Bail out

September 26, 2008 at 8:03 pm 1 comment

Just wanted to get this out quick because it’s the best summary I’ve seen this week …

COLLEGE STATION (Real Estate Center) 09.26.08 – As negotiations continue over the proposed $700 billion bailout of the nation’s financial system, Dr. Mark Dotzour, chief economist for the Real Estate Center at Texas A&M University, offers his perspective:

“It’s a sad day in America when the federal government (the American taxpayer) has to bail out homeowners who purchased homes they couldn’t possibly afford. It’s sad because of the vast majority of Americans who live within their means and pay their mortgages on time are now being asked to pay for other people’s mistakes.

“It’s a sad day in America when we have to spend billions to bail out financial institutions that made loans to those people, then sold those loans to pension funds and endowment associations that had no idea of the risk they were taking when they bought the ‘complex and sophisticated’ bonds. ‘Complex and sophisticated’ is just a euphemism for ‘I have no earthly idea what I’m buying.’

“Now for the pragmatism. If we don’t bail out the banks, the American economy grinds to a halt. Many U.S. businesses are financed with short-term notes that mature in 90 to 180 days. This is called commercial paper. What happens when your 90-day note matures, and nobody will refinance it? Just ask Fannie and Freddie, who had $225 billion in short-term notes mature and nobody would refinance them. Hasta la vista. The commercial paper market is virtually frozen, and many businesses are in the same boat as Frannie was.

“The smartest people working in the global financial system say that this $700 billion is a good first step, that it might help to thaw the frozen credit markets but that the devil is in the details. Some say it might take another $500 billion later.

“The fact is that there is a market for these bad loans. It’s about 22 cents on the dollar. The problem is that nobody wants to sell for that price as long as the taxpayers will pay a higher price. So the federal government will buy these assets for a higher price, and it’s possible that they can sell them later and make a profit. It’s possible that the net cost to the taxpayer will be very little. The bottom line is that we are in uncharted waters, and this $700 billion plan is the best plan that seems to have some hope of temporarily solving the problem.

“The long-term problem is still on the table, and that is the simple fact that the U.S. government can’t keep spending more money than it has. Even governments can go bankrupt. The long-term solution for the U.S. government and every American household is to live within their means.

“Who is going to want to invest in mortgage bonds in the future if the federal government can freeze the interest rates below what was promised? Who is going to want to invest in mortgage bonds if the government can cram down the principal on the bonds you bought? Until the federal government can restore some confidence in the global investment community that if you buy a mortgage bond you have a reasonable certainty of getting your principal and the promised interest, the problems will linger.

“The bailout is inevitable and has to happen. Expect more to come. These are just bandages on a gaping wound. Hopefully lessons will be learned, and we will begin to address the illness and not just put on more bandages.”

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1 Comment Add your own

  • 1. David A.H. Brown  |  September 28, 2008 at 9:25 am

    Not One Dime!

    • $700 billion in taxpayer money would be wasted in a federal bailout – it would be the wrong people paying the bill, the wrong people making the decision, and the wrong reforms to fix the underlying causes.
    • The industry (not government) should set up a distressed debt fund to provide liquidity to mortgage-backed paper until maturity.
    • A new Financial Services Authority should be established, replacing the SEC and other federal regulators.
    • Other key reforms are needed and outlined here: to election financing, bankruptcy courts, mortgage lending, executive compensation, director certification, accounting practices, and risk-weighted capital.
    • Commentary on “financial bailout” by governance expert David Brown

    The House Republicans have it right – they may not know exactly how to solve the current financial crisis but their “gut” is working fine when they realize that a massive $700 billion taxpayer bailout of Wall Street does not pass the “smell test” and is just not a good idea.
    Such a bailout is neither necessary nor helpful. It does nothing to address the root problems, and, as a frustrated mid-western father said on TV news last night, “When you reward bad behaviour, you get more bad behaviour – any parent or teacher knows that.”
    So, what are the problems and solutions?

