On Punishing The Job Creators, Or, “The Poor Have It So Good Today”

You know what the problem is with America?
The poor don’t get just how great they have it.

I’ve hear this a lot lately; the basic thrust of the discussion is that all those cars, TVs, DVD players, refrigerators, and stoves that have found their way into the homes of the economic underclass are proof there’s really no such thing as “poor” in America.

If they were truly poor, the argument goes, well…think recycled corn.

And if the poor want things to get better, let ‘em pull themselves up by their own bootstraps – and if they can’t, then let ‘em rot, because that’s the best thing for the economy.

But I don’t buy all that, and by the time we’re done today, I hope to have given you a whole new perspective on how jobs get created in this country.

There isn't a rich man in your vast city who doesn't perjure himself every year before the tax board. They are all caked with perjury, many layers thick. Iron-clad, so to speak. If there is one that isn't, I desire to acquire him for my museum, and will pay Dinosaur rates.

--From the letter "A Humane Word From Satan", by Sam Clemens

We must have completely misjudged how many Americans live here about 15 years ago, because everywhere I go I see vacant buildings.

Empty retail space, empty office buildings, empty factories, and all of it apparently just thrown up for no reason whatsoever.

But then I recently saw some historical pictures from the 1990s, and it turns out a lot of those buildings used to have businesses operating within their now-abandoned walls – businesses which have since gone away.

And that’s when I began to get confused.

You see I’ve always known, just as you have, that it’s all about capital; that’s why it’s only the very wealthiest people who can create jobs in this country.

And I’ve always known that they can only do that when they are 100% certain that nothing was going to hurt their current economic condition, and that any sacrifice on our part, no matter how large, was crucially important to keep this very special source of economic vitality full and happy and creating jobs for America’s future.

And when I look at the statistics, I know we’ve been doing our part: the wealthy have been getting wealthier, faster, over the past 30 years than at any time in memory…and yet, for some reason, all those businesses were closing down.

So many, in fact, that I began to question whether America actually understands how jobs get created. It even began to cross my mind that maybe we’ve been coddling the wrong people.

I mean, what if the actual job creators…are the people who no longer work in those empty buildings?

It makes sense, if you think about it.

The common argument is that those with capital make investments, which creates jobs.

But why would anyone invest capital unless there was perceived demand for a product, or a need to do research to meet perceived future demands?

That seems to suggest demand drives investment; a good way to “prove” the point would be to consider what happens to capital without demand: building factories and ships and warehouses does no good if there are no buyers at the store.

Of course, I’m not the first to think workers drive demand: Henry Ford famously paid his workers double the prevailing wage; part of the idea was to create demand for all those Model Ts he was cranking out in his new factories.

So now that we know who the job creators really are, and we established years ago that we have to do every single possible thing on the face of the Earth to keep the job creators happy, happy, happy…how do we get started?

Well, here’s an idea: the Fed willingly gave more than $1.5 trillion to banks for bailouts, mostly by simply “creating” money; now I’m proposing we do the same for homeowners.

If you have a loan backed by Fannie Mae or Freddy Mac, let’s allow you to apply for a one-time $200,000 markdown on your mortgage – and let’s allow the first “tranche” of any markdown to apply to any back-due loan payments.

The amount of “haircut” (fancy technical term) you might impose on each loan could vary, but $1.5 trillion would allow 7.5 million writedowns at $200,000 each; if you limited the haircut to 50% of the loan value many would be less than $200,000. (It’s estimated that 11 million homes in the USA from are underwater; $2.5 trillion or less would cover all underwater loans.)

Since Fannie and Freddy back $10 trillion or so in mortgages, and you probably won’t be able to write down every loan, how would you decide who gets writedowns?

One way would be to create a “triage score” that incorporates things like the odds an applicant/borrower can pay off a restructured loan and the amount of foreclosed or underwater homes in any given community; the 7.5 million highest (or lowest) scores get the writedowns.

