CSO

85Billion / 200Million is only $425. Now i expect that the bailout will cost closer to 3 trillion so that equates to $15,000 per person 18+. Of course we are are being told that this is really just an investment and we will get that back. Yea right.

Unfortunately, as our country is facing the greatest financial crisis since the Great Depression, policymakers and lawmakers alike, in their rush to show that they are taking action to help the American economy, have designed a financial bailout plan that is not only misdirected but may further exacerbate the problems in the housing market—the key cause of the financial stress the U.S. economy is facing today. Most Americans, and even many lawmakers, know in their gut that this bailout has fundamental problems, such as how it is largely being directed at those investment banks and large commercial banks that were the principal participants in causing this financial crisis. Further, many economists and capital market participants correctly worry about the moral hazard impact for the future that establishes the expectation that every time the large financial companies act inappropriately, the government will rush to save them because of the systemic risk they pose to the greater economy. Thus, if these large financials are always bailed out, they will continue to take outsized and imprudent risks during the good times. Although, these are valid issues there are even more troubling problems with the bailout bill relating to how it will be implemented, which will further worsen the existing housing and financial crisis.

The Treasury’s plan is to purchase $700 billion of primarily residential mortgage-related securities and whole loans. At each level of the purchasing, holding and disposition of these assets, there are significant problems with the Treasury’s plan. First, in regards to how the Treasury intends to assist the financial service sector and at the same time protect the U.S. taxpayer, there is a fundamental conflict between the two objectives. If the Treasury buys these securities and whole loans at their true economic value where the projected cash flows will ensure that the taxpayers get a return on their investment, then the discount at which the banks will have to sell these assets will cause significant erosion of their capital base and put many of our largest financial companies into insolvency. Conversely, if the Treasury buys these assets at inflated values to protect the banks’ capital ratios, then the taxpayers will be absorbing enormous losses at a most crucial time and the federal government’s financial stability will be further weakened. The Treasury has just experienced its largest budget deficit in history and now, with the significant decline in projected tax revenues due to weakening economic activity, the deficit’s projections over the next few years will materially worsen.

However, what is even more concerning are the next two stages of the government’s plan: the holding and divesting of these assets. If you assume that the government is going to spend $700 billion, and assuming an average mortgage balance, the government may end up buying and holding approximately one million troubled mortgages or homes that are in the foreclosure process. The government will then be left with a very difficult decision as to how to deal with delinquent borrowers. Democrats have put into the bailout legislation that every attempt must be made to keep delinquent borrowers in their homes and to make modifications of their principal balance and interest rate. While this sounds like a worthy effort, it unfortunately will trigger the law of unintended consequences in which it will only accelerate more mortgage defaults. To explain this, let me use an example. Take any street in southern California where a borrower has not been paying their mortgage for many months. The homeowner’s mortgage is then purchased by the government, and, at some point many months later, the government contacts the homeowner and proceeds to restructure the mortgage by reducing the individual principal balance by $50,000 and the interest rate from 8% to 4%. Now put yourself in the shoes of that homeowner’s neighbors. Many of these neighbors are also facing financial difficulty, yet have been scraping by to make their mortgage payments in order not to lose their homes. Most neighbors will know by the chatter in their neighborhood that the delinquent homeowner has not only been able to stay in their home for a year or more but was rewarded for being delinquent by being given a significant reduction of their principal balance and interest rate. Other homeowners will then start to question why they continue to make their mortgage payments and several will make the choice to stop paying in hopes of receiving the same government assistance. As a result, this will trigger a new flood of mortgage delinquencies and defaults which will only exacerbate the financial crisis our country is facing. If you question whether this will happen, let me make two relevant points. First, there are already web sites that instruct borrowers on how to receive a modification of their mortgage by defaulting on their existing mortgage even if they have the ability to make the payments. Second, no sector in our economy has witnessed such a heightened level of fraud than the housing and mortgage markets over the last six years.

Now, let us assume the government turns in another direction and proceeds to foreclose on delinquent borrowers and takes control of the underlying homes. There is no governmental agency today that is in any position to assume and take the responsibility for overseeing hundreds of thousands of single family homes. It has been suggested that the FDIC would serve in this role. However, the FDIC is already overwhelmed and understaffed by the new wave of bank failures. Further, even if a staff were in existence, it is an almost impossible task to ask people that have no direct economic incentives to properly care for the magnitude of the housing inventory the federal government could assume. This is a critical issue because anyone who owns a home understands that uncared for real estate will deteriorate in value at a very rapid pace. If a leak in a roof or a broken pipe is not immediately addressed or a faulty electrical wire or any other assortment of problems are not immediately fixed, then the value destruction of a home can and will be profound. Therefore, the federal government is left with two untenable options, one of which could cause even more mortgage defaults and the second producing even greater losses to the taxpayer by holding these assets.

