2/9/2009 3:17:17 PM
This week, I continue to explore the perfect storm scenario, of a global housing bubble, a crashing financial market, and credit markets that seized up. I find that time is of the essence as the Obama administration will reveal its plan to address toxic paper in financial institutions by Tuesday, February 10th, 2009. Due to the imminent announcement, we need to cover several subjects in this issue, which means that coverage will necessarily be brief, but I hope sufficient.
The subjects that will be covered are:
Recent bank Failures
The housing market with some history and various looks at where we are today
The history between the FDIC and RTC and how the S&L Crisis was handled
What is the Obama administration likely to announce on Monday and how does it affect the economy and financial markets
With that ambitious agenda before us, let's dive in together...
Fourth, Fifth, Sixth and Seventh Bank failures of the Year
A week ago and for the first time in nearly five years, the Federal Deposit Insurance Corp. (FDIC) was forced to shutter a failed bank. Utah's MagnetBank became the fourth bank failure of the year as the FDIC was forced to directly refund depositors after being unable to find another institution willing to take over its operations. It is estimated that the bank had no uninsured funds.
The FDIC said it has also closed Maryland-based Suburban Federal Savings Bank, and Florida's Ocala National Bank. Tappahannock, Va.-based Bank of Essex agreed to assume all of Suburban Federal 's deposits, the FDIC said. Winter Haven, Fla.-based CenterState Bank has agreed to assume all of the Ocala National's failed bank's deposits.
On Friday, the FDIC added the seventh bank to the 2009 list stating Georgia's FirstBank Financial Services has been closed and $275M of its deposits will be assumed by Regions Financial Corp (RF $4.20 +$1.37). The FDIC will retain most of FirstBank's loan portfolio for later disposition.
This brings the number of failed institutions since the recession began to 32.
The Housing Market
This will be brief look at a complicated subject, so hang on. Firstly, there have been many housing bubbles globally and the bursting of these bubbles simultaneously is what we are experiencing at this time. In order to focus on manageable examples in the brief space we have, we will only look at the U.S. housing market with the understanding that there is a larger game afoot.
Before we get started in earnest, I would like to debunk a myth perpetrated by the National Association of Realtors. The marketing put on by the NAR uses something called the Housing Affordability Index (HAI) to indicate that it is a good time for homebuyers to buy a home. At this time, the HAI is quite high, in fact, the highest it has ever been.
Of course the problem with this single index is that it takes mortgage interest rates as the primary basis for home payments and then used median income to determine the affordability of housing.
It seems obvious when looking at the HAI and US Mortgage Rates that the HAI isn't a good indicator of whether it is a good time to buy a home. A better use of indexes would be to monitor HAI for when problems are likely to occur. Of course this isn't a widespread generally adopted practice by potential home buyers, nor is it something the NAR would like potential homebuyers to do. Take a look at the HAI through the first half of 2005.
It is obvious that housing was becoming rapidly less affordable as the Fed continued to raise rates, even though, from a historical perspective, the rates were still quite low. It is a veritable canary in a coal mine, warning of the imminent collapse of the U.S. housing market.
Now, take a look at the prices in the U.S. housing market in that timeframe along with the price effect as the HAI indicated that homes were becoming less affordable.
All a potential homebuyer had to do was to conduct a cursory review of the crashing HAI and elect not to buy a home at that time. The housing market clearly peaked by the beginning of 2006 and all the warning signs were there. Of course, from an historical perspective, home loan rates were no where near where they had been in precious corrections. The problem was that credit was so cheap and lending standards had become so lax that a small change in the rates drove affordability down markedly. The widespread use of adjustable rate mortgages that became completely unaffordable as they adjusted depended on a continued rise in the housing market. This perpetuated the bubble until a minor rise in the rate of interest caused the house of cards to come tumbling down.
Any solution to the burst bubble of the housing market can't allow for the same sort of mania to continue. Tighter lending standards should forestall some of that. I am hopeful that the government might also regulate loan types that can be packaged into "standard" mortgage instruments. Requirements for Loan to Value (LTV) ratios with a maximum of 80% would require 20% down payments. Of course, there are many potential scenarios, but we must curtail past mistakes to ensure a more secure future.
The Historical Context of the Resolution Trust Corporation
The creation of the Resolution Trust Corporation (RTC) occurred in February 1989 in response to the Savings and Loan (S&L) Crisis that saw the collapse of 747 Savings and Loan Associations.
To understand what happened to the S&Ls that failed during that time it probably takes a bit more space than we have in this issue. In summary form, you must first understand that it was an era of high interest rates. However, S&Ls were limited in how much interest they could pay on certain deposits. Depositors were withdrawing funds to deposit them into higher interest paying money market funds. The redemptions were forcing S&Ls to sell long-term securities, such as mortgages paying around 5% in fixed rates. Due to the high interest rates at the times, the market for these securities caused them to sell at significantly lower prices than their face value. This caused the S&Ls to implode as they tried to raise cash to pay depositors but had to sell assets at fire sale prices.
