Sitting here in Limbo
Waiting for the tide to turn.
Yeah, now, sitting here in Limbo,
So many things I’ve got to learn.
Meanwhile, they’re putting up a resistance,
But I know that my faith will lead me on.

– Jimmy Cliff

And then the harder they come, the harder they fall, one and all!

Whither the GSEs?  A year and a half into their conservatorship, nobody knows – and we could easily wait another whole year with no progress.  As reported in the Washington Post:

The federal government has spent the past half year seeking to roll back its emergency efforts at propping up the financial markets – with the notable exception of its involvement in mortgage giants Fannie Mae and Freddie Mac.

Taking over Fannie Mae and Freddie Mac wasn’t about propping up the financial markets, but rather keeping upright the housing markets.

Houses, not banks

As recently as December, the Obama administration said it expected to release a preliminary report on how to remake Fannie Mae and Freddie Mac around Feb. 1.

The best laid schemes of mice and Administrations gang aft agley.

But no plan was produced, and in response to questions from lawmakers, Treasury Secretary Timothy F. Geithner clarified last month that it would be another year before the government proposes how to restructure the firms.

That’s for me not to know and for you to speculate about, isn’t it?

Sixteen months after they were seized to prevent their collapse, the companies remain wards of the state –

Regarding the GSEs’ continued limbo, I’m of two minds:

1. Don’t risk open-heart surgery.  The GSEs are a lifeblood of the American housing finance system – and hence of the global capital markets.  Tinkering with them now risks a disruption we simply cannot afford.

Don’t tug on that … you never know what it might be attached to

2. Doing nothing is unacceptable too.  Because the GSEs are so important, they cannot be left with no hand at the strategic tiller.  The GSEs should be part of the solution, not simply a metronome ticking away on momentum.

Further, lack of management isn’t just bad strategy, it’s bad governance, and dangerous:

– running a tab that has now exceeded $125 billion in what has become the single costliest component of the federal bailout for the financial system.

Lack of transparency means lack of practical oversight … and we know how well opacity worked for them before, don’t we?

It looked really good until it failed miserably

Some members of Congress have complained that the huge public commitment is unsustainable.

It is – and without transparent reporting, we have no way of knowing whether the GSEs are rebuilding their balance sheets and net equity or continuing to run up losses not of their past executives’ making.

But the administration has been reluctant to start reforming Fannie Mae and Freddie Mac, officials and analysts say, because the firms in their current form play an essential role in supporting the housing market at a time when it is still under severe stress.

Absolutely, categorically true – we cannot allow the housing market’s financial heart to stop pumping liquidity.  Even if it’s artificial.

Don’t worry, your Federal government is at th econtrols

As other financial firms have exited the market and credit has seized up, Fannie and Freddie have been behind the vast majority of mortgages made since the start of the financial crisis. The companies now own or back more than half of all U.S. home loans.

With FHA right behind, and itself weakening.

Moreover, the companies are helping the administration pursue policies designed to make new homes more affordable, ease the burden on struggling borrowers and direct funding to parts of the country especially hard hit by the downturn.

Allow us to be crystal clear here – by continuing to supply liquidity, and to “ease the burden on struggling homeowners” [translation: forbear – Ed.], the Administration is almost certainly increasing Fannie Mae’s and Freddie Mac’s losses. 

A rising tide lifts all boats?

Their bet is simply that the gains to others (e.g. homeowners, other banks, securities holders) and the macroeconomic benefits (lower interest rates, support for employment) outweigh the costs. 

Any initiative to remake the firms could distract energy from these programs or, in some cases, put an end to them.

By their actions, Fannie and Freddie are taking a concentration of the pain that would otherwise be diffused throughout the economy. 

The companies have also been tapped by the Treasury Department to rewrite the terms of home loans for struggling borrowers facing foreclosure. But this program – carried out by Fannie, Freddie and other firms – has had less success. Although 1.3 million borrowers have been eligible, only about one-tenth have had permanent mortgage modifications.

Many of those eligible are under water in all scenarios; most of them should never have been homeowners in the first place.

And keeping the companies solvent has been costly. To cover their losses, the firms have both said they will need additional federal money beyond the more than $125 billion already committed.

As a taxpayer, I think and hope their strategy has been right for the country – I’m willing to pay more if it serves to strengthen the economy.  Were I a director of either institution, I’d want explicit exculpation from breach-of-fiduciary-duty claims.

Yes, something like that

Nor is the administration eager to foster a debate over Fannie Mae and Freddie Mac in an election year, according to analysts and lawmakers.

As a policy wonk, I had overlooked this.  Yes, raising the GSEs’ future now has to be a net loser for the Administration.  With all their current political tribulations and pitched battles on Capitol Hill, the Democrats can ill afford to open another political front.

The pair have long been lightning rods for criticism by many Republicans, who call them [1] an intrusion into the free market and [2] a Democratic patronage haven.

Yes on [1], probably No on [2].  Democrats and urbanists like housing subsidies more than Republicans do, so the leadership of Fannie and Freddie probably veers toward the liberal. 

Many Democrats, even as they faulted companies’ excesses, have defended the firms’ role in fostering homeownership.

Well, if the GSEs haven’t done that, why did we give them all those awfully big advantages?

And with Obama’s campaign to overhaul financial regulation facing resistance on Capitol Hill, administration officials don’t want to add another divisive issue to the mix.

Especially if the Administration is unsure what it wants to do.