The last flaw to the bailout plan is the timing of when the government plans to divest itself of these assets. History has shown that when investors buy assets from any government agency, they do it with the assumption of getting a very cheap value. This is clearly the case with any sheriff or IRS sales and tax-lien sales, and was most visibly evident during the days of the Resolution Trust Corporation (RTC). In fact, one of the biggest myths created in trying to obtain support for this bailout bill is that the RTC helped stabilize the markets in the late 1980s and early 1990s. Speaking as someone who was deeply involved in numerous RTC transactions and who had a front row seat to watch how the RTC was created and, subsequently, managed and disposed of large pools of primarily commercial real estate loans and properties, it actually exacerbated the decline in commercial real estate values for several years and, resulted in causing even more thrift failures in the early 1990s. Please take a moment to think for yourself how the mortgage and residential real estate markets will react when the government begins to divest nearly one million restructured mortgages or homes. Moreover, the value of any mortgages held by the government will be even further reduced in the eyes of potential buyers should the government significantly modify those loans by lowering the principal balance and reducing the interest rate to below market levels. Just as foreclosure sales are pressuring housing prices today, government sales will only make matters worse. If the government decides to hold these loans for a much longer period than three or four years, then the value destruction for tax payers will be even greater. On a much smaller scale, we have already seen how the government handled problem residential real estate through the Department of Housing and Urban Development (HUD). HUD, through the late 1960s and throughout the1970s, amassed large portfolios of residential real estate via their various housing programs. These properties became dilapidated and after costing taxpayers billions of dollars, Ronald Reagan, upon assuming the presidency, forced HUD to sell these assets.

Equally troubling about this bailout plan is that it does not even go to the root causes of the crisis—which is deflating asset values, found principally in the housing market, and a lack of capital in the banking industry. Numerous countries, including our own, have previously faced systemic failures in their banking industries: Sweden, Norway, and Japan—just to name a few— and, most importantly, the U.S. during the Great Depression. The eventual solution in almost all of these cases was to have the respective national government provide capital infusions into their banking sector and take ownership stakes. A recent IMF working paper that studied global financial crises found the only successful way to remedy a banking crisis was through this action. This is exactly how the U.S. ended up stabilizing the banking sector in the Great Depression through the creation of the Reconstruction Finance Corporation (RFC), which provided capital infusions into those remaining banks. This has another benefit of being far simpler to execute and it protects the taxpayers and citizens from substantial losses. Each government held these economic ownership interests until their economy regained its footing. Subsequently, these ownership interests were sold at values that achieved a return on the capital provided and, in many cases, even a profit. There are also other ways for the government to provide economic incentives to attract private capital into the banking system. One is to provide capital loss coverage on a percentage of a bank’s troubled loan portfolio whereby the government would assume any further losses after these assets have already been written down. This mechanism provides safety to new capital to invest in and recapitalize a troubled bank and, for the government providing this guarantee it could, again, receive equity warrants and ownership in exchange for this backstop. There are numerous solutions to address the recapitalization of the banking industry and, at the same time, protect the taxpayer. Further, it not only addresses one of the two core problems, but it also leaves the assets in the private sector where, again, there is the infrastructure and economic incentive to maximize value.

The last myth being prophered to garner support for the bailout bill—is that buying these assets from the investment banks’ and large commercial banks’ balance sheets will re-stimulate lending. Many people have a significant misperception of what is actually happening in the credit markets. If you are a business or individual with good credit standing and have a stable source of income, credit is still very available. Where credit has been fundamentally constricted is for those individuals or businesses that have a checkered credit background and unstable sources of income. Whether the government buys these assets off the large banks or not, it will not change their risk appetite to lend to high-risk borrowers, particularly given the results of the credit decisions of the last six years. This is especially the case given that the economy has entered a long-term, slow growth environment. Given the fragile state of our economy, it is critical that careful consideration be given to constructing a federal assistance package that will work and not ultimately make the current economic situation worse or damage the federal government’s future financial health. Remember, we are a mere three and a quarter years away from 2012—a fateful time frame which policymakers have known about for decades as it will cause significant strains on federal budget deficits from 2012 and on. Why is 2012 so critical? Because that is when the beginning of the Baby Boom generation turns 65 and starts to receive Social Security and Medicare benefits. To say the least, given this enormous upcoming financial burden, the federal government’s finances are not in a position at this critical juncture to absorb hundreds of billions of dollars of financial losses via purchasing inflated mortgage assets.

As such, with the entire global financial system watching U.S. policymakers’ every move, let us hope that Congress reconsiders its options and presents a bailout bill that is directed in a more positive and productive fashion than what is on the table today.

We would strongly urge you to discuss this issue with your trade associations and, especially, lobby your respective members of Congress.