By early 1989, 3-month T-Bills were paying more than 8%! You can now understand the squeeze as depositors moved their deposits to money market funds. While the seeds for the S&L crisis were sewn in 1982 and some S&Ls were technically bankrupt by 1983, the problems kept getting worse until the government finally acted in 1989.
The Federal Deposit Insurance Corporation (FDIC) was running out of money to cover insured deposits as more institutions were failing. The administration, with Congress as a less than willing partner, decided to create the Resolution Trust Corporation in order to create a "bad bank" that would receive the assets from failed institutions. The RTC would then clean up the assets and resell them over time. The cost to taxpayers to resell the assets eventually amounted to about $125B, which contributed to the budget deficits of the early 1990s.
Bill Seidman was the Chairman of the FDIC at the time and was named Chairman of the RTC as well. This kept the disposition of assets under some semblance of control by the FDIC, who held the charter to handle failed financial institutions.
The formula for the RTC was pretty simple. Let an institution fail then sell its depository assets off to another bank or Savings and Loan. The "problem assets" were then held by the RTC as they sought buyers for these assets, which might be for commercial properties that had come down significantly since a loan was made, etc.
A similarity exists in that the real estate market was involved in some of the assets holding less value when the loans were made originally. Local property market bubbles were seen with significant corrections eroding the prices for single family homes and even attached homes, such as the condo market. These local markets occurred mostly on the coasts and weren't a national phenomenon. It was the commercial real estate development deals that soured the most and resulted in significant losses to the institutions that made these loans.
In summary, the RTC was created as a separate entity but something of an adjunct to the FDIC. Its purpose was to gather up the "bad assets" so that the financial crisis could be averted and the financial markets could get back to normal and credit would begin flowing yet again.
The Obama Administration's Likely Course of Action
To understand what The Administration is likely to do, we need to understand who the important players are in the Administration (and the Fed) in this context. The cast of characters includes:
Federal Reserve Chairman
President of the United States
Federal Deposit Insurance Corporation (FDIC) Chairman
First we come to Fed Chairman Ben Bernanke. Bernanke is the outsider to the administration. He has been transparent about his position on financial and economic issues and has walked the walk as he talked the talk. At this time, Bernanke has led the Federal Reserve to a position of quantitative easing. The economy is awash in cash loosening credit to financial institutions as a driver to enable financial institutions to ease credit to businesses and individuals.
Bernanke is likely to be supportive of the Administration's actions taken to increase certainty in the value of bank assets and has proven a willing ally in the past Administration's attempts to shore up the U.S. financial system. The Fed has already gone beyond historical precedent in taking on varied collateral in order provide liquidity to and certainty in the value of assets to the financial system.
Next we come to Barack Obama. He has pushed for a rapid move by Congress to approve a stimulus package. He has kept Sheila Bair on as Chairman of the FDIC, and supported the appointment of Timothy Geithner as Treasury Secretary. He will be supportive of Geithner's Monday announcement of the Treasury Department's actions to aid the financial industry and appears to be supportive of Bair's approach of a "bad bank" to purchase toxic assets from the commercial banks.
Treasury Secretary Timothy Geithner weathered the controversy of his income tax dance before having his nomination approved. He was respected as the President of the New York Federal Reserve and clearly understands a lot about what is happening on Wall Street as well as in commercial banks.
Geithner made his stance on the current financial crisis clear, along with the support of President Obama in his prepared remarks to the Senate Finance Committee. I have included a portion of it as it serves to have us focus in on four areas where Geithner believes aggressive action is warranted:
Finally, we must move ahead with comprehensive financial reform now so that the U.S. economy and the global economy never again face a crisis of this severity.
Senators, in this crisis, our financial system failed to meet its most basic obligations.
The system was too fragile and unstable, and because of this, the system was unfair and unjust.
Individuals, families and businesses that were careful and responsible were damaged by the actions of those who were not.
We need to move quickly to build a stronger, more resilient system now, with much greater protections for consumers and investors, with much stronger tools to prevent and respond to future crises.
Geithner's prepared remarks, for his confirmation to the Senate Financial Committee hearing, clearly lay out Geithner' and Obama's strategy and actions. They can be found at the following link:
I have summarized them as follows:
Act swiftly and in size and scope commensurate with the financial crisis we are facing provide substantial support for economic recovery and to get credit flowing again. Do not take a tentative and incrementalist approach. Ensure transparency and accountability. Fundamental reform of the existing program is necessary to ensure that enough credit is flowing to support recovery.