“We’ve obviously had our hands full, as has the Congress,” said Michael Barr, assistant Treasury secretary for financial institutions. “We’re just beginning to see some positive signs in the housing market, but we’re not out of the woods yet and so we want to be careful to be sure that we had an appropriate, paced process.”

There’s a Barr in them financial woods

Barr said Treasury officials have been meeting informally with their counterparts at the White House and the Department of Housing and Urban Development and exchanging policy papers to develop principles for overhauling Fannie Mae and Freddie Mac.

All well and good – maybe it starts to coalesce a thought cloud – but a far cry from actual progress, particularly as the Republicans will weigh in strongly before anything happens.

These principles include, for instance, that the government ensure borrowers could still get mortgages even when the private market is no longer offering loans.

A laudable principle if the reason the private market isn’t lending relates to a credit crunch.  But if the private sector is sensibly pulling back from risk, and the GSEs zag when they should have zigged, we will be much worse off.

You are here …

But whatever replaces Fannie and Freddie, it should not be allowed to grow so large that its failure could threaten the financial system.

Oh, brilliant …

“And that’s how there’ll never be any financial crisis ever again.”

“Great, Jackie.”

“They weren’t planning to do much about it,” said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, in an interview. “They’re busy, and it’s hard and it’s complicated and they’re trying to put it off.”

So the Administration, understandably, put GSE reform into the too-hard-revisit-later basket.

Where did I file it?

Frank said he is “forcing” the issue by scheduling a committee hearing later this month, summoning Geithner and other officials to discuss options for reforming the firms.

A hearing, useful though it may be, will not force the issue, but at least it will raise the issue.

Once among their strongest supporters, Frank has more recently called for their abolishment.

As independent entities, that is. 

“Independence may be overrated”

Future scenarios for reforming Fannie Mae and Freddie Mac range widely – from total privatization to total nationalization. But no consensus has emerged over the best fix.

Nor will it any time soon.  This is guaranteed to be divisive. 

Spokesmen for Fannie Mae and Freddie Mac said their current focus is on keeping funds flowing into the mortgage market and helping distressed borrowers remain in their homes.

As it should be.

The companies did not address the question of how they should be restructured.

In view of their obvious self-interest, nothing would be gained by the GSEs’ management vocalizing about their future.  They will be keeping their heads down.

When the Bush administration seized the firms, it said it would make $200 billion available to them. The Obama administration a year ago doubled that figure, then decided late last year to offer them unlimited financial assistance as a signal to investors that the companies’ solvency was guaranteed.

But critics warn this has given Fannie Mae and Freddie Mac a blank check.

That is the problem.  They do have a blank check.

Fill in the zeroes later

“This idea of having money laying around that they can spend on whatever they think politically makes sense is certainly consistent with what we’ve seen from this administration,” said Rep. Jim Jordan (R-Ohio), a member of the House Oversight and Government Reform Committee who has called for an investigation into the delay in planning for the companies’ future.  

True enough, but there are good reasons for caution.

“Any suggestion now about future changes could destabilize the market,” said Karen Shaw Petrou, managing director of analysis firm Federal Financial Analytics and a longtime observer of housing finance policy. “The U.S. mortgage market is so fragile that all Treasury needs to say is ‘boo’ and it could fall apart.”

But time could be tight. Under the firms’ agreement with the Treasury Department, they must shrink their mortgage portfolios every year, eroding their ability to support the market.

That is, unless the rules get changed … yet again.

I’m smiling outside, and crying inside

James Lockhart, a former top regulator of Fannie Mae and Freddie Mac, said the administration is erring by waiting another year to begin the reform process.

“The clock is ticking. We need to reinvigorate the private mortgage market and create something new and we know how long Congress takes,” Lockhart said. “It’s unhealthy to have as much government involvement in the mortgage market as we have in this country.”

He’s right, of course, but limbo is no state for us to be in.

Could be dangerous

Sitting here in Limbo

Waiting for the dice to roll.
Yeah, now, sitting here in Limbo,
Still got some time to search my soul.
Meanwhile, they’re putting up a resistance,
But I know that my faith will lead me on.

– Jimmy Cliff

I said forgive them, Lord, they know not what they done

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By: David A. Smith

[A full year's Month in Review available here: Dec 09, Nov 09, Oct 09, Sep 09, Aug 09, Jul 09, Jun 09, May  09, April 09, Mar 09, Feb 09, Jan 09.]

In January, aside from one little post about the invisible delights of apartment living (It’s what you don’t see), everything I wrote covered capital markets and macro policy, proving just how deeply intertwined are home asset values and fiscal economy.  The first 2010 tree I ran into was a contradictory set of housing price indicators out of which one could assemble any narrative one wanted, as I observed in Pick a direction. 

At least we don’t have to go far for help

That being unsatisfactory, I sought to provide some fearless 2010 predictions – worth every bit as much as a California promise – starting with Part 1, global macroeconomic factors:

1. Ben Bernanke will be easily reconfirmed as Federal Reserve chairman

2. After a ‘decent interval,’ the Fed will start raising interest rates

3. The recession will linger like a bad cold

4. The dollar will defy financial gravity … for the year, anyway

5. ‘Sovereign bankruptcy’ will enter the lexicon

6. Global finance will be whipsawed by sovereign-bankruptcy worries

We ended 2009 with the US economy still losing total employment.  That may not be the economists’ definition of a recession, but it’s the public’s practical definition, and the one with most relevance to housing, for when jobs and people’s earning power are shrinking, so too is their consumption of housing.