(One caveat: many who are having trouble today with home loans are also laid off; unless we can find ways to keep those folks in homes until they can find work, we’ll still have a substantial foreclosure problem.)

Writing down mortgages does several things: it quickly applies a “moral hazard cost” to those who deliberately lent to unqualified borrowers, it turns millions of “underwater” loans into homes with equity, it turns millions of “nonperforming” loans into “performing” loans, keeping millions out of foreclosure, it gives communities a chance to either stabilize or recover from “mass foreclosure-itis”, and it finally breaks the deadlock between banks and regulators over who will blink first on loan “haircuts” versus bank recapitalizations.

Wait? What was that last one?

Banks are scared to death that if they write down all these loans they will have to find new capital to make up the losses – and they probably won’t be able to raise that new capital by charging a $5 fee to have a debit card.

That could mean a few things: it could mean big banks are going to have to more sneakily raise lots of other fees and sell things to raise capital, or, perhaps, the Feds ease back a bit on capital requirements.

Or…it may mean that the banks end up having to get smaller. Consider this scenario: a forced haircut of significant size, followed by regulators who stand firm on capital requirements, followed by a less-than-stellar round of stock offerings or asset sales; next thing you know, “too big to fail” becomes “we have to spin off some part of the retail business for reasons related to the rules governing capital requirements”.

This could happen without the passage of new regulations or legislation beyond the initial bailout authorization – and even that might be within the power of Federal regulators already, since Fannie and Freddy, as the owners of many of these loans, have the power to forgive some or all of that debt, and capital requirements are not set by legislation.

And where does all that leave you?

Well, you’d have 7.5 million families that could more easily afford to make house payments than before, and those folks will probably take that money and spend it on things they haven’t been buying for several years: home improvements, cars, appliances, and the travel and entertainment markets could all see substantial bumps in sales.

Many, if not most of those families, would immediately go from being “underwater” to having equity, which always helps turn reluctant consumers into willing consumers.

Cities could begin to recover as well, as the number of foreclosures bottoms out; once banks are forced to write those properties down from “2006 value” to today’s market value they’ll be looking to sell ‘em at bargain prices; that’ll help soak up today’s housing supply “overhang”. All of this is good for beleaguered new home builders, who are today in a holding pattern.

And here’s the best part: if you get a handle on foreclosures, and put some cash back in some pockets, and start selling stuff…well, that looks like a bit of a jobs program, even if Congress might not be willing to sign up for one just at the moment.

So how about that?

If we make an effort to give to the actual job creators the same level of incentives that we gave to the “demand responders” since November of ‘08, we could actually find ourselves creating actual jobs with our money – and doing it by the millions, just when we need ‘em.

Considering how fast we were able to find ways to create TARP, QE1, QE2, an alternative auto industry bailout, and anything else a banker could ask for, including, I’m sure, partridges in pear trees…well, we should be able to knock this out over a weekend, assuming we can either make a really convincing argument – or do like the banks do, and lay out a million a day for lobbyists until it gets convincing enough to get things done.

Of course, if we have to we could also start Occupying the Offices of reluctant Members of Congress to help make the point; as long as the end result is some serious pampering of the real job creators, I’m all good.

On Crying Wolf, Or, Why I Don’t Want To Give You $700 Billion

As this is being written we are in the midst of the second day of testimony before Congress by Ben Bernanke and Henry Paulson in support of the Administration’s proposed financial rescue package.

The basic sales pitch is that the Nation’s financial problems are at this moment so severe that the only solution is to expose to risk $700 billion dollars of taxpayer money to buy assets with a currently unknown price…and to give the absolute and total power over what those valuations are, what should and should not be bought, what repayment terms will be sought—and additionally, what happens to any money recovered--to one man, Henry Paulson.

There are those who are not on board. They have critics, who continue to stress the dire consequences of inaction.

With all due respect to those critics…we have been down this road before with this Administration—and last time, they weren’t so big on telling the truth…or getting the job done effectively.

