. This week’s news is that the Federal government is engineering a $700 billion plan to acquire troubled mortgage assets from Wall Street companies.

And all of this is on top of the collapse of Bear Stearns and IndyMac Bank earlier this year, not to mention the massive multibillion write offs that have hammered almost every large financial institution in the country.

The root of this turmoil is the collapse of the housing bubble. Houses that used to sell for $500,000 are now selling for $350,000. Houses that were selling for 250,000 are now selling for $175,000. More declines in housing prices are forecast for next year. People who purchased houses with 100% loan to value mortgages, or who pulled all of the equity out of their house with home equity lines of credit (HELOC, in banking jargon), are being foreclosed upon in record numbers, leaving their bank with collateral that is now worth less than the balance owed on the loans.

But there have always been foreclosures, big bankruptcies have occurred before. What makes the impact of current conditions so severe? In a word: leverage.

One of the reasons the stock market crash of 1929 led directly to the Great Depression was leverage on the part of individual investors. During the stock market boom of the twenties, investors could buy 5 shares of stock while putting in the cash for only one share. The rest of the money was borrowed. The practice of buying stock with borrowed money is called buying on margin.

When the market crashed in 1929, stock values dropped low enough that the cash the investors had put in was wiped out. The brokerage that had loaned them the money then turned around and required the investors to come up with more cash. This is known as a margin call. In 1929, the margin calls set up a feedback loop. To raise cash, investors sold more stock. The increased selling lowered prices further, which led to more margin calls. More margin calls, more selling, lower prices, more margin calls. Rinse, repeat.

The problem was set off because investors had borrowed too much money compared to the equity they put into their portfolios. They did it because the more shares they controlled with borrowed money, the bigger the return on the equity they had put in. At least, that was true as long as stock prices were going up.

Borrowing money, or leverage, amps up returns when assets prices are rising, but it has the reverse effect when asset prices are falling. Falling like they are these days.

Leverage is everywhere in today’s economy. Let’s say you buy a new car that costs $25,000. You trade in your old car for $5000, and finance the rest. In this instance, you have leveraged your equity (the value of your trade-in) by a factor of four. If you buy a house with a standard 20% down payment, you are leveraged four to one.

Industrial companies use leverage as well. They finance their operations through a combination of stockholders equity (capital) and debt instruments like corporate bonds. Usually the ratio is less than one to one. That is, they have more capital than debt. The thing about debt is that you always have to make the interest payments. With equity, you can always cancel your dividend when you hit a rough patch.

In the last few years, Wall Street firms have piled on an astonishing amount of leverage. The investment bank Goldman Sachs has leverage of 22 to 1 currently. Before it collapsed, Lehman Brothers had leverage ratios of over 30 to 1. That means it only took a 3% loss to wipe out the equity in the firm.

But despite the media coverage, we can’t blame all of the current financial crisis on greedy Wall Street financiers. There is plenty of mud to throw at Main Street folks as well.

Consider a homeowner who buys a $200,000 house and takes out a $160,000 mortgage. That guy is leveraged 4 to 1, right? Now watch the homeowner take out a $30,000 HELOC a year later. Now the homeowner is leveraged 19 to 1. That’s getting up into Wall Street territory. During the bubble inflation years, it was possible for subprime borrowers to take out 100% loan to value mortgages. The banks went to people who had a history of not paying off their debts, and let them take on leverage ratios of over 100 to 1. That’s like giving a six year old a can of gasoline and a book of matches, and then telling the kid to go out and play.

Now our financial system is burning down around us.

Debt is a good servant, but a bad master.

The Fundamentals of the Economy

John McCain gave a speech yesterday where he said "The fundamentals of the economy are strong." He was immediately excoriated for that remark.

"How out of touch is that guy? Wall Street is collapsing! People are losing their homes to foreclosure! Gas prices are up! I found a double yolked egg when I went to make breakfast this morning! Damn Bush and those neocons!"

You know what? All of those things may be true (except for the double yolk egg part. I usually eat cereal for breakfast). But I happen to agree: the fundamentals of the economy are strong.

This is not to say that things are booming, because they're not. I work for a company that makes subassemblies for the major appliance market. We've taken a big hit this year, both in sales that are off because of the slowdown in the housing market, and in our costs, because commodity and energy prices are up so much this year. I've had to conduct several rounds of layoffs to get our company's workforce down to the right size for our current volume of business.

But we're still selling product, still meeting payroll, still investing for the future in both people and equipment. Just as you can have slow sales, but a fundamentally sound business, so too can you have a recession, even a severe recession, and still have a fundamentally sound economy.