That economic weakness will be worldwide, for a 10-20% global de-leveraging simply does not happen overnight, uniformly, or predictably.  Sucking that much cash out of the financial ecosystem has external consequences – a premium on liquidity, lower asset values, and a steeper risk curve.  Nor are we done with the financial aftershocks – the multiple governmental shadow bankruptcies yet to come, for example – that will knock the props out from under people (like pensioners and public employees) who up to now have thought themselves immune.

Who, me?  Nothing wrong with me!

Of these, Bernanke’s reconfirmation [1] happened, although some may question ‘easily’ (although really, what did all the noise amount to?), and [5] has arisen (at least in the Eurozone, with Greece, although not yet here at home).  The others have to ripen, but as a portfolio of predictions, I like it.

Part 2 covered US capital markets:

7. All the big TARP banks will recover

8. In 2010, many regional banks will fail

9. TALF will be revived

10. The GSEs will be frozen in time

11. The risk curve will widen and stay wide

12. Financial and real estate service-sector consolidation will continue

Right now, global capital is scared.  Scared of lingering recession.  Scared of monetary policy.  Scared of sovereign insolvency.  Scared of the unknown future. 

I’ve got reason for being scared

When capital is scared, it ventures only a short ways from safety, which means safe nations, safe security types, safe asset classes, safe maturities – and always with a line of retreat, meaning a liquidity option.  Flight to higher-credit assets requires collateral, not counterparties, in view of the market’s loss of faith in ratings agencies and guarantors.  Every asset class will stratify, and for real estate assets, the stratification will occur by location, property quality, debt service coverage, sponsor.  Safer will be overly rewarded and riskier will be overly punished.  The gap between creditworthy haves and creditless have-nots will become more palpable and more painful.

The result is a steep yield curve and a steep risk curve.  You want to borrow money for a long period, secured by a repositioning asset, and with anything less than sterling credit?  Be prepared to pay up for it.

Is that loan proposal a joke?

It will be Ben Bernanke’s job to keep the yield curve smooth and relatively flat. 

While one shouldn’t judge solely on the froth of journalism, that the big TARP banks are now targets of populist anger suggests they have recovered (Prediction 7). 

This isn’t good for the brand

About the others, we’ll see. 

The remaining predictions are much more sector-specific.  In Part 3, housing and affordable housing, I covered the macro supply factors, and concluded that we have too many entities and not enough business for them all to do.  Major consolidation is in order:

13.  Total US households will be level, not increasing

14.  Average national home prices will rise, but weakly

15.  Rent increases will be held back by the shadow rental market

16.  2010 net housing production will be nearly at a standstill

17.  LIHTC pricing will stabilize at 75¢ or so

18.  LIHTC will lose market share to newer tax credits

19. Consolidation will squeeze out 15-20% of sponsors

Though it pains me to tell my friends this, the shakeout is long overdue.  We have too many too-small sponsors; we need more scalable Production MEEs.  We also need comprehensively to rethink the distribution of Production MEEs around the country, and how we can use legislative motivation and resource incentives to drive portfolio rationalization: capable Production MEEs spaced continuously across the national landscape, each one successfully owning a geographically logical and localized portfolio of properties.

Cover the landscape, and make best use of the resources

Whew!  Compared with all that heavy going, the month’s remaining posts are meringue indeed.   Start with a remarkable anti-defamation lawsuit brought on behalf of Rumpelstiltskin (aka the U S Government), whose case is pressed in Rumpelstiltskin’s fee: Part 1, the libels, and Part 2, the motives:

If it please the court –

Comes now my client, your honor, the United States government, affectionately known as Rumpelstiltskin – who having rendered a valuable, nay an essential, service to the fair maiden investment banks and her father the banking industry, is now being both cheated of the compensation which he demanded and to which the parties agreed, and libeled for doing so.

Lot of straw, little lady, and not a lot of gold here, is there?

The essential facts are not in dispute. 

Parties at interest in this litigation

“Prince” Charles Miller (bank)

“Dolly” Miller [not her real name], the investment banker

Cassius King (representing the retail customers)

Rumpelstiltskin (Treasury)

The defendant and alleged victim was an investment banker.  Under our financial privacy shield laws, her name must be withheld so we will refer to as Dolly Miller.  Dolly claimed that via securitization, she could spin straw (unrated mortgage instruments) into gold (ratable securities), which her father the miller (major public banks) sold to Cassius King and his extended family, at vast profits.

[I note for the record that we will be joining other parties, such as the rating agencies, in derivative actions.]

Add a bit of outrageous flattery suggesting that Great laws from little blog posts grow:

If virtue is its own reward, can an AHI post change a law? 

One blog post = one wing flap?

Though I would never claim such a thing, Dr. Zhong Yi Tong, principal analyst of the Washington DC homeownership tax credit, traces a direct link between a July, 2003 AHI report and the newly-extended national first-time homebuyer credit.  I was utterly unaware of this until December 29, when he wrote me an out-of-the-blue email connecting the dots. 

So modest he insists on a small photo

Zhong Yi’s email, from which I quote with permission, is in dark red:

Several years ago you wrote a blog post [Tax credits boost regeneration markets – Ed.] on my dissertation study on the impact of targeted homeownership tax credit program – evidence from DC.  You also used some of its information for your UK experiment.  Now it seems to me that my study on this matter might have somewhat contributed to the housing recovery for the US. 

