Dave Spicer: The Bailout: We Have Met the Enemy and He is Us

“What country poses the greatest threat to the United States?”

I heard this question being asked of several politicians on some of last Sunday’s morning talk shows. In each case, the politician would pause for a few minutes of thoughtful deliberation and then respond with either “Iran,” “Iraq,” or “Pakistan” and elaborating on their concern. It seems to me they’ve missed the point. Given our perennial lack of leadership when it comes to the issues we face, and with the addition of our recent “mortgage meltdown,” we may be our own biggest threat. It’s sad when the “smartest person in the room” is Pogo, a retired cartoon character who said, “We have met the enemy and he is us.”

With regard to the mortgage crisis I believe, as with other issues we face, we have been poorly informed as to its causes and even less well informed regarding the proposed $700B “bailout.” I recommend everyone read Paulson’s short document to establish a grounding in his proposal.

It’s clear that our politicians never took a Marketing 101 course since their first problem is calling what’s being discussed, a “bailout.” That word is never mentioned in Paulson’s document and has strong negative connotations. The real objective is to restart the credit markets through investments in mortgage-backed securities. In addition to a turnaround, if properly handled, these investments will provide considerable profit for our treasury. Instead of calling it a bailout, we should be calling it a “restart” for our economy. What they also should have said is that $700B is the cap on the investment. If handled correctly, it could turn out to require a much smaller number as I’ll discuss below. The only people who will not benefit are those who do not depend on credit and do not depend on companies that do depend on credit. I know of no one in that situation.

Let’s understand what’s required:

1. We need to make funds available for new credit, be it commercial loans or new mortgages to keep the wheels of our economy turning.
   
2. We need to make sure the situation that caused this disruption is never allowed to occur again.

Our financial infrastructure is broken not because people borrow money to buy homes, but because of the way in which their loans were packaged and securitized. Loan originators lured people who should have known better into taking loans they couldn’t afford. These companies took the origination fees (points) and promptly sold bundles—up to thousands of these loans—called Mortgage-Backed Securities (MBSs) to banks, thus passing the risk to them. The banks, unsure of the quality of these securities, bought insurance from companies like AIG, thus passing the risk to them. When the music stopped, AIG didn’t have a chair. Banks can only lend up to a multiple of their capital. Because of the freefall in the value of their mortgage assets they now find themselves in the position of not having enough capital to cover the loans they’ve made, not to mention new loans they need to make—be they mortgages or just regular commercial loans—to keep the economy going.

No market means no value

According to SEC accounting rules, mortgage-backed securities are valued on a mark-to-market basis meaning that the value of these instruments is based on their trading value, a change the SEC instituted in November 2007. When the world became suspicious of some of these mortgages, MBS mark-to-market value fell, causing the value of these securities to fall even further, until we are at the point where there is no market thus there is no value.

Here’s the irony. The ultimate value of an MBS is the intrinsic value of the real estate covered by its component loans and 80% of those loans are solid. However, by valuing on a mark-to-market basis, instead of on, say, an assessed valuation basis, the market price of these valuable assets has been driven to zero.

Pushing the “reset” button

What’s needed to restart the credit markets is a “market maker” who will step up and take a long position in these securities, and that long position can be something conservative, say 10 cents on the dollar relative to assessed valuation. Once traders know that there is someone willing to buy, that will restart trading. Over time, these securities will begin to move toward their intrinsic value, say 80 cents on the dollar and along the way, the market maker can sell at a profit. So who should be the market maker? It needs to be someone with deep pockets and staying power…and the only candidate with those credentials is the US government. This is the crux of the use of the $700B that is proposed to be allocated. We may never require that entire sum be invested before traders feel confident that the market is back in operation, but the market needs to know we can “go deep.” And again, we stand to make a considerable profit in the process.

Making sure it doesn’t happen again

An important piece missing from the Paulson proposal, and something we should insist on, is a plan to ensure that essential credit transactions like mortgages do not cause a repeat of this debacle. Remember, we got into this mess by writing shoddy mortgages and allowing the people holding them to sell them off at a profit while passing the risk to someone else. For existing mortgages it may mean reverting to a more stable set of accounting rules, moving away from mark-to-market. For new mortgages we may need to establish a new set of rules: these mortgages CAN NOT BE SOLD, the originator must process them and live with them which will encourage originators to scrutinize borrowers more carefully and get back to reasonable terms including greater-than-zero down payments. This means the under-capitalized fly-by-night originators “The greatest deal since the history of earth...” will go out of business and borrowers will get loans from banks that will process them to maturity, just as we used to.

Summary

Basically, we need to become the MBS market maker by purchasing some of these securities at a low price to kick-start trading. This will provide capital for new credit, both commercial and mortgage, with mortgage loans under a new (actually old) set of rules that will ensure we don’t revisit this situation again. The credit markets are in cardiac arrest. Picture Paulson and Bernanke each holding one paddle of a financial defibrillator to the chest of our economy and yelling, “Clear!”

It’s time to get this done so we can get our country back to work solving the real issue of our time, our continued dependence on imported oil. If we think a one-time expenditure of up to $700B is upsetting, we should keep in mind that that is the same amount we spend annually on imported oil. Imagine what we could do if that capital was retained in our economy!

Addendum – 9/26/2008

Since my original posting of this article I’ve had a great deal of supportive feedback asking that I add to the discussion the following issues:

Executive Compensation

Much of the discussion by the team of politicians negotiating the “restart” plan are concerned with executive compensation for companies that have failed their customers and investors. This is a red herring. While I agree that underperforming CEOs should not be rewarded, relative to the many trillions of dollars at stake, a fee million is a nit. That problem can be deferred until after we get the patient stabilized. It’s like having a cardiac patient on the gurney and debating if we should trim his fingernails before applying the paddles!

Purchasing securities above market value

I have seen comments concerned that the government will begin purchasing these securities at above-market prices. When the current value of these securities is zero, it will be difficult NOT to begin purchasing above that price!

Nationalization

Some reports are claiming that the Paulson plan amounts to nationalization of the companies in trouble. Anyone who reads the document will understand that nowhere does it state we will be taking an equity interest in these companies. What’s being proposed is an investment opportunity for taxpayers—us—that will restart the credit markets and if properly executed, a nice profit for our country.

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