We’ll cover that ground, we’ll talk a bit about “mark to market” issues—and on a positive note, we’ll address the role of “warrants”, the negotiating power of Warren Buffett, and how the taxpayer could actually see substantial recoveries of money down the road.

So let’s start with the biggest elephant standing in the Plan’s way:

Weapons Of Mass Destruction.

This Administration flat-out lied to the American people to justify the current Iraq adventure. “Just trust us” was the basic message at the time, followed by “we absolutely know that Saddam is an imminent threat because of his Weapons Of Mass Destruction”, followed by “this will cost maybe $50, 60 billion…maybe as much as $200 billion”--which turned out to be possibly the worst estimate in the history of budgeting--followed by variations on The “I’m not the Commander-in Chief, General Petraeus is” Theme…followed by flag-draped caskets that the Administration still hides from public view.

All of this to find not one single operable WMD.

Now comes before us Federal Reserve Chairman Henry Paulson and Treasury Secretary Ben Bernanke, who tell us of imminent threat, who tell us to just trust them…who tell us that they are the most qualified people to understand the issues and take the appropriate action…and who, to top it off, must be left to the task unsupervised and uncontrolled, otherwise the plan will fail.

We are also being told that if we were just economically sophisticated enough we would understand why this plan must be put into place, and that our objections must be related to our economic ignorance.

To which I pose a question to the Joe Kernans of the world (well, one of them anyway): what if the public fully understands that the system is at risk…but we don’t trust the leadership?

(Ever watch “Sex And The City”? This would be the part where they would cut to Carrie’s laptop screen and we would see the words appear as she types them...)

…What if we think the Administration is lying?

I have heard so many lies from the President and his advisors that if Jesus Christ was Treasury Secretary and Mohammed (PBUH) was Chairman of the Federal Reserve I would have doubts about this proposal.

Back in March, Paulson (who, it turns out, is not a Deity) was telling us that “the worst is behind us”…meaning he either does not really understand what is going on here—or that somebody is trying to blow smoke up some unpleasant places, using Paulson as a sort of economic “General Petraeus” who is intended to divert attention from the real economic Commander-in-Chief.

So can this Administration be trusted to handle this without outside supervision?

“Trust, but verify”, Ronald Reagan used to say, and without outside oversight this proposal should be instantly dead on arrival to the Congress.

This might be the most critical issue surrounding this entire plan…and we must demand Congressional oversight. This is far too big a process for any single individual to manage—and too big for any single branch of Government, as well.

Go watch this satirical slap at Bernanke from a wannabe Bernanke.
It’s hilarious—and revealing.

That issue resolved, some economic education is in order:

What, you may ask, is “mark to market”?

Holders of assets are required, for accounting purposes, to report the value of those assets based on what they are worth at the current time. Normally you do this by seeing what “the market” thinks your asset is worth—something that is fairly easily done if the asset is, for example, your house.

On a larger, corporate scale, this marking to market each accounting period can cause the state of your company’s balance sheet to lurch around and gyrate from time to time—sometimes violently…which is the source of much complaint from corporate interests, but for the most part, it all works out. Recently, it has not.

The challenge in today’s economic environment is to figure out what an asset is worth when no market exists for that asset.

Banks are holding quibzillions © of dollars worth of paper that represent streams of mortgage payments that will continue for years into the future…but some unknown number of those mortgages will not be repaid.

The concerns about what can be repaid (or not) and who is holding how many of these “nonperforming” loans has caused virtually all the normal buyers of these kinds of assets to run away in fear, which is the simplest way to explain the “credit crunch” we hear so much about.

The Paulson proposal is based on you and I buying some portion of those assets, today, from the current holders and reselling the assets later. This will allow banks and other institutions to begin making loans, and will hopefully create the confidence needed to induce investors to again buy “pools” of those loans from those banks…after which, the lending cycle begins anew.

The hoped-for outcome, from the perspective of ordinary mortals such as you and I, is to minimize any losses to the taxpayer…or maybe, if we get lucky, generate a profit.

The hoped for outcome, for the current holders of these assets, is to minimize their loss.