    Problem 1: the wrong people are paying the bill.
    Principle 1: those who reap the rewards should take the risks.
    Solution 1: the financial services industry needs to step up and solve its own mess.
    Lenders and institutions who issued and hold all the “mortgage-backed” paper that is currently distressed need to pool their resources and set up a massive liquid fund to buy all that paper.
    Today’s financial crisis is the result of lending decisions that took too much credit risk (the risk that mortgage borrowers might default), and because these mortgages were re-packaged and re-sold several times, this credit risk has been spread across much of the financial system and much of the world. The uncertainty around the eventual credit risk loss (how many homeowners will eventually default) has caused a liquidity crisis, where the holders of these “hot potato” distressed debt cannot sell them for any price.
    The short term solution is indeed an injection of liquidity, but not taxpayer or government liquidity. The industry itself has more than enough liquidity available, and as Friday’s $10 billion share offering by JP Morgan Chase showed, can readily raise more at the drop of a hat.
    An industry fund would hold mortgage securities until their natural maturity and refinancing in a stable environment, and be able to minimize credit losses by re-negotiating mortgages in a free market place, reaching the fairest possible deals between distressed homeowners and lenders.
    Credit risk and liquidity risk are the two simplest and easiest risks to understand and quantify in the financial industry. They are offset by capital, by stock market equity built up by these institutions in the good years. The owners of these shares, be they Chinese and Arab sovereign wealth funds, mutual and pension funds, or you and me, reaped the reward when profits were being made, and are the right people to be asked to shoulder the burden when losses are being incurred. That’s how the market is designed, that’s why the stock market doesn’t come with deposit insurance.

    Problem 2: the wrong people are making the decision.
    Principle 2: those who benefit from decisions shouldn’t be involved in making them (“conflict of interest”.)
    Solution 2: regulate the regulators (“stop the madness”.)
    Haven’t you wondered why President George Bush, a conservative Texas Republican, Senator John McCain, a maverick Arizona Republican, and Senator Barack Obama, a community activist Illinois Democrat all agreed to pay out $700 billion of your money so quickly? Along with all the rest of the Senate and House Democrats?
    Conflict of interest. Lawmakers and regulators are both directly and indirectly tied to the financial industry. Their direct ties are their own assets and financial futures: to become President or Senator in the United States today requires millions of dollars in personal wealth, and 50 per cent of wealthy families’ assets are invested where? In the stock and bond markets. They are using your money to bail themselves out, and using their power and influence to make sure their families stay wealthy. In Russia, you might expect the powerful elite to lord it over the common people, but in America we have to find a way to curtail it.
    The indirect ties are even more dangerous. For years, federal politics have been dominated by moneyed lobbyists and special interest groups, and if you think Big Oil has power in Washington, that’s nothing compared to Big Banks. I am amazed that House Republicans have even had the courage and character to raise a few potential objections to the biggest boondoggle in American history.
    What can we do about it?
    • Election finance reform: until lobbyists and special interest groups are truly limited in their ability to influence elected politicians and their appointed regulators, decisions will continue to be made in their interests and not in the independent interests of the country. This is not getting better, it is getting worse: the Sarbanes-Oxley Act and Homeland Security Act are two of the most pervasive federal government interventions in history, enacted by a so-called conservative Republican President and a bi-partisan Congress. Neither was needful, and neither has served its purpose. Unless the purpose is to enrich special interest groups, lawyers, accountants, and security firms, and to put as many people as possible on the public payroll. The bailout would be a third leg to this stool, creating a federal financial institution that would last for 30 years, employ tens of thousands of people, and reduce the efficiency of markets at a time when China, India, Brazil and the GCC are building new capital markets to compete with us. Can anyone spell socialism?
    • Regulator reform: establish an independent financial services authority (FSA) that regulates and oversees all the pillars of the industry – banking, insurance, securities, pensions, thrift, etc. Roll in the existing federal regulators, including the SEC – it has become impotent and fossilized under too many years of political appointments and aimless direction. Leave FDIC to provide deposit insurance, but establish a close accountability relationship between the new FSA and FDIC. Leave the Federal Reserve to do what it’s supposed to do – monetary policy and interest rates – but don’t pretend that the Fed can or should regulate industry.
    • Fire the current regulators: Senator McCain is bang on when he says the SEC chief should be fired, but if you stop there, you have not communicated the right message of accountability: “if you fail, you can’t stay.” Secretary Paulson and Fed Chair Bernanke have to go, too, tomorrow morning would not be too soon for the two men who almost let the financial system go belly up, then almost bankrupted us expecting us to bail them out. Shame.