I don't want to make light of the real suffering going on out there right now. People are losing their jobs and their houses, and that has just got to suck. High gas and food prices are taking a bite out of my income just like everyone else's. But I went out jogging the other day, and I noticed a funny thing: there was no blood in the streets. I would have noticed too, becuase it hadn't rained for several days.

Layoffs are up, but 94% of us still have a job. Foreclosures are up, but over 97% of homeowners are still making their mortgage payments. The stock market is down, but it is not shut down. You can still buy and sell stocks. At a personal level, it easier to get a table at the local Outback Steakhouse, but only after 8:00 at night. The dollar doesn't go too far if you're in France for vacation, but it still spends just fine in Wal Mart or Target.

At least, I think it still spends fine in Wal Mart or Target. I haven't bought anything at either store in months. Gas prices are up, so I compensated by cutting back on the amount of Chinese made crap I buy.

My point, however, is that the economy is still functioning. People are adapting and adjusting to tough times, and when this deleveraging process we're going through runs it's course, we are going to get back to growing and creating businesses. We're going to do this without a lot of help from the government, by the way.

The people who work for my company are coping with the current economic environment in a variety of ways. Some are carpooling to work to save gas. Some are finding second jobs to replace the overtime they've lost. Some are cutting back vacation plans. One thing they are not doing is cutting back on helping each other. When a coworker or family member hits a rough spot, they chip in to help to the same extent as in better times. At a fundamental level, they are muddling through this rough patch. So, yeah, I think John McCain is right when he says that the fundamentals of our economy are strong.

Tough times never last, but tough people do. At the core, Americans are tough people.

Bad News, Good News

I noticed something interesting in the news today. I was reading an article about the housing market, detailing that housing prices nationwide have dropped about 18% in the last year. The news article went on to state that more bad news was expected, as housing prices were expected to drop an additional 15-20% before leveling off at the end of 2009.

Why is it bad news when housing prices drop? Shelter is a basic human need. Housing is a product that we all use, and many of us would like more of. If housing prices fall, than buyers who were priced out of the market can now buy. Other buyers can now afford more house. From this perspective a drop in housing prices is good news.

“Oh, but what about the poor house sellers,” you may say. “Now they aren’t making any money when they sell their property.” Well, when big screen TV’s drop in price by 50% in a year, I don’t hear any boohooing over the fate of the poor TV manufacturers. What I hear is “Now I’m gonna get me a 54” wide screen. In HD. When those linemen hit that quarterback, I’m gonna see his ribs crack! A bigger TV is my right as an American. I heard it says so in the Constitution.”

Anyone who has lived in their house for five years or more isn’t going to be hurt by the drop in housing prices. Anyone looking to buy their first house is going to be helped by the drop in housing prices.

But what about the people losing their houses due to foreclosure? Well, they aren’t losing their houses because prices are dropping. They are losing their houses because they are not paying the mortgage. In many cases, they can’t afford the mortgage because the house was too expensive for their income.

The history of the housing boom over the last six years was people taking on more and more debt to buy ever more expensive houses. They were able to take on this debt because of mortgage products such as “liar’s loans” and negative amortization loans. The current process of price correction is mostly painful to the lenders, who are suffering the losses from loaning more money than people can afford to pay.

Housing prices are going to continue to slide until someone with the median household income can afford the mortgage payments on the median priced house. The faster that happens, the faster the housing sector, and the economy as a whole, will recover.

And that will be good news for everyone.

Locking the barn door ...

A week ago the Federal Deposit Insurance Corporation (FDIC) took over California based IndyMac Bank. It was reopened on Monday, July 14 as IndyMac Federal Bank. On Monday and Tuesday of last week there was extensive news coverage of depositors lined up at the bank to cash out their accounts. The lines went around the block. Some people had lined up hours before the bank was due to open. They brought lawn chairs.

This behavior was both predictable and inexplicable. Predictable, because humans are prone to panic when they’re threatened with ruin. Losing access to all of your money because your bank locks its’ doors fits my definition of ruin. So it is completely understandable that some of the depositors would act out of fear.

Inexplicable, because there was never any risk that the depositors would lose a nickel due to the bank being closed. None.

Banks are required by law to buy deposit insurance from the Federal government. The more deposits the bank has, the more they pay in premiums. The deposit insurance guarantees that the depositors will get their money back if the bank fails for any reason. So you have to wonder why the people lined up, since they derived no advantage from doing so, but they did lose the opportunity to do something more profitable with their time.

I also wonder why the media coverage didn’t do a better job of pointing out this foolishness.

Federal deposit insurance does have a limit. You are only insured up to $100,000 held in any one bank. If you have multiple accounts at one bank, even if they are joint accounts with someone else, the total insurance coverage is still a total of $100,000. Many of the people interviewed in line at the bank had assets way over the limit with IndyMac Bank. Given how easy it is to keep accounts at several banks, you really have to question what these guys were thinking.