Argh, pity me

Then pity the poor pirate who, having looted the high seas, now discovers he needs to reintegrate with civilization to enjoy the proceeds of his plunder, by Burying treasure:

Pirates have a real estate problem and a capital problem. 

We’ve got the capital, now we need the real estate!

Like highwaymen (land pirates) and kidnappers (wilderness pirates), for their business they need a work environment of vast uncharted spaces and complete lawlessness – for which the high seas often serve admirably. 

We’re ordinary fisherman … until we attack you

The pirates’ real estate problem is that, conducting their business in a place of no law – and hence no monetary or economic resources – they must nevertheless equip and base themselves in a place of monetary and economic resources – and hence of some law.

Readers who have stopped following this blog for having activated their estates will be pleased to learn that for them, Death is a bonanza:

Have you died so far in 2010?  If you have, you’re in luck!

I’m from eternity and I’m here to help you solve your tax problem

If you’re still alive in 2010, but wonder how much longer you’ll make it, then you have a decision to make.

“Now, you have a decision to make: do I feel lucky?”

Rich Cling to Life to Beat Tax Man

You mean you’re not glad to see me?

[Article published in the The Wall Street Journal on December 31, 2009.]

Nothing’s certain except death and taxes – but a temporary lapse in the estate tax is causing a few wealthy Americans to try to bend those rules.

[Snip]

As my earlier exposition suggested, there is a logical linkage between estate tax and capital gains tax.  Capital gains are payable when an asset is sold from Owner A to Owner B.  In an estate, the assets pass from Owner A to Owner B without benefit of an economic sale, but certainly within benefit of a sale for legal and tax purposes (the old owner is legally dissolved, a new one created with full protection of the law).

The idea is that you shouldn’t be able to put assets into a vehicle and pass them, generation after generation, without tax.  Legal vehicles have their force because government protects property, and the capital gains and estate taxes can be seen as a user fee for protecting wealth when it passes from the hands of a capable person to potentially less capable beneficiaries.

Finally, the month ended with another multi-part post – hey, it’s complex stuff, and all soundbites are misleading without context – on the puzzle of pay.  In January, I posted Part 1, what should happen, executive level, and Part 2, what should happen, company level:

With the economy in the tank and banks (including the Federal Reserve) making record profits, populist ire has settled on the bankers themselves. 

Were you paid a great deal of money?

Yes, we … uh …

Guilty!  Until proven innocent!

Deservedly so?  That question is implicit in a lengthy Steven Brill piece in the New York Times, a largely sympathetic profile of TARP paymaster Kenneth Feinberg.  Brill makes much of Feinberg’s flagellating bankers, as others are lining up to take their turn.  The bankers are facing a financial crisis tribunal and being bashed by the President:

“Those who oppose this fee [The proposed $90 billion tax on all banks – Ed.]  have also had the audacity to suggest that it is somehow unfair,” President Obama continued, “that because these firms have already returned what they borrowed directly, their obligation is fulfilled.”

(How naively audacious I am, to think that repaying a debt ends the obligation.)

Next you’ll be telling me I can get it from a tap

Some of the shots are truly deserved, as when Goldman CEO Lloyd Blankfein walked into a verbal door:

You mean you open it first?

Testifying to the Financial Crisis Inquiry Commission, the body established by Congress to determine the causes of the Wall Street debacle, Lloyd C. Blankfein, the chairman and chief executive of Goldman Sachs, drew most of the fire.

Mr. Blankfein parried repeated questions over his bank’s extraordinary profits and salaries. At one point, when he likened aspects of the financial crisis to a “hurricane” and similar acts of God, the commission’s chairman, Phil Angelides, a Democrat and former California state treasurer, cut in to say, “Acts of God, we’ll exempt. These were acts of men and women.”

Score one for Chairman Angelides!

How do you like me now?

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[A full year's Month in Review available here: Dec 09, Nov 09, Oct 09, Sep 09, Aug 09, Jul 09, Jun 09, May  09, April 09, Mar 09, Feb 09, Jan 09.]

A blog is pointillist – sparkly bits of insight (we hope) collected by the roving eye of an intellectual crow.  Yet step back from the dots and you may see a pattern, and patterns are what make ecosystems out of the rhythms of life. 

Fascinating … and logical

That’s what calendar increments like decades are for – to let us take stock.

I opened the new decade by looking back at the old one, with the longest and most substantive post I’ve ever written, seven parts on the decade’s biggest invisible stories:

All of them are important, and if there is only one post of mine you read in its entirety, it should be that one, but as I despair of receiving the undivided attention of our ADD/ Twitter generation, I will succumb to market forces and provide sound bites, starting with Part 1, the perpetual-motion credo:

By no stretch of the imagination was Mr. Raines unusual in the Aughties – nearly every financial wizard, on or off Wall Street, was similarly enraptured with the wealth machine that was the decade’s global capital markets.  It was all driven by the belief that risk could be quantitatively controlled by hedging strategies – a deeply seductive belief.

Tell me again how default risks are not correlated

For that, one needed an unwitting wizard.  Cometh the willful disbelief, cometh the formula.  As I wrote [Posted March, 2009]:

The E = mc² of financial engineering

Guaranteed perpetual motion!

Suppose I offered you a free lunch?  Would you take it?

Between Li’s formula and Raines’s willingness to believe it and massively bet on it with the country’s money for his stockholders’ and his own profits, we were ready an asset boom.  That was amplified by two other forces documented in Part 2, yield starvation and dematerialization of global capital:

When I was a kid, financial capital was represented tangible: gold, silver, currency.  Bonds were bearer bonds, stock certificates.  Actual pieces of paper (that’s not an oxymoron) with embossing, stamping, engraving, or certification of authenticity.  Possession of the scrip was critical to proving no-questions asked credit.