So how do you decide what price the taxpayer will pay for these assets?

Picture, if you will, a $100 US Savings Bond. If you bought that bond today, it would cost you $50, and in 17 years the US Treasury will pay you $100, representing the interest income to you from that loan to the Treasury.

The “hold until original maturity” value of that bond is $100.
The “mark to market” value, if you’re “marking” it the day you bought it, is $50.

If you became convinced the Treasury might not pay back the loan, or all the interest, you might sell the bond for less than the original $50, just to recover something from the deal.

That process will work as long as someone else is willing to believe the bond will be repaid, and is willing to put up enough money on that bet to get you to sell.

If no buyer can be found, your bond’s value becomes either “unknown” or “zero”, your personal assets decline—and maybe, down the line, your credit score is affected by some small amount.

Picture that on a massive, quibzillion © dollar scale, and you can see what is happening in the mortgage market today—and to the investors, all over the world, that hold the debt from our collective mortgages.

When the Treasury prepares to buy a CDO or some other mortgaged-backed security from an investor in the near future, Paulson will have to decide, with no help from any market mechanism, if that paper is worth the “hold to maturity” value, zero, or somewhere in the middle…and he has no way to know if the pool of mortgages he’s buying with our money will be 100% repaid, 0% repaid, or something in between.

This issue will be one of the most contentious parts of the entire deal (and the most ripe for abuse…as it would be very easy indeed to reward friends and punish enemies in a system with no oversight), so watch carefully to see how it plays out.

Hint: when asked about this today, I heard Bernanke answer that he expected the Treasury to pay prices similar to what are seen “…in a more normal market…”.

Another satirical video: “Damn, it feels good to be a Banka”.

What’s a warrant?

It sounds all technical and tricky, but actually it’s not.

Warren Buffet invested $5 billion dollars this morning in Goldman Sachs, and as part of the deal he got the right to purchase up to $5 billion in Goldman Sachs stock, at a time in the future of his choosing, for $115 a share (roughly 43.5 million shares). That right is referred to as a warrant.

At this moment, the stock’s last trade was at $130.48. The difference between $115 and $130 is the current available profit to Buffett if he were to “execute” this warrant right now (which is just over $650 million profit in less than 12 hours)…but it’s not the maximum potential profit executing this warrant might bring.

In November of ’07 Goldman Sachs traded at $250 a share…and if Buffett is able to someday execute the warrant at that “strike price” (fancy technical term) the profit on his 43.5 million available shares would be $5.8 billion.

When we take assets from banks and other investors with depressed stock prices, we as taxpayers need to make the same deal Warren Buffet made—we need to demand warrants, and later, sell that stock back to the market, reducing the cost to the taxpayer over the long term…and maybe even making us actual profit….which could help to repay some national debt, perhaps?

There is precedent here. In the 1980’s the US did a bailout deal with Chrysler that involved issuing warrants…and the profit to the Treasury was substantial.

This is an additional huge part of the deal…and you can bet that there will be investor stockholder groups that will lobby—and lobby hard--to stop us from getting warrants.

We need to demand that we get our cut of the profit our tax dollars create…and to do that we need to get warrants as part of these deals…so bug your Member of Congress loudly and quickly on this one.

So, for the moment, let’s recap:

If the Administration wants to sell this plan they better acknowledge that it isn’t economic ignorance that’s the issue…that, instead, the problem is the basic element of distrust that they previously created by lying about matters of war and peace and Katrina…and if you want any plan at all, this is the issue you need to fix first.

Next, we need confidence that the prices paid for bad assets are not going to be excessive, we need oversight that allows us to be confident this isn’t another typical “reward and punish with taxpayer dollars” operation; and finally, we need to demand warrants, the tool that could make this something that turns the transactions, for a change, to the advantage of the taxpayer.

If we insist on these sorts of protections we have the chance to make this at least a fair deal for the taxpayer—and maybe even a good one. After all, if Warren Buffet can get good terms for a mere $5 billion investment…imagine the negotiating power $700 billion should be able to get us.

