Monday, March 23, 2009

Tim's Nifty Stew

I wish I had really good news about Tim Geithner’s TALF plan.  I want to make up for that last repulsive blog - everyone complained, but no one disagreed with the message.  I sure hope this economy gets turned around and we can still be our own masters afterwards.  

The good news is that the vote that counts- the stock markets - rose in a roar of congratulations on the details of Geithner’s plan.  There are some things I like about it: his clever use of investor leverage, that the Government guarantees will allow the investors to ride a hopefully rising tide as the assets begin to appreciate some day, and its resemblance to the Resolution Trust plan, which actually made money.

Let’s not forget the underlying assets of the bolus that clogs the banking system is asset backed securities.  The underlying asset of those is sub-prime mortgages.  Those mortgages were failing at a rate ten time higher than prime mortgages.  The last rate I remember was: 18% were over 90 days past due, and it was going to increase as the variable rate boosts kicked in and the housing values declined.  When one of these mortgages finally defaults, it takes quite a while for the unfortunate mortgage holders to be forced out, repairs and clean-up performed, and the house to be put back on the market.  During that period, the value has declined further, and the debt yields no income to the bank.  

My sympathies lie with the evicted householders before the banks, and with the unevicted, prudent  taxpayers who are going to pay for this fiasco.

Mortgages used to be retained by the banks that issued them until Fannie Mae and Freddie Mac opened up a big resale market.  Banks started selling off the sub-prime loans to Fannie and Freddie.  Those big mortgage companies had four operations-level officers that ran the mortgage purchase program and worked under the influence, if not the direction, of Senator Dodd and Congressman Frank. the heads of the all-powerful Senate banking and House Finance Committee, respectively.  Those elected worthies subscribed to the notion that every American deserved to own a house, whether they could afford one or not.  So Fannie and Freddie, under various anti-discrimination policies, and quiet directives arranged by Democratic party members, bought massive amounts of bad mortgages issued to blue-collar workers, migrant Mexican laborers and welfare families.  Those loans were likely to fail, and everyone knew it.  Prime loans were retained by the issuing banks.  The mortgage service, such as collecting the monthly payments, issuing lucrative late fees, and holding the real estate tax escrow accounts, also stayed with the issuing banks.  Those are the most lucrative pieces.

Everything went well for year or so.  Housing prices continued to rise.  The theory was that even if a few non-payers were evicted, their houses would sell for enough to pay off the mortgages.  Houses had been safe investments since the Great Depression.

Then Fannie and Freddie were taking losses on these sub-prime loans.  They needed to raise money to cover those losses, and they did not want to admit the extent of the problem by going to the Government.  That problem was over $2 trillion, and might be as much as $6 trillion, but no one knew for sure, or rather, they did not want to discuss it.  The numbers were simply staggering.

People at Goldman, Merrill and Lehman had a bright idea:  Why not chop up the tainted meat into hash and sell it as asset-backed securities?  Of course, it was the same bad hamburg as before, but it was so much more difficult to trace it to the particular unpaid mortgage.  Still, it was tainted.  Someone, whose name should go down in infamy, decided the sausage needed a casing.  Why not go to AIG, now that Hank Greenberg is no longer there to protect it, and buy insurance wrappers for the tainted meat?  Now, what was previously unpalatable became gourmet quality and was rated by gourmet rating agencies such as Standard and Poor (with the emphasis on Poor).  Fannie and Freddie and Goldman and Lehman and Merrill, had a bonanza of ready-at-hand securities to sell to all comers, packaged, rated and insured.  Everyone bought them.  All you had to do to get more meat for these sausages was to allow more people to get sub-prime mortgages.  Bankers were recruiting failed insurance salesmen and fired cops as mortgage brokers.  These brokers opened up the funnel to some really foul ingredients, raking in six-figure salaries in the process.  I knew one who worked from a small sailboat in Mexico who never met his clients at all.  A few hours a day, when he was not on a binge, he worked the mortgage market.

When these newly vacant houses started coming on the market, and the asset-backed bond holders began to taste the taint, they could not swallow it.  The market for these tainted sausages dried up.  Mortgages became tight.  Houses became plentiful.  The market swooned, then dropped like a stone in the Marianas Trench.  Now the asset backed sausages were nearly worthless.  Every lender choked on them.  They clogged the banking digestive system.  Estimates of the tainted product were $4 trillion.  The market just fell off the cliff and continues to fall in a spiral of decreased housing value followed by decreased bank liquidity.  The crisis had expanded from the housing market to the credit market to the global economy.  

As the value of the underlying assets falls below the insurance level, AIG has to make payments to offset the declining market value.  That’s what they mean by that curious euphemism “counterparty liability”.   When we bail out AIG, we are paying those asset-backed bond holders all over the world - China, Deutsche Bank, Dubai Sovereign Fund, etc.

Along comes Mr. Geithner.  This chef thinks he can take these unpalatable sausages that are costing us so much money, gather them into a big Government stewpot, add some magic bailout money and sell them as TALF bonds.  Let’s keep in mind that so far nobody has directed much money or attention to the fact that the underlying housing values are the root cause, and that if they were to recover, none of this TARP, TALF or tweaking would be necessary.  

Problem is, the stew is still made from the same tainted meat, and I’m afraid it will still taste awful.

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