Money, though an intangible concept, through 1999 had a tangible expression.

During the Nineties, many indicia of status dematerialized.  Airplane tickets went electronic (when was the last time you saw a paper one?); so did driver’s licenses.

My identity is an illusion, as is everything else here

Most significant in this dematerialization was that of capital.  From having once had a tangible existence, by the time the Aughties opened, capital was evidenced by matching sets of numbers contained in bank and financial institution computers, making a mockery of the old how-to-steal-a-million caper movie that was a screen staple when we were growing up.

From this vision of money …

… to this, art replacing cash

Now there was plenty of financial-asset demand globally, and the potential for an expanded supply domestically.  To that tinder we needed wizards to strike matches, with they did, as documented in Part 3, tangles in the financial web, with FIN 46 (shielding companies from the dreaded ‘consolidation’) and allowing the explosion in Credit Default Swaps:

Along with thousands of others, I can testify how much accounting brainpower was consumed defining the maximum perimeter of entities in which the Parent had a big economic stake without the dreaded FIN 46 consolidation.  This still goes on today, consolidation being the Thing To Avoid At All Costs.

Simple, isn’t it?  Vinot Kothari’s FIN 46 flow chart

As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.

A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.

That was the invisible story.  FIN 46, which sought to make things more transparent, in fact made them more opaque.  While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.

Our structures have a firm foundation

By mid-decade the economy was humming merrily away, and it seemed the party would never end, but as covered in Part 4, the 2006 crest, two things should have tipped us off: FAS 157 was issued, and Angelo Mozilo began cashing out:

During 2006 Angelo Mozilo, Countrywide’s founder, CEO, and largest stockholder, began selling his positions; in fact, Mr. Mozilo “modified the executive sales plan in late 2006 to accelerate his stock sales. Critics say he sped up them up because he was aware of problems at Countrywide.”

Problems?  What problems?

By mid-2007, Mr. Mozilo was coming under fire, although at the time the smoldering appeared merely fumes and not a conflagration.

[Snip]

Regarding his stock sales, I thought Mr. Mozilo’s explanation credible, said so at the time.  Later I came to feel a complete chump for having done so.  But here’s the invisible story – as far as I know, despite the stock price sliding, there was no more detailed investigation into Countrywide’s business model and finances, if only to rebut the presumption that Mr. Mozilo was cashing out while the cashing was good:

[In 2009] the SEC released emails in which Mozilo referred to certain mortgage products as “poison” and “toxic” at the same time Countrywide was making riskier and riskier moves with its lending operations.

Don’t paste this label on the product, okay?

At the time, Mr. Mozilo’s actions were scrutinized; FAS 157 was overlooked.  That opened the window for the last mover (Fannie Mae) before the world inverted.  As covered in Part 5, the wrong zags, the capping folly was that, as Angelo Mozilo was beetling out of subprime, Fannie Mae (under Daniel Mudd, Raines’s Mister-Clean successor)  was gobbling it up:

Moreover, shifting to riskier securities – moving up the risk curve – meant that the companies could increase their profits by increasing the risk to us taxpayers.  That’s what they did – just at the moment that many (like Angelo Mozilo) were dramatically reducing their exposure to subprime lending, the GSEs increased theirs. 

Where Angelos fear to tread …

[Snip]

Mr. Mozilo, who was closest to the action, was cashing out of Countrywide and cashing Countrywide out of these loans.  Fannie Mae and Freddie Mac, who were further from the risks and from the touch on assets necessary to evaluate and manage those risks, were aggressively buying them from aggressively selling Mr. Mozilo.

Somebody had to be wrong.

They couldn’t all have been right at the same time: Johnson, Raines, and Mozilo

By 2007, we were looking unhappily at a risk curve hit by a seismic shock, with sudden paper writedowns of virtually every financial situation in the world.  That led to the first of many responses.  As described in Part 6, rule changes with the game in progress, to the volatile mix we added new uncertainty:

2007: Repeal of the uptick rule

During the summer of 2007, as the credit crunch deepened and the decline in asset values started to accelerate, the SEC inexplicably did the equivalent of severing the runaway automobile’s brakes [Posted December, 2008]:

Who repealed the uptick rule?!?!?

[Snip]

Aftermath.  Realizable values of structured assets collapsed to fire-sale prices.  Those discounts became the bludgeons of FAS-157-driven writedowns.  One by one Wall Street’s financial pillars – Bear Stearns, Lehman Brothers, AIG, and Fannie Mae – suffered bear raids.  Billions of capital disappeared even as some capital migrated to the raiders.  Finally, in April, 2009, the SEC restored the uptick rule.

Finally, in Part 7, effects not yet visible, I listed the two big invisible stories of 2009 whose importance wouldn’t surface until this year.  One of them (Chairman Bernanke’s reappointment) proved a bit more contentious than I expected – although really, they never laid a glove on him – and the other, although small at the time, is like that first corn kernel to pop in the pan:

2009: California’s shameless IOU issuance

In July, the state of California did an extraordinary thing: it repudiated its debts.

Why pay debts when you can print money?  A California IOU

Instead of paying its bills with cash, the state printed paper, backed by nothing, and ordered people to accept it.

If you or I did that, we would be summarily hauled into court and our property potentially seized. 

