Month: September 2008

Lies about the bailout

Politicians keep lying about the bailout:

Lie Truth
It won’t cost more than $700 billion. When have huge government programs ever cost as much as promised? NEVER! Paulson, et al, have hardly a clue what their bailout will cost, partly because…
The government will pay a fair price for troubled debts. Nobody knows how to price these troubled debts. That means means that “we the people” will get soaked.
The government could make a profit. Think about it: if loans will be profitable and that the companies can cover any losses, then why are we even buying these loans? That’s a sound market environment!
Financial firms will repay the government for any losses.

Only one thing is certain about this bailout: the taxpayers will be screwed.

The economy may have to take a bitter pill. Don’t let the government screw it up worse!

Jeb Hensarling is my hero

This came from my US Representative, Jeb Hensarling (R-Dallas):

Every day in Washington people throw around the word “crisis,” but this week I’ve given it more weight than before.  Last week, the Bush Administration requested $700 billion from Congress to bail out banks on Wall Street that held troubled mortgage-related assets.  I am extremely concerned about the state of our economy, the status of our capital markets, and how the problems of Wall Street are being assumed by Main Street.  I remain skeptical of the Administration’s plan and am utterly unconvinced that this is the only alternative.

I have concerns about the ultimate cost to the Texas taxpayer.  I am concerned that the federal government is becoming the lender and guarantor of last resort.  I am concerned that the plan will put the taxpayer on the hook for a trillion dollars and still might not solve the problem.  I am concerned that the plan could fundamentally change the role of government in the American free enterprise system.  I am concerned with any taxpayer bailout for Wall Street that does not set strict limits for executive compensation. I am especially concerned for future generations who will have to pay to bail out Wall Street.

Fifth District residents have made it clear that they want a “work out,” not another bail out. I am fighting for an alternative that reduces taxpayer exposure and does not reward the people who made bad decisions with other people’s money. We need to quell the panic and get some capital back into the market, but that capital ought to come from Wall Street, not the Texas taxpayer.  This problem on Wall Street can impact Main Street, but Wall Street has to pay for it.

This is a serious situation that needs to be resolved, so inaction is not an option, but it is always more important to do the right thing rather than the quick thing.  The time has come for Congress to rationally debate alternatives – the consequences are too severe for us to rush to judgment, because we may have a taxpayer bankruptcy for the next generation.  It is essential to stop thinking only about today and start thinking about the next generation.

He said it a lot better than I did.

Did I get my math right?

In my post Manufactured American financial crisis: all thanks to borrowers, I surmised that investors can get most their money back on creative mortgages.

But I forgot something: the loans were repackaged as securities and sold off. This changes the dynamics of the first point.

Simple model

Under a really simple model, a bank lends cash to a borrower. The borrower uses the cash to buy a house. The borrower pays the bank a series of identical payments over many years. These payments will repay the principal and provide a profit.

Suppose the borrower defaults. If the bank can recover its investment, including the principal and expenses of dealing with the default, it is out nothing except anticipated profits. It retains profit earned to the point of default, and recovered principal can be used towards a new investment.

Securitizing the loan

The problem is when you securitize a loan, where you convert it into a financial instrument. Its price will mimic bond pricing, where the bond’s price is based on expected future payments from the bond issuer.

For example, suppose a bank lent someone $200,000 at 7% yearly interest payable monthly over 30 years. That means the borrower owes $1,330.60 per month for 360 months. In nominal dollars, this is $479,016 over the life of the loan.

For the right amount, an investor can purchase the rights to this series of payments. This can be a win-win: the bank doesn’t have to wait 360 months to get all its money back, and the investor can be assured a fixed income with a known risk for 360 months.

Further suppose someone has investments returning 4% annually. Using a financial calculation called “present value,” this person would break even by purchasing the rights to the mortgage payments for $278,709.13. That is, after 360 months, the investor would end up with the same end result regardless of whether he left the $278,709.13 it in the 4% account or used it to purchase the rights to the mortgage payments. (Obviously, the investor would purchase the rights to the mortgage payments for less than “present value” to come out ahead.)

Pitfall

Here’s a key point: the investor paid way more than the loan’s value.

Suppose the borrower for the $200,000 7% loan defaults right after the investor purchased the loan. The most the investor could recover from foreclosure is the value of the loan. That means in a best case scenario, the investor loses almost 30% of his investment!

In real life, these investments are backed by some kind of insurance. But if masses of irresponsible borrowers default, insurance may have too many losses to pay out.

But politicians exaggerate

It’s obvious that mortgage investments could be more risky than investors anticipated. But does that added risk mean much more than lower return or a modest loss? Nah:

  1. The mortgages are still backed by homes. You can recover most of the outstanding balance of the mortgage.
  2. The vast majority of borrowers will properly pay the loan. I have yet to see any reason to believe that the vast majority of borrowers would be unable to pay their mortgages.
  3. The mortgage investments appear to be in a mix of mortgages. Mixed in with the risky loans will be a ton of perfectly good loans.

I don’t believe the hype, which is why I don’t support the “bailout.”

Welcome to Chase Bank

I checked the news on my phone this evening after a several-hours hiatus from all things internet. My phone told me I am now a Chase Bank customer.

The Office of Thrift Supervision, part of the Department of the Treasury, closed down Washington Mutual (WAMU) and sold it off to Chase Bank. As of 10:58 PM CDT, the Washington Mutual home page gives no hint:

An old curse is “may you live in interesting times.”

I am cursed.

WSJ on the “bailout”

The WSJ Opinion Journal site is more skeptical of the proposed $700,000,000,000 federal bailout than the traditional media, although they take its necessity for granted.

In Bankruptcy Ploy, they agreed that Democrats are buying votes by “[making] it easier for borrowers to renege on their mortgage payments yet still keep their home.” They are clearly buying votes from greedy, irresponsible, or naive borrowers, and in the process they will increase the interest rates of new mortgages.

In Let’s Get the Bank Rescue Right, the editors argue that any plan must (this is a quote):

  1. restore the stability of the financial system quickly and at the lowest possible cost to the taxpayer;
  2. punish those who are responsible for losses;
  3. address the root cause of the crisis — the price collapse in the residential real-estate market.

The editors go on to discuss technical points, including that we need to trust politicians to devise a wholly new scheme to appropriately price purchased securities. Yeah, like they won’t abuse that!

I think the WSJ is “putting the cart before the horse.” It appears that they believe an ongoing seizure in the economic markets may hamstring access to financing, thus making homes unsellable and causing all sorts of economic calamity.

But they don’t address why time-tested and reliable financial instruments are in danger. What about them would turn off investors? Does anyone really know?

I guess instability in home prices?

Oooh, vicious circle: financial market seizure may cause instability in home prices, and instability in home prices may cause market seizure. This can only go so far, however. People still need a place to live. There will be demand for shelter, the “nice areas” will still be desirable, and investors will still be willing to invest in well-understood financial instruments such as mortgages where you actually determine the borrower’s ability to pay and don’t lend for 100% of the home’s value.

Still sounds like a leadership issue to me, not a $700,000,000,000 or $1,400,000,000,000 bailout, depending on whose estimates you use.