We must make investments and reforms now that will strengthen our economy and make us more competitive. Specific areas mentioned included, "expand access to health care and reduce its cost, to move toward energy independence, to sharpen and deepen the skills of American workers and to modernize our infrastructure." This appears to be mostly a statement to support the Obama backed legislation making its way through Congress at the moment.
The extraordinary measures taken now must be unwound when the financial sector is stabilized. We must put into place now, clear and compelling commitments to go back to living within out means, suggesting that the government deficits required to undertake a bailout must be eliminated when it is clear that a sustainable fiscal position has been reached.
The financial system should undergo comprehensive reform. The reform should include much greater protections for consumers and investors, with much stronger tools to prevent and respond to future crises. Geithner stated "Individuals, families and businesses that were careful and responsible were damaged by the actions of those who were not."
With all that said, it is clear that Geithner prefers not to nationalize banks and instead wants to ensure that the current banks, for the most part, do not fail. He wants to ensure that the banks don't profit from this to the tax payers detriment.
Finally, George W. Bush appointed FDIC Chairman Sheila Bair in mid-2006. Bair seems to be about results and has built support on both sides of the aisle in Washington as well as found support on Wall Street and from the more conservative banking industry. To understand more about Bair, I include an Op-Ed piece that she wrote that was published in the NY Times on October 19th, 2007:
THERE have been many proposals to deal with the problems in the mortgage market. But the best place to begin is by looking at the poor lending standards and weak consumer protections at the root of the problem -- in particular, the troubling loans called 2/28 and 3/27 subprime hybrids. They have starter interest rates of 7 percent or more for the first two or three years, and "resets" that raise rates to as much as 12 percent, causing monthly payments to increase by at least 30 percent.
When housing prices were rising, borrowers could sell or refinance their homes to pay off the loans before reset and avoid crippling monthly payments. But this year, as prices have dropped, more than $150 billion in these loans have undergone reset, and an additional $300 billion will do so before the end of 2008.
Merrill Lynch estimates that if home prices decline by just 5 percent, a quarter of subprime loans may enter default, resulting in losses of almost $150 billion.
A government bailout is not the answer. Bailouts erode market discipline, raising the likelihood of repeat episodes. And efforts to expand refinancing options will help only those borrowers who have enough equity to refinance.
What happens to those who are unable to refinance and cannot afford the rate resets? Most of their loans are managed by firms called servicers. Typically, servicers sit back and wait for people to default, then foreclose and sell the properties. But in today's troubled housing market widespread foreclosures will only maximize losses for servicers.
Renegotiating terms loan by loan is too costly and time consuming. Servicers have modified only one percent of these mortgages that reset in early 2007.
So subprime servicers should take a more standardized approach: restructure all 2/28 and 3/27 subprime hybrid loans for owner-occupied homes in cases where the borrower has been making timely payments but can't afford the reset payments. Convert these to fixed-rate loans at the starter rate.
This would be no bailout. These borrowers would still be required to make their monthly payments -- at rates higher than what prime is today. Billions in savings would be generated by avoiding the administrative, legal, marketing and other costs of foreclosure, which can run to half or more of the loan amount. And avoiding foreclosure would protect neighboring properties and hasten the recovery of markets burdened by an excess supply of houses.
The mortgage crisis is growing, and the mortgage industry has the ability to help solve much of it on its own. Subprime borrowers need a better deal -- one that they can afford.
Recall that Bair was appointed in mid-2006 when the housing market had just peaked so she inherited a growing problem. The Op Ed piece appeared a bit more than a year later and it is very clear that Bair believes that mortgage servicers can help themselves by rewriting home loans where the terms are so onerous it would force homeowners into foreclosure, which hurts the homeowners directly involved, the mortgage holders, and the rest of U.S. homeowners who get to participate in a continued collapse in home values.
Fast forward to more recent times and it is Bair who held out for better terms for the Wachovia bank sale, getting $15B for Wachovia from Wells Fargo without providing guarantees on Wachovia's toxic paper. This was after Citigroup had maneuvered into a $2.2B offer and had the government guaranteeing $100Bs of toxic loans. Geithner was supporting Citigroup at the time as the NY Fed President. In other words, Bair and Geithner were on opposites sides of that deal.
Bair has advocated a "bad bank" proposal where the U.S. Government would create an institution to buy up the "toxic paper" associated with the mortgages written during the height of the housing bubble. She continues to advocate this as a solution citing past success by the RTC and a reduction on demands on the FDIC.
Let's synthesize what we know and offer elements of the plan that Geithner is likely to put forward:
Substantial immediate action will be undertaken to alleviate the credit crisis. Since the TED Spread has already moved near a normal range, this means that to get credit flowing Geithner will proposed a carrot and stick method. The Carrot is a "bad bank" plan, and the stick is that financial institutions that have taken TARP funds must prove that they are reacting in kind by increasing their lending.
