Insider's Game

Financial markets just gave Hank Paulson a vote of no confidence. Unfortunately, it’s the rest of us who will pay the price. As Paulson made clear this past week, he is stalling, subverting the express intent of Congress when it passed the bailout bill, by his refusal to take action on foreclosure relief for distressed homeowners. Paulson’s inaction has triggered a chain reaction that goes something like this:

First: Treasury says it won’t take steps to prevent home foreclosures, so that
Second: Prices of mortgage securities collapse, so that
Third: Bank equity gets wiped out, so that
Fourth: Banks, with shrunken equity capital, are forced to cut back on all types of credit, so that
Fifth: Financing for anything, especially residential mortgage loans, dries up, so that
Sixth: Market values of homes decline further, so that
Seventh: Mortgage securities decline further, and the downward spiral becomes self perpetuating.

This phenomenon is best illustrated by the numbers.

The free fall in mortgage securities.

The free fall in market prices for mortgage securities implies that the eventual recovery on distressed mortgage loans will be a lot worse than anyone expected on the eve of Obama’s election. We see that from the Markit ABX Indices, which are something like a Dow Jones Average for subprime mortgage securities.

Market Price
ABX-HE-PENAAA 07-1, November 3: 55 November 20: 34.25
ABX-HE-PENAAA 06-2, November 3: 82 November 19: 58.32

When ABX-HE-PENAAA 06-2 traded at 82, or 82 cents on the dollar, the implied recovery rate on the entire mortgage pool is was something like 66%. When the same security trades at 58.32, the implied total recovery is about 47%. Here’s why. The way these securities are structured, different classes of creditors, or different tranches, all hold ownership interests in the same pool of mortgages. But the tranches with the lower ratings – BBB, A, AA – take the first credit losses; they are supposed to get wiped out before the AAA bondholders lose anything. Typically, AAA bondholders represent about 75-80% of the entire mortgage pool. (Market Price@ 82 X approx. 80% of total pool = 66% total recovery). (ABX-HE-AA 06-2 currently sells at about 12; ABX-HE-A 06-2 sells under 6. At those prices, a buyer is betting that the eventual recovery will far exceed the market’s expectations.)

Mortgage securities and bank stocks fall in tandem.

From the price graphs of the ABX benchmarks, accessible via hyperlink, you can see how the downward slopes closely match those for bank stocks since election day.

Market Price
ABX-HE-PENAAA 07-1, November 3: 55 November 20: 34.25
ABX-HE-PENAAA 06-2, November 3: 82 November 20: 58.32
Citicorp, November 3: 13.99 November 20: 4.71
Bank of America, November 3: 23.61 November 20: 11.20
JPMorgan Chase, November 3: 40.73 November 20: 17.35
S&P 500, November 3: 966 November 20: 752

Since November 3, Citicorp, Bank of America, and JPMorganChase have lost in excess of $240 billion in market value. Most of the other global banks, such as UBS, Barclays, BNP, have suffered similar declines.

The link between ABX indices and bank equity requires some further explanation.

Declines in mortgage securities wipe out bank capital and confidence in our global financial system.

About 18 months ago, banks lost control of their balance sheets. Losses on securities receive different accounting treatment than losses for loans. Comparatively speaking, loan losses are more predictable and more manageable. Before they report their quarterly results, banks review their problem loans and calculate the associated loss provisions. Banks don’t expected to be whipsawed by market events on the last day of a fiscal quarter.

Things changed around July 2007, when AAA mortgage securities started trading at prices materially below par, or below100. Up until then, many banks had bulked up mortgage securities that were rated AAA at the time of issue. Why? Because they believed that AAA bonds could always traded at prices close to par, and consequently the bonds’ value would have a very small impact on the earnings and equity capital. The mystique about AAA ratings dated back more than 80 years. From 1920 onward, the default experience on AAA rated bonds, even during the Great Depression, was nominal. Similarly, during the Great Depression national average home prices held their value far better than they have in the past two years.

Those assumptions, of a highly liquid trading market and gradual price declines, proved to be way off the mark. Beginning in the last half of 2007, the price declines of AAA bonds was steep, and the trading market suddenly became very illiquid. Under standard accounting rules, those securities must be marked to market every fiscal quarter, and the banks’ equity capital shrank beyond anyone’s worst expectations. Hundreds of billions of dollars have been lost. The losses in mortgage securities, and from financial institutions like Lehman that were undone by mortgage securities, dwarf everything else.

Before the end of each fiscal quarter, bank managements must also budget for losses associated with mortgage securities. But since they cannot control market prices at a future date, they compensate by adjusting what they can control, which is all discretionary extensions of credit. Banks cannot legally lend beyond a certain multiple of their capital.

This uncertainty about banks in general, and the ripple effect of reduced credit, creates a crisis in confidence throughout the financial system and the broader economy.

Why Treasury’s intervention was needed to forestall a bigger glut of foreclosures.

Why did mortgage securities and bank stocks fall so much more sharply in the last few weeks? The market was expecting that Hank Paulson would act in a manner consistent with Congressional intent when it passed the bailout. As time passed, anxiety about treasury’s inaction increased. Then on November 12, Paulson announced that he would do nothing soon to provide foreclosure relief to homeowners.

As we’ve seen above, stabilizing home prices is key to stabilizing the broader economy. And the key to stabilizing home prices is to limit the spate of foreclosures that would flood the market. If homeowners are able to remain in their homes and make partial payments on their mortgages, lenders may attain a better recovery than from a series of fire sale liquidations.