Oh, wait – it was the court itself that was welshing.

To be sure, the state dressed up this reneging on its debts with flowery language:

[Snip]

We are living in interesting times.  The decade upcoming promises to be no less interesting.

Does this mean danger/ opportunity?  

With the Chinese holding $800 billion of our paper, we’re about to find out.

With that as the forest, let’s plunge into the trees:

Enlightenment’s in there

[Continued tomorrow in Part 2.]

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[Continued from yesterday's Part 1.]

When the court adjourned yesterday, I was representing my client Rumpelstiltskin, doing business as Uncle Sam’s Club financing,

“You pays your money and you gets your loan.”

Mr. Stiltskin is single-handedly keeping the American financing system flowing with liquidity, and –

[Your Honor, must I listen to these public-gallery outbursts about "record deficits," "mortgaging the next decade," and "drunken-sailor spending"?  However true, they are irrelevant to the matter at hand.]

–        and the court will recall, yesterday we met my client, who heroically rescued flighty maiden “Dolly” Miller (not her real name), who had via securitization claimed she could spin straw (unrated mortgage instruments) into gold (ratable securities), and whose retail brokerage arm, Pied, Piper & Company, had sold to Cassius King and his extended family around the world.

Don’t forget, when we got stiffed, we took your children

Parties at interest in this litigation

“Prince” Charles Miller (bank)

“Dolly” Miller [not her real name], the investment banker

Cassius King (representing the retail customers)

Rumpelstiltskin (Treasury, my client)

Yesterday, quoting from the Grimm Financial Times (a/k/a the Wall Street Journal), After the Bailouts, Washington’s the Boss, I made reference to this statement:

John Taylor, a former Bush Treasury official who is now a Stanford University economist, says the government’s role will be far greater than Mr. Summers suggests.  “We have a bailout mentality in this country.”

To which I reply, on my client’s behalf, yes, we do.  And probably will need to have a muscular role for my client’s credit enhancement for the next five to ten years. 

“Notice who is conspicuously absent when my client is doing all the work.”

Under my client’s previous Treasury Secretary, Hank Paulson, my client intervened massively to prevent the Second Great Depression.  Having now caught the credit-enhancement bus, my client’s customers and counterparties now face the enormously difficult challenge of disengagement:

One concern: Even if the government withdraws, business will expect bailouts in the next crisis, and that will inspire another round of cavalier risk-taking. “If we don’t re-regulate the banking system properly, we’ll either get very slow growth from overregulation, or another financial crisis in just 10 to 15 years,” says Kenneth Rogoff, a Harvard University economist and co-author of a new book on financial crises since the Middle Ages. 

Mr. Rogoff is a tremendous individual, who’s never shied away from confronting unpleasant truths or challenging pompous incumbents:

“Pushing money around is not banking”

The essence of the ‘this time is different’ syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply.

–         Kenneth Rogoff, Harvard Economist and Historian

He recognizes, as does my client, that having rushed in to save the foolish alleged virgin Ms. Miller, my client gains no thanks for doing so and now must endure brickbats for simply expecting its counterparties to live up to their bargains.

In finance, the recovery has been striking. Since bottoming on March 9, the Dow Jones Industrial Average is up 60%, and financial stocks have more than doubled.

While this by itself does not assure the economy will recover – there are many reasons to remain deeply bearish in 2010 – consider the alternatives.

Where would the Dow have been without our interventions, hmm?

Global capital is running to America, largely due to my client’s actions, and the major financial institutions like Mr. Miller’s banks, and their investment banking arms like Ms. Dolly Miller’s financial wizards, are once again able to make money and realize stock market gains – again a result of steps my client took at their behest.

Yields on junk bonds, issued by companies with the highest risk of default, have fallen from almost 17 percentage points above yields on Treasury bonds in March to about 6.5 points higher now.

Seventeen hundred basis points’ of risk spread is categorically insane; compared with that, 650 basis points of spread is merely gluttonous,

That signals both an improving economy and a renewed investor appetite for risk.

Capital cannot work unless the world has a rational risk appetite.  This is an essential recovery sign.  More significantly, my client’s aggressively experimental actions threw a safety tarp over the major financial institutions, a critical move of confidence that has definitely succeeded.

Most big banks appear back on their feet. Of the $245 billion invested in bank shares by the Troubled Asset Relief Program, more than $175 billion has been repaid. Since the Treasury tested the financial strength of 19 large financial firms in May, they have raised $136 billion in equity capital and borrowed $64 billion without U.S. guarantees.

My client saved the global capital system.  Has he been thanked?

Could I get thanked?  But nooooo!

But the strengthening of the big banks may be distorting the market. Although smaller banks have long had a higher cost of funds than big ones, the gap has widened. The gap averaged 0.03 percentage point for the first seven years of the decade, but it jumped to a 0.66-point disadvantage for smaller banks in the four quarters ended Sept. 30, estimates Dean Baker of the Center for Economic and Policy Research, a liberal think tank.

Your Honor, that is precisely the sort of Wall Street whining to which my client objects.  Having rescued the nation’s largest financial institutions, and charged a below-market or equitable risk premium for so doing, my client must endure this sort of carping.  Observe that the price of being a smaller bank has effectively doubled, from 33 to 66.

That suggests investors think the government would bail out big banks, but not small ones, if crisis erupted anew, he says.

Or that investors think big banks are less likely to need bailout. 