The Obama-backed Congressional legislation will get passed with bipartisan support limited to $800B. It will not create much immediate benefit but will have an effect by later in 2009 and on an ongoing basis over the next few years.
Certain "temporary" aspects of the financial bail-out will need to be unwound later. Presumably, assets in the "bad bank" would not be held to maturity but rather, they would be sold off over time as value and liquidity were realized. In addition, the governments equity positions in private banks would, be exited over time, presumably at a profit to the government.
Reforms to the financial system must be enacted to prevent some of the problems encountered in this latest financial crisis.
I believe this means that use of leverage may be limited.
Credit Default Swaps (CDS) will be traded on exchanges instead of in back rooms.
Credit ratings agencies will be held to a higher standard such that AAA credit ratings on instruments including sub-rate loans will not be possible.
Off-balance sheet assets and liabilities must be kept on the balance sheet or sufficient transparency needs to exist.
Relief for homeowners in the form of interest rate subsidies is already under discussion and likely to be included as part of the package.
Additional relief for homeowners facing foreclosure is also likely to be an element of the plan.
Bad Bank Proposal
There are several camps in how to jump start the economy by making currently illiquid "toxic" mortgage instruments liquid. Chief among these is the idea that the government could set-up a "bad bank" that would acquire these toxic assets from the financial institutions that hold them. Former FDIC and RTC Chairman, Bill Seidman recommends "closed bank assistance." The Obama administration doesn't appear to favor letting the large banks fail, so it is more likely that a pricing mechanism must be found to buy up the toxic assets.
The pricing mechanism is 90% of making the "bad bank" work. I haven't seen a lot written on the subject, but I am hopeful they will arrive at a pricing mechanism that takes the assets off of financial institutions at about what they are marked at today. The idea is that the banks have already reserved for this level of losses and this would effectively remove these assets from the financial institutions that hold them. That would free up capital in the banks to lend to businesses and individuals, as they would no longer need to keep large reserves in place for the next mark down of the toxic assets.
The problem, of course, is that the assets may be worth more than they are today, since the market is illiquid, and no one really knows what they are worth. That is why the government wants to get private parties involved in the bidding process for the assets. The private parties should be able to competitively bid for the assets and arrive at a fair valuation, with the government providing the majority of funds.
Another solution, that I prefer, is to set the pricing and have profits or losses that are realized later, shared between the government and the financial institutions selling the assets to the "bad bank". Since these mortgage instruments have up to thirty years of life to them, the profitability won't become known for quite some time. If a floor is put under home prices and mortgages can be refinanced, many of these instruments will prove to be worth more than they are marked to today. This actually allows upside for the buyers and the sellers. On the other hand, if the assets are worth substantially less than the government pays for them, the financial institutions will be on the hook to forward further payments to the government to settle these losses.
This is a complicated problem, and the method I suggest involves the toxic paper coming off the books of the financial institutions that sell them to the "bad bank." However, these institutions still bear a risk that the toxic paper isn't worth what they sold it to the government for, and they will still have to provide funds to cover losses, or a portion of losses, just as if there are profits, the government and the financial institutions share in those profits. The benefit is that the banks begin lending again immediately, the economy is jump started, and the recovery begins, making many of the mortgages in the "toxic paper" good loans and the "toxic paper" turns into "recyclable paper" that when processed becomes a valuable resource.
Market Outlook and Conclusion
The rally seen in equities is confidence in the government's bailout plan that will help alleviate risk at financial institutions. That, in theory, will perpetuate an increase in lending as banks are no longer worried about the toxic assets on their balance sheets and instead turn to lending to businesses and individuals in search of profits instead of simply preservation of capital.
The credit markets treaded water in the past week. The TED Spread rose most of one basis point to close at 0.967 on Friday.
As is evident from the chart, the TED Spread has broken down through support and is nearing its final support level. A break down through that level suggests that interbank lending isn't a problem and rather credit flowing out from banks to businesses and individuals will become the focus. Unfortunately, figures on this are less easy to come by than for a transparent model, such as the TED Spread. Let's hope that Geithner's proposal provides for such transparency such that we can easily monitor this important sign that the credit markets are functioning normally.
I believe that the asset bubble known as the U.S. housing market will continue to deflate and that is will continue to act as a drag on the economy. If other parts of the economy begin growing, however, much of that will take place in the background as we wait for the rather protracted bottoming process to be completed.
We continue to believe that the asset bubble in long term treasuries will be deflated. The yield for the 10-year note, 20-year note, and thirty-year notes continues to rise and price has been falling. We believe that the price of these notes will fall at least 30% from peak, which means they have a ways to go yet.
Near month crude oil futures closed the week at $40.17. It has traded in the range we suggested it would.
We continue to await a retest of the lows. This test could be deferred months from now, so we are actively exploring opportunities to purchase assets at attractive prices.
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