The problem is concentrated among private-label securitizations. Though they represent only 20 percent of all mortgages, they represent 60 percent of all defaults, according to The Financial Times. Unlike most mortgage securities that follow the standardized underwriting guidelines of Fannie Mae and Freddie Mac, private-label securities make it almost impossible for the lender to negotiate modifications with the homeowner. Congress passed the bailout package on the condition that a large chunk of the $700 billion to assume control of these assets so that the government could renegotiate terms with distressed homeowners.

Paulson ignored Congressional intent, and went off into an entirely different direction, allocating funds to bolster securitization of credit card receivables. Barney Frank, with great specificity, called him on his bad faith bait-and-switch tactics. But that exchange didn’t get nearly as much coverage amid Paulson’s platitudinous soundbites and talk about bailing out GM.

“The primary purpose of the bill was to protect our financial system from collapse,” Paulson told the House Financial Services Committee. And the markets signaled what they think of Paulson’s job performance.

Addendum
Here’s a taste of how Barney Frank tried to cut through Hank Paulson’s dissembling and evasiveness yesterday.

REP. FRANK: Let me just say there are pages — it’s four pages of specific authorization to buy up mortgages and write them down. Section 109(c), “upon any request arising under existing investment contracts, the secretary shall consent where appropriate in considering — (inaudible) — by the taxpayer to reasonable requests for loss mitigation measures.”
In Section 110, homeowner assistance by agencies. “To the extent that the federal property manager holds on to controlled mortgages, they shall implement a plan that seeks to maximize assistance for homeowners.”

 

The bill is replete with authorization to you, not simply to buy up mortgages, but in effect to do some spending — because we are talking about writing them down.

 

So the argument that, frankly, of all the changes that have come with the program, this — this wouldn’t be a change. This was the program. And my colleague from California, who’ll be — you’ll be hearing from shortly, made a big point of this on the floor.

 

So the argument that this is not part of the program simply doesn’t wash. So — would, do you agree, Mr. Secretary, that in fact the bill does authorize aggressive action, not simply to buy up mortgages, but in buying them up, take some action to reduce in some ways the amount owed so we diminish foreclosures?

 

SEC. PAULSON: Mr. Chairman, two things. First, I need to just say a word about AIG, because the primary purpose of the bill was to protect our system, protect our system from collapse.
AIG was a situation, a company, that would have failed, had the Fed not stepped in. Had we had the TARP at that time, this is right down the middle of the plate for what we would have used the TARP for.

 

As it turned out — because it should have had preferred (and a ?) Fed facility, and as it turned out, we needed to come in again to stabilize that situation and maximize the chances that the government would get money back.

 

So I just wanted —

 

REP. FRANK: I’m not objecting to the AIG. I am just saying, though, that the standards of what we do — and obviously foreclosure is also a serious problem for the economy.

 

SEC. PAULSON: I agree with you on the bill. There is no doubt that — and so don’t misunderstand what I say, that the —  We came to Congress with the intent to get at the capital program that banks were facing and the system was facing through purchasing large amounts of illiquid assets. And so the bill — and it was to purchase those assets and then resell them.

 

And our whole discussion — because that’s what we were talking about, was how to use these and use this investment position to make a difference and mitigate foreclosures.

 

My only point is now that we haven’t bought those assets, illiquid assets, that the — that at least the intent is, I had seen it. At least all the discussions we had went to buying assets and reselling them. It didn’t go to a direct subsidy. But

 

REP. FRANK: No, Mr. Secretary, I have to interrupt you. No, you are talking legitimately about your intent. But we had to get the votes for the bill.

 

SEC. PAULSON: Right.

 

REP. FRANK: Our intent was also relevant. And I read you sections of the bill which says, write it down, give them assistance. So the bill couldn’t have been clearer that one of the purposes —
And, by the way, we’re talking about, what, 24 billion (dollars) out of 700 billion (dollars)? You’re talking about 4 percent of the total amount.

But the point is that clearly part of this was not just to stabilize, but to reduce the number of foreclosures, for good macro- economic reasons. And so again, the intent couldn’t be clearer, from what I’ve read.

 

SEC. PAULSON: Let me then, Mr. Chairman, say what you’ve heard me say a number of times before, that going back many, many months, before it was as topical as it is now, we’ve been working very, very aggressively at the individual, helping the individual. As recently as last week —

 

REP. FRANK: Mr. Chairman, I’m sorry — Mr. Secretary — we don’t have a lot of time, and I don’t usually do this, but —

 

SEC. PAULSON: Okay, well, let me just —

 

REP. FRANK: What — the question is the language in the TARP. We understand that there are other activities going on. I don’t accept them as a substitute for using the authority that we very specifically and carefully wrote into the TARP and that was essential to it getting passed.

 

SEC. PAULSON: Well, what you’ve heard from me, and what you heard from me last night, and which I will say again, that I am going to keep working on this and looking for ways to use the taxpayer money as they expect me to here, with regard to foreclosure mitigation.

 

We have been, you know, as recently as last week, taking a step which I think will have —

 

REP. FRANK: No, I’m sorry, Mr. Secretary. Those are not substitutable. Because I will tell you this, and I apologize for taking the time, it is nobody’s view that we have been as successful as we need to be for the stake of the economy in reducing foreclosures.