Not all of the rescues look successful. The U.S. had to redo its initial bailouts of giant insurer American International Group Inc. –

Man, that AIG acquisition went bad, didn’t it?

– and of GMAC Financial Services, which was once a car-finance and mortgage firm and is now a bank holding company.

Final answer?

Both remain unable to raise private capital.

GMAC was special case as it was tied to automakers. 

The intervention comes with long-lasting costs, among them huge budget deficits that could eventually push up inflation and interest rates.

Of course it will; see Predictions for 2010, Part 1.

The International Monetary Fund estimates U.S. government debt will swell to the equivalent of 108% of annual economic output in 2014, from 62% in 2007 –

[Your Honor, will you instruct the galleries to stop hooting in derision?  Thank you.]

Entitlements for all my friends!

– absent politically difficult steps such as raising taxes or cutting benefit programs.

[Must I listen to these catcalls?]

Only 21% of Americans polled by The Wall Street Journal and NBC News in December said they trusted the government to “do what is right,” versus 64% shortly after the attacks of Sept. 11, 2001.

In conclusion, your Honor, I wish to make clear that my client has no designs on Wall Street beyond their first-born child, as specified in the original contract.

I’m being shortchanged and I demand my rights

The nature of post-crisis capitalism will depend in part on how the administration and Congress wield their new power. Inside Washington, there is profound ambivalence about this.

Herbert Allison, who left the private sector to run TARP, says, “We can’t wait to get out of these investments. We don’t view ourselves as a long-term investor.” But in the here and now, the government is torn between its roles as shareholder and guardian of the public interest.

Having provided the gold, are we not now in a position to make the rules?

Remember the Golden Rule?

The disagreements over how to wield power over business are playing out both within the Obama administration and between the administration and Congress – as is happening now in the auto industry.

The White House forced out a CEO of General Motors in March, and crafted car-maker bankruptcy restructurings that drew howls from some creditors. But it later lightened its hand. It appointed a board of private-sector directors and let that board oversee GM. The board, six months later, was able to fire a subsequent CEO without getting prior White House approval, according to Treasury officials.

Allow me to leave the final word to my amicus curiae co-counsel, the distinguished litigator from the 535-person fractious law firm at the other end of Pennsylvania Avenue:

Who says we’re fractious?

Congress isn’t so willing to surrender its leverage. That was clear when GM and Chrysler decided to terminate about 3,400 dealers. Many turned to their lawmakers, and Congress got involved, prompting the companies to reinstate about 110. But the dealers felt that was insufficient.

GM’s frustration with the process boiled over at a mid-November meeting in the office of Sen. Richard Durbin (D., Ill.). GM’s usually cool-headed chief lobbyist, Ken Cole, was too agitated to sit, say several participants. When Tammy Darvish, an executive of a dealership in Silver Spring, Md., pressed Mr. Cole about whether it would cost the company any money to reinstate a terminated dealer, the GM team started to pack their briefcases and threatened to walk out, according to Ms. Darvish and a government participant in the meeting. They say the GM team stayed only at the insistence of congressional staffers.

Congress later enacted a provision giving axed dealerships broadened grounds to appeal in arbitration procedures – broader than the White House or car companies sought.

A spokesman for GM declined to comment on the dealers meeting or Mr. Cole. But the auto maker, now 60% federally owned, said the arbitration law will hurt its efforts to turn a profit and repay the government, which has invested roughly $50 billion in the company.

I’m in charge now, remember?

My client in no way associates with the peremptory demands being made by those other bodies.  Leave it to them and any plan will be lit up like a Christmas tree.

Go easy on the earmarks, big guy, okay?

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If it please the court –

Comes now my client, your honor, the United States government, affectionately known as Rumpelstiltskin – who having rendered a valuable, nay an essential, service to the fair maiden investment banks and her father the banking industry, is now being both cheated of the compensation which he demanded and to which the parties agreed, and libeled for doing so.

Lot of straw, little lady, and not a lot of gold here, is there?

The essential facts are not in dispute. 

Parties at interest in this litigation

“Prince” Charles Miller (bank)

“Dolly” Miller [not her real name], the investment banker

Cassius King (representing the retail customers)

Rumpelstiltskin (Treasury)

The defendant and alleged victim was an investment banker.  Under our financial privacy shield laws, her name must be withheld so we will refer to as Dolly Miller.  Dolly claimed that via securitization, she could spin straw (unrated mortgage instruments) into gold (ratable securities), which her father the miller (major public banks) sold to Cassius King and his extended family, at vast profits.

[I note for the record that we will be joining other parties, such as the rating agencies, in derivative actions.]

My client’s skill – credit enhancement – is exceedingly valuable, and Ms. Dolly Miller coveted it for her personal gain and that of her bank. 

Sure I can turn this into that … but it’ll cost you something

Unfortunately, so impressed was Cassius King that he shut Dolly up in a tower with a spinning wheel (investment banking division) and demanded she make gold endlessly.  This she could not do, but that did not stop her from enjoying the fruits of her claims.  When she realized that it was nothing but straw, she begged my client’s help. 

“Let the record show the maiden was glad at my client’s arrival”

He gave it freely (Bear Stearns), arranging for a first consignment of straw to be transmuted into gold and acquired by another miller (JPMorgan Chase).  Dolly professed thanks. 

Oh, she was lovey-dovey enough then

Then she asked again for her wayward non-identical twins Fannie and Freddie, and again my client wrote an enormous check. 

