SeriousBull

Implications of the new bi-partisan bailout plan.

Tags: Barney Frank + Economy + Fannie Mae + Foreclosures + Freddie Mac + housing

Congress is at the threshold of passing a new bill to bailout Fannie Mae and Freddie Mac—two publicly traded (shareholder owned) mortgage companies that have access to cheap money from Treasury to guarantee pools of mortgage loans so that they can be resold to investors

stimulating growth. According to House Finance Chairman Barney Frank the House looked at several alternatives to help the US consumer and reduce widespread foreclosures and ultimately decided to go with a plan to induce banks and mortgage lenders to write down their loans by 13%, if it made sense, in return for loan guarantees from Federal Housing Administration (FHA).

What’s incredulous about this bailout plan is that banks will be most incented to write-off ‘at risk’ loans they’ve made that haven’t been already guaranteed by one of the GSE’s or Ginnie Mae. In that case they would write-off a full 13% of the mortgage principal value–$13,000 for every $100,000 of principal. True it will cause some banks to scramble to raise additional capital because it would haircut their reserve capital by just shy of three times their loan deposit requirement (4.86%). But let’s face it for a ‘for profit’ corporation this is preferable to incurring the potential full Monty of the entire loss on loans they didn’t have the foresight to already sell. Furthermore, for banks it simply means whatever amount they write-off they must replace capital at a ratio of 1:20. But that’s not a bad trade-off for banks to pass the bad loans to the taxpayer while at the same time improving shareholder net worth.

To the extent that banks have been using fair value accounting methods like Wall Street investment banks are required to use, the write-downs won’t hurt more. But there-in, of course, lays the second problem with this bailout bill (the first being the need for some banks to (again) come up with additional, replacement reserve capital).

But accounting treatment may be more problematic still. You see banks have this special ‘hold for investment purposes’ category of their loan portfolios that allows them to manipulate their balance sheets and capital requirements by not marking these bad loans to the market. Foreclosures have been forcing some of these toxic loans out of the “principal safe pool” and banks have had to raise new capital to shore up their reserve requirements when this has occurred. But because of the convenient accounting rules banks enjoy, there is more pain to take and banks will be maneuvering for ways to pass the bad paper on with the greatest profit spread to them—perhaps just ahead of rising indication of default thereby trading a 13% loss for a gain.

The third problem with the bailout bill is that the Congress is fixated on aggregate loan losses while banks are looking at net exposure loss to themselves knowing that the GSE’s are already on hook for 90% of the losses on most of the originated loans anyway—reportedly 50% of all mortgages not including Ginnie Mae’s are held by Fannie and Freddie. So for loans originated by banks and already sold to Fannie, Freddie and Ginnie Mae there is only 10% exposure and a 1.3% net loss exposure instead of the full 13% exposure. For loans in this bucket at banks the Barney Bill will be less attractive an incentive costing banks only 13% of 10% or 1.3%— $1,300 per $100,000 principal value. Is Congress inadvertantly now positioning banks to become the premptor of greater problems at the GSE’s when they (banks) opt to write-down their loans and accept the FHA guarantee on loans with only 10% exposure?

This would be comic if it wasn’t real taxpayer dollars being spent! But we are where we are and something has to be done. Besides, the bailout bill does also include a provision for a new, tough regulator to police future activities. But what confidence can the public have when thus far Congress is overlooking how the mortgage debacle occurred and who is responsible? The problem still not addressed is that lenders have had Congressional incentive to originate loans and sell them to the government. Largely not being their money loaned, no one has cared about the final outcome (until now). Fannie, Freddie, and Ginnie Mae, completely detached from the origination process, bought blind pools of mortgages at ever and ever, growing, inflated prices. MBIA, Ambac and other mortgage insurers likewise jumped into the mortage market and insured other mortgage pools that were sold as insured investments to pension plans, mutual funds and sovereign governments. One can only imagine the earful President Bush, Treasury Secretary Paulson, and Ben Bernanke have to listen to by sovereign governments (think China) seeking reassurance and being told what would happen if the US didn’t pay off.

Indeed the irony of this whole debacle is that the Congress has already given banks, Wall Street, and mortgage originators everywhere a blank check to Treasury. The question is what percentage of the $12 trillion in US mortgages will default and how much will your burden as a taxpayer finally be? Again, no argument here that we need some kind of bailout bill. The rub is that those responsible are spending our money without consequence and Congress is squarely one of the culprits.

Get ready for higher taxes and inflation and welcome to the new world of neo-capitalism where we privatize the profits and socialize the losses! In God We Trust.

July 25, 2008 - Economy, Markets, Politics