Even in an industrial, post-modern society like ours, the old expression “Don’t keep all your eggs in one basket” still makes sense.

I keep reading the terms Bear Stearns and bailout used in the same sentence, or at least in the same paragraph. Usually the gist of these news stories is that Wall Street (i.e. Bear Stearns) got a bailout, therefore fairness demands that Main Street (i.e. the poor schlemiels who paid too much for their house) also get bailed out. I've got two problems with the folks who make this argument.

First of all, next month the Federal government is going to mail out checks of up to $1200 to almost everyone in America who filed a tax return. People who have not paid taxes in years, like many Social Security recipients, are being advised to file for 2007, in order to reserve their place at the public feeding trough. The cost of this government largesse will total $150 billion. Surely that's enough of a bailout to satisfy the most ardent of parachutist, isn't it?

But more to the point, it is hard to see how the Bear Stearns deal could be considered a Federal bailout in the first place. To make the deal go, the Fed gave $30 billion to JP Morgan Chase, the acquirer. In exchange, the Fed received a portfolio of Bear Stearns assets with a book value of $30 billion. For political reasons, the cash given to JP Morgan was called a loan, and the Bear Stearns assets were called collateral. Frankly, these assets are certainly not worth the book value in today's market. However, the Fed does not have to sell the assets on any timetable. In the fullness of time the Fed may be able to recover most of the money they put into the deal. There will almost certainly be an eventual loss, however, and that loss will be borne by the taxpayers.

The Fed took this action not to bailout Bear Stearns, but to keep the financial markets from freezing up in the panic that would have accompanied a bankruptcy filing by the fifth largest US investment bank. That panic would have hurt a number of large financial institutions. Institutions like the pension funds that pay pensions to retirees. Institutions like the insurance companies that pay to rebuild your house if it burns down. Institutions like municipal governments that issue bonds to build roads and sewage systems. Institutions that serve local Main Street interests.

Meanwhile, what happened to stockholders of Bear Stearns stock? Many of these stockholders were Bear Stearns' employees. As a matter of fact, the employees owned about 30% of the company. In January 2007 the stock was worth $170 per share. The Friday before the deal with JP Morgan, the stock was still worth $30 per share. The latest offer from JP Morgan was $10 a share.

So. over the weekend, two thirds of their equity was wiped out. Adding insult to injury, large numbers of the former owner/employees are facing pink slips in the very near future.

Calling this a bailout is like saying that what Henry the Eigth did to Anne Boleyn was a haircut.

Sometimes It's Just Hail

I'm a contrarian by nature. Hand me silver, and all I see is the lining to a cloud. As far as I'm concerned, there is no glass so overbrimming that evaporative losses won't eventually make it half empty. When things look bleak, I remind myself that it is always darkest just before it gets really dark. But although I discount good news, I also take news that the world is coming to an end with a grain of salt.

A case in point came in today. Swiss banking giant UBS announced that it was writing off $19 billion in assets related to subprime mortgages in the US. This is on top of the $18 billion that they wrote off less than six months ago. UBS is seeking to raise $15 billion in fresh capital to shore up their balance sheet, and oh yes, they've pitched their chairman out the airlock for orchestrating this debacle. "Can you breathe vacuum, Herr Chairman?"

The headline for this story is obvious: "UBS Writes Off $19 Billion." I think the critical item comes a little deeper than the lead paragraph, however. The asset write off came as part of UBS's announcement of first quarter earnings. For the first quarter of 2008, UBS lost $12 billion, including the write off. A little simple math tells us that without the subprime mortgage problems, the bank would have earned $7 billion in the last three months.

That is the real story here. The banks taking the hits that have shaken the global financial system are large diverse organizations with multiple lines of business that are still very profitable. In time, they will work their way out of the mess that they created, and will begin providing a return for their investors again.

We're not out of the woods yet. Housing prices are going to fall further, and we are going to see further write downs on securities backed by unpaid mortgages. We haven't seen the full effect of the collapse of the housing bubble, as it plays out on the wider economy. There will be a lot of pain, and a lot of bad headlines still to come.

But the sky isn't really falling. At least, not today.

Bear Stearns: RIP

The big business news this Monday is the acquisition of Bear Stearns by J P Morgan Chase over the weekend. At the close of the market last Friday, Bear Stearns was valued at $30/ share. When the deal was announced on Sunday, Morgan was only paying $2 per share. In addition, the Federal Reserve agreed to loan Morgan $30 billion dollars, taking as collateral mortgage backed bonds in Bear's portfolio. Basically, the Fed (by which I mean the taxpayers) took the bonds most likely to go into default off JP Morgan's hands.