Even without the Priceline Negotiator, we should still demand the best deal possible…and if the currently frozen financial services industry doesn’t like that, perhaps they should borrow $700 billion somewhere else.

On A Way Forward, Or, Practical “Subprime Crisis” Solutions

AUTHOR'S NOTE: This was originally published on February 14th of this year, but it seems to be exceptionally timely today.

We had a lively discussion last week regarding the causes and possible future of the “subprime crisis” that is on everyone’s lips these days.

Having examined the sources of the problem, and noting the lack of holistic thinking about how things might be resolved, I’ve taken it upon myself to come forward with an idea that can actually get at the root causes of today’s difficulties…and do it in a way that offers a potential “win-win-win” outcome for homeowners, investors—and the taxpayer.

Paying attention, Presidential candidates?

Good—because time is short, and we need to get to work.

For today’s solution to make sense, we, like Sherman and Peabody, need to make use of the “WABAC Machine”. We’ll set the time dial to the late 1980s, and we’ll set the location as the headquarters of the Resolution Trust Corporation.

What we’d find is a governmental organization established at the height of the “savings and loan crisis” of the 1980s. The savings and loan companies had made a series of bad real estate investments (much like today), and many had already entered or were in danger of bankruptcy.

Perhaps not surprisingly, many of the same names we recognize today from the world of politics were also to be found “doing bidness” at the time of the birth of the RTC…and if you look it up, you’ll find such luminaries as John McCain, Barney Frank, and even Neil Bush doing things that they today wish we would forget.

In fact, there were so many people doing things they wish we would forget that the RTC was needed to find buyers for all the bankrupt savings and loans that had piled up across the nation. The way this was accomplished was to use regulatory pressure to politely force the bankrupt to accept offers from the more solvent.

As a result, the Silverados of the world vanished, and Keating Five became part of the lexicon.

And with the history lesson complete, let’s scoot on back to the “WABAC” machine and return to the present day, shall we?

Those who participated in our bond insurance discussion (and many who didn’t) may recognize that the biggest problem currently affecting the American financial sector (and beyond) is an inability to accurately determine the exact value of various financial assets.

As you may recall, we noted that one form of these assets are “collateralized debt obligations” (CDOs), which are fundamentally income streams from loans backed by real estate collateral. The original debt was incurred in the form of mortgages or equity loans. The current owners of these assets are not the originating lenders; but instead investors scattered across the planet which have purchased bundles of these loans, a process known as “securitization”.

Because there is a disconnect between an investor in Singapore who purchased a CDO and the borrowers back in the USA who are supposed to be making the payments; it is at the moment impossible to determine with any accuracy the actual value of any particular CDO. In other words, if you invested in loans and you don’t know who might fail to pay, how can you know what your investment is worth?

Lenders, regulators, and investors prefer clarity above all else. In a perfect world, borrowers who might be in trouble would promptly contact lenders to initiate a “workout”. Then everybody would know the status of every individual CUSIP, and life would again return to a state of near normality. (CUSIP is a fancy technical term: each individual loan that makes up a CDO is known colloquially as a CUSIP, and has a CUSIP registration number. Other types of debt instruments, such as bonds, also use the CUSIP registration process.)

But how is that supposed to happen when neither the borrower nor the investor know each other?

That’s where this proposal comes in.

Imagine, if you will, a new Resolution Trust Company that would be chartered with the purpose of creating a “clearinghouse” where investors and borrowers could reach accommodation—and where the status of individual CUSIPs could be determined, registered, made known to participating investors, and, in a privacy protected form, to the public at large.

On the investor side, the process would begin with each investor voluntarily “registering” their CDOs with the new RTC. The registration process would determine exactly which CUSIPs are associated with every registered CDO, and this data would be maintained in a public database.

On the borrower side, an advertising campaign that might look like the ads you see for “credit counseling” services would be run by the RTC…something like: “Are you facing foreclosure? We can help to keep you in your home. Call 800 NO FORECLOSE today”.