    Problem 3: the wrong reforms are being put in place.
    Principle 3: those who don’t learn from the past are condemned to repeat it, and repeat it, and repeat it.
    Solution 3: regulate the right things, upstream and without wasting hard-earned taxpayer money.
    We are rushing headlong to enact a Sarbanes-Oxley Act part II without realizing that part I was an unmitigated disaster – if that railroad crossing had worked, why didn’t it stop this train?
    There are sensible, simple reforms that we can and should undertake today to avoid crisis after crisis in governance in the years to come:
    • Go back to basics on home lending: loan-to-value ratios (i.e. require home owners to make a down payment, so that they have equity at risk), debt-service ratios (i.e. require lenders to check that a borrower can afford to pay), income verification, and portfolio diversification (to limit exposure to geographic or other market segments.)
    • Fully adopt and enforce Basel II: the international accord that requires lenders of all types to hold adequate capital against their assets, weighted by risk (particularly credit risk, including residual credit risk in derivatives and financial instruments.) If lenders had sufficient capital cushion, they wouldn’t be needing a bailout today.
    • Regulate executive compensation: require companies to pay incentive compensation based on proven historical audited earnings, and require executives to pay back compensation that was paid on illusory or inflated earnings. Ensure that risk is factored into executive compensation, i.e. defer compensation on uncertain earnings until they are certain. Consider putting caps on executive pay – while it is an unwelcome intrusion in the market place, it may be the only way to stem this rising tide of greed and the vicious cycle it engenders.
    • Go slow on adopting IFRS (international financial reporting standards): historic cost accounting has served us well for hundreds of years. By adopting “mark to market” Euro-accounting rules, we are moving to a system that will see much more volatility in earnings, losses that by-pass the P&L and are charged directly to equity, and so many complicated accounting practices that investors, bankers and directors will be unable to understand financial statements. The new FSA and the current PCAOB need to be involved in deciding on adopting IFRS or not – this is too important a decision to be left to accounting pros. Recent reforms to financial instrument and pension accounting have already contributed to market uncertainty.
    • Empower bankruptcy courts: while home owners who received mortgages in the sub-prime lending mania should be expected to diligently and responsibly pay back as much as they can, we should give bankruptcy courts the power to force lenders to take settlements, whether that means a partial write-down of principal, or interest relief. This is not only fair to people who were enticed to borrow, but it is probably necessary to shore up real estate prices which will be critical to restoring long-term sustainability to the capital markets and limiting the calls on the distressed debt fund.
    • Require Board members to be certified: if we expect directors to act professionally, to provide independent oversight to corporations, and to give confidence to investors and lenders, they need to understand governance, strategy, risk, metrics and compensation, and how they link together and drive each other. And we need to be assured that they do. The United States is lagging its industrial competitors in director education and certification. Unfortunately, its director association, the NACD, is weak and not adding value. A national director certification program should be established and mandated. Programs run out of Chicago and Stanford are a good place to start. For some reason, the Ivy League and the northeast are not firm foundations for such a national program, but they could be brought into a tent that qualified programs built.

    Will it take courage, character and competence to enact these simple reforms and to rebuild confidence in our financial system? Absolutely, but this suite of reforms is exponentially more effective, and exponentially less expensive, than the current bailout package seriously being considered by our leaders in Washington. Not one more dime of our money!!

    David A.H. Brown is a leading corporate governance practitioner; he is co-founder of the Directors College at Niagara-on-the-Lake, and is principal of Brown Governance Inc.
    Contact:

    David A.H. Brown
    9 Antares Drive, Ottawa, Canada
    Tel: 613-447-4277
    e-mail: brown@browngovernance.com

    September 28th, 2008

    Reply

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