This looks like a steal for JP Morgan. They're paying $2 a share for a company with a book value of $80 a share. Even if it is written down by half, the assets would still be worth 20 times what Morgan is paying for them. The real estate held by Bear Stearns alone is worth about four times the purchase price.

Bear Stearns was one of the five largest US investment banks. The employees owned 30% of the stock. Their stake is now valued at less than $5500 per person. The Chairman of Bear Stearns, John Cayce, was one of the richest Wall Street executives, with holding in BS stock worth oven $1 billion less than a year ago. What could have convinced the management of Bear Stearns to take a deal that essentially wiped them out?

In a word: liquidity.

Liquidity is a measure of how easy it is to convert assets into cash. Cash is always the most liquid asset of all. Normally, stocks are almost as liquid as cash. Call your broker, tell him to sell, and you can have cash within a couple of hours. If you have a store that has inventory, you will usually liquidate the inventory every couple of months. Anyone who has ever tried to sell a house in a down market knows that real estate can be one of the most illiquid forms of asset.

Bear Stearns ran their financial trading operations using a lot of borrowed money. Some of the money was given to the firm by it's clients. Some by other banks. What happened last week was that these parties started to pull their loans from Bear Stearns. In order to keep operations going, Bear Stearns would have had to sell assets from their portfolio. The problem is that right now, no one is buying mortgage backed assets. That market will probably come back in a few months, but Bear Stearns needed money right now.

Basically, the brightest minds in finance became part of a panic driven run on a bank. And a Wall Street titan that survived the Great Depression is no more.

Bells on bobtail ring...

The subprime mortgage meltdown mess and the collapse of the housing bubble have created a new phenomenon. Basically, people who can no longer afford their mortgages, and who know that they cannot sell their house, have decided to spare the mortgage holder the need to have them evicted. They simply put the keys in an envelope and send the keys to the bank.

It's called "Jingle Mail."

There was a story on "60 Minutes" last week about foreclosures, and as part of the story, Steven Kroft interviewed a couple who are going to walk away from their house becuase it has turned into a bad investment. They are willing to take the hit to their credit rating. What made this couple interesting is that they could continue to afford the mortgage. They just felt it was a money losing deal, so they wanted out.

On the one hand, you can make a case for walking away as a rational business decision. On the other hand...

Ultimately, modern societies run on a scarce commodity: trust. We trust that our paycheck won't bounce when we deposit it. We trust that the bank won't go belly up and lose our money. We trust that when we pay our insurance premiums, our car will be repaired if we're in an accident.

At the same time, businesses trust us. They trust us to return rented videos. They trust us pay for the dry cleaning, and not shoplift. And yes, they trust us to pay our credit cards and our mortgages.

All of the business regulation, insurance, and contract law that we have does not and cannot replace what is at the heart of every deal, from a used car sale to the biggest mergers: people keeping their promise to do what they say they are going to do.

So when we say it is okay for people to walk away from their mortgage, we're actually sapping the foundation of a civil society.

Stimulus Package, Part I

There has been a great deal of coverage of the proposed economic stimulus package in the news for the last week or so. Today's news is that the bill that passed the House will not pass quickly through the Senate, largely because the esteemed Senators do not think there is enough being done. From my admittedly superficial research, it looks like the Senate wants to load on a whole bunch more giveaways onto the plan. This is because handing out $150 billion is not enough to satisfy the Solons of the Beltway.

If you're going to give a bunch of politicians a chance to hand out other people's money, you better be prepared to jump back quick to avoid getting trampled. Now, I don't want to seem as if I object to getting handed envelopes full of money. I love a windfall as much as the next guy, and my household's share of the swag would be about $1200. But frankly, I don't think this stimulus is going to work. To paraphrase Tennessee Ernie Ford: "You load $150 billion, and what do you get? Another day older and deeper in dept...I owe my soul to the Chinese government." After all, where do you think the money is going to come from?

The stimulus plan won't work for two reasons:
1. The current ecomomic malaise is being caused by structural problems in the financial services and banking industries, which in turn were triggered by the collapse of the housing bubble. Six hundrred dollars per person ain't going to reinflate the housing market. It is only enough to cover the increased mortgage payment on a subprime loan that resets this year. For a month. The next month, that home owner (sorry, that mortgagee; it's actually the bank that owns the home--poor bastards) will be unable to make the higher payment and then he starts to slide into default.

2. The other problem with the proposed stimulus is that since the US is already running a massive government deficit, another deficit piled on top of that will have little to no effect. For a Keynesian stimulus to work, the assumption is that government spending is in balance with revenue. The burst of deficit spending in a stimulus package jumpstarts economic activity, leading to a virtuous circle of economic growth. I'm going to say a little more about Keynesian theory in my next post.