At Fannie Mae and Freddie Mac, where the Treasury holds warrants allowing it to acquire stakes of nearly 80%, the administration has put public interest first. It has instructed their regulator to have them administer efforts to cut monthly mortgage payments for millions of Americans to avert foreclosure.

[Your Honor, will you please remove those disgruntled shareholders form the gallery?  Again I call the court's attention to the evidentiary stipulation that nothing in this case may be used by the outraged shareholders of Fannie and Freddie as the basis for a breach-of-fiduciary-duty claim against my client.  We shall defend that action at the proper time.]

“My client opened the vault for us”

Now that my client has rescued Dolly Miller and her father’s millery (bank) – indeed, without  my client, the entire milling industry would be bankrupt – the Miller family is libeling me whenever and however they can.

As evidence, I introduce this article from the Grimm Financial Times (a/k/a the Wall Street Journal), After the Bailouts, Washington’s the Boss:

In 2008 and 2009, Washington strove to save the economy. In 2010, Americans will get a clearer picture of how Washington has changed the economy.

Only as the recession recedes will it become fully evident how permanently the state’s role has expanded and whether, as a consequence, a new, hybrid strain of American capitalism is emerging.

One thing is clear: The government is a much bigger force in today’s U.S. economy than it was before the financial crisis. “The frontier between the state and market has shifted,” says Daniel Yergin, whose 1998 book Commanding Heights chronicled the ascent of free-market forces starting in the 1980s.  “The realm of the state has been enlarged.”

Is it all downhill from here?

This is inevitable and predictable – indeed, I predicted it (Banks, paying your rescuer and Catastrophe is a precondition to financial reform). 

The histories of depressions show that a period of economic chaos is invariably followed by a period of extremely rigid economic controls – during which all the variables, the only partially controllable factors like commodity speculation, unlimited credit, free marketing, and competitive wages get shut out.  There’s a new imperialism starting where we used to be free.

– James Blish, Earthman Come Home, pages 421-422

Now this is coming to pass, and my client intends to claim his payment:

My client’s legitimate demands are libeled with this type of cheap visual editorializing

To prevent crumbling housing and credit markets from sinking the broad economy, the Bush and Obama administrations and the Federal Reserve spent, lent and invested more than $2 trillion on one initiative after another. If you owned a credit card or a money-market fund, had a savings account, bought a Dodge pickup or even a hunting rifle, or borrowed to buy a home or finance a small business, odds are good that the U.S. stood behind you or the firm that served you.

“Behind your card is my client’s card”

Not to put too fine a point upon it, my client is single-handedly holding up the global financial system:

“That’s a great deal of gold my client lent or invested against straw”

Washington pumped $245 billion into nearly 700 banks and insurance companies and guaranteed almost $350 billion of bank debt. It made short-term loans of more than $300 billion to blue-chip companies. It propped up life insurers and money-market funds.

It bailed out two of the three U.S. auto makers.

Now owned 70% or so by Uncle Sam

It lent billions trying to jump-start commercial-real-estate, small-business and credit-card lending.

Uncle’s behind every one of them

Today the U.S. government, directly or indirectly, underwrites nine of every 10 new residential mortgages, nearly twice the percentage before the crisis.

“80% owned by my client, and rising”

Your honor, my client regulates every financial institution, and is expecting to close 700 or more banks this year.  This is hardly a trivial service being provided.  Nor has my client suggested in way that he has dreams of world domination:

Lawrence Summers, President Barack Obama’s chief economic adviser, says the intervention was essential, short-term therapy, not a reinvention of capitalism. “Our overarching goal was to save an economy that was near the abyss, where depression looked like a real possibility,” he says.

(Pay no attention whatsoever to the embarrassing self-interested internecine squabbles among Mr. Stiltskin’s administrative staff; these are irrelevant to the larger issue.)

The bailouts “were designed to be, and have proved to be, temporary,” Mr. Summers says. “There is no aspiration of any kind to change the private-sector basis of our economy.”

Your honor, please also disregard Mr. Summers’ last statement.  He is not the Fed chairman, and regulation is a set of values in itself, whether the regulator knows it or not.

“In charge of shooting down bad ideas?”

Even so, he says government won’t return to its pre-crisis form. “The way our financial system was operating was much more fragile than many had supposed. Those events point up a need for substantial changes in the way in which we regulate the economy and regulate finance,” he says.

An expansion of legislative authority and international standards regarding financial instruments’ structure, disclosures, and collateral is of course necessary, for capital has de-materialized and gone fully and instantaneously global:

Law enforcement always lagged behind law violation.  Thus, in the old days following the invention of the automobile, state troopers could not cross state lines.  … They had no authority beyond their own jurisdiction, while the public enemies flitted unhampered from place to place.  … A man could perpetuate any financial crime imaginable without fear of consequences, for in an hour his money could be so far away from the scene as to be completely beyond the reach of the law.

– E. E. Smith, Galactic Patrol, pages 14-15, slightly modified

Future financial regulators of the world, unite!

Any suggestion that my client is a megalomaniac bent on imposing a dictatorial rule of bureaucracy over the fair maidens like Ms. Dolly Miller is the sheerest calumny:

John Taylor, a former Bush Treasury official who is now a Stanford University economist, says the government’s role will be far greater than Mr. Summers suggests. “While we may be past the emergency, we’re still in a mode that will create similar interventions for quite a while, even for minor emergencies,” he says. “We have a bailout mentality in this country.”

Allow me, therefore, to rebut these scurrilous accusations.

“Let me say this about that.”

[Continued tomorrow in Part 2.]

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