The RTC would be empowered to act under a limited power of attorney on behalf of the registered investors and would have the authority to negotiate payment arrangements that might include extending the term of the loans at lower payments, some form of delay on “teaser rate” ARM adjustments, or converting the ARM to a fixed-rate loan—or any combination of the above, as warranted.

In extraordinary cases, the RTC could facilitate direct negotiations between homeowners and investors—and in cases where the home is “under water” (the amount owed is greater than the home’s value) such negotiations will be needed.

Every day, as more and more homeowners call in and the status of their loans is determined (“current—no issues”, “default”, “in processing”, “resolution unsuccessful”, “unknown”, and “resolved” are examples of categories to which the loans might be assigned) they can be matched to their registered CUSIP. As the database fills, this creates the clarity that allows more accurate valuation of the CDOs associated with the CUSIPs…which should be the necessary first step in resolving the valuation issue that’s currently choking up the financial markets.

By publicly posting the loan status and the CUSIP number-without other personally identifiable information-it would be possible, to some degree, to protect the homeowner’s personal credit information from public view, while still offering an “open and public” assessment by an independent third party of the CDO to which the CUSIPs are associated…which means private financing can return to the mortgage market with renewed confidence in what they’re buying…which should also have a positive affect on the stock prices of some of the most beaten down companies in today’s market.

At the same time, as the foreclosure rate declines (if this proposal were successful, that could happen rather quickly) less surplus real estate appears on the market…making investment in land and homebuilding once again a reasonable business proposition. Fewer foreclosures also means less decline in the value of affected neighborhoods, which means the neighbors benefit as well.

All of this could be funded by a registration fee per CUSIP (or based on the amount of the loan) charged to the investors that covers the cost of the RTC’s operations.

You might have noticed that I have not referenced what might be the most daunting problem a new RTC might face: the problem of large loans for large projects. How does the $30,000,000 loan to the Florida land developer who has a half-finished condo complex as collateral get worked out?

I have no idea, but it seems to me that the role of the RTC might be best served by doing the high-volume, “cookie-cutter”, single-family home resolutions (and similar duplex, triplex, and other “small unit” properties), leaving the most complex solutions to be negotiated directly between borrower and investor, with loan servicers and bond insurers charged with facilitating resolutions of these problems on their own.

If solutions can’t be found, the bond insurers are on the hook for the income stream, but if the bond insurers default the investors will get nothing (even when they do get paid the cross-ownership is so convoluted that as we move through the process some of the investors will potentially have to work out deals with themselves), so everyone involved should already-or soon will-have what R. Lee Ermey once famously referred to as “the proper motivation”.

So with all that said, what do we have?

We have a proposal that creates a new RTC for the purpose of “clearing” CUSIPs, which allows CDOs associated with those CUSIPs to be valuated, which creates the conditions for private investment to return to the mortgage market.

We do this with the only cost to the taxpayer being limited to incidental costs (registration fees not collectable, and the cost of enacting the legislation, for example) and the burden of bearing the upfront costs of establishing the RTC and launching the ad campaign—which presumably will be recovered as the process moves along to conclusion.

We also do this without changing the “risk profile” of the loan portfolios held by Fannie Mae and Freddie Mac—a potentially huge benefit to the taxpayer.

The investors, bond insurers and loan servicers win because it suddenly becomes possible to credibly and independently valuate the CDOs, communities win if foreclosures return to normal levels, and homeowners get to keep their homes and credit ratings…and the larger economy benefits as the CDO market, for the first time, feels the “cleansing effect of sunshine” brought on by greater disclosure.

And to top it all off, the “moral cost” of the bad choices made are borne by the involved parties, rather than the American taxpayer: homeowners who made bad loan choices still have to pay off the loans, even if it takes longer than they originally thought…investors will lose or have delayed some portion of their interest income…and the best part—investors and “predatory lenders” who foolishly participated in sketchy loans to currently “under water” borrowers will probably lose some or all of the value of those investments as the true state of their CDO portfolio becomes known to the market at large.