Market commentators and political talking heads find themselves in a pickle these days given that strange cops like Jon Stewart have surfaced. So they are watching what they say and the dilemma is how to ask people to spend money to stimulate the economy and at the same time talk about the reckless living that got us into trouble in the first place. While it is entertaining to see Obama and his staff balance the politics of sounding responsible and encouraging spending at the same time, I don't think this dance is needed.
Just ask people to save and that will stimulate the economy just as well if not better. Let's take a closer look at what saving does. Assuming we are not going to the mattresses yet, a basic saving act is to fund your checking account. So what does this do? It capitalizes your bank. Your bank has more assets. When banks have more assets, inter-bank lending rate goes down. When these rates go down banks are getting money for cheap so they are willing to lend for cheap and interest rates on loans go down. Given a 10 to 1 reserve ratio, the banks can lend out 10 times what you gave them. When this happens investors and entrepreneurs who have worthwhile projects capitalize on the availability of money at low interest rates and execute their projects. These projects create jobs. These jobs create income and this income creates the spending that you want. It’s all about jobs. If people feel safe in their job or see availability of jobs they are going to spend.
This kind of stimulation I would argue is better than "spend baby spend". Spending rebate checks has only intrinsic value. It has no time value and it does not leverage the 10% reserve ratio. On the other hand, saving grows the economy for all by making the pie larger. I'm convinced that despite all the spend talk, savings will grow. Bank deposits are showing growth and at some point two things will happen. First, banks will look more profitable and people will start buying Financial stocks again and secondly, banks will lose the fear of being able to raise capital and will start lending more freely.
So, let's in no way delude ourselves that by saving we are hurting the economy. Take that check to the bank. It’s good for you, it’s good for everybody.
Sunday, March 15, 2009
Tuesday, March 10, 2009
Fake Problems And Solutions That Make Them Real!
What frustrates me most about the lending nightmare we are going through is that there was no real problem to begin with. Allow me to explain.
When you buy a house with a mortgage there are two distinct assets - not one. One is the house you bought and another is the mortgage document itself. Why is that the case? The house is your asset and the mortgage paper is the banks. So what's the connection between these two assets? If the mortgage asset ever gets into trouble the house asset is the collateral. That's all. The house is the secondary asset. It does not get into play unless the primary asset of the mortgage is in trouble or "non performing".
So who does the mortgage perform for? When you pay a mortgage it does two things - principal reduction and interest payment. Principal reduction is yours and interest payment is what the bank shares with the investors. What investors? They are a block of people who bought small pieces of rights to your mortgage's performance. This means when you pay your mortgage and the interest gets collected on time, these investors get paid a portion of that profit. This enables banks to not have to wait the term of the loan to get their money back and benefits all in the game.
So what happens if the house forecloses? The primary asset now becomes non functional as the bank is not getting any money. The investors who bought rights to the proceedings from the primary asset lose. This should be fine given that any investment has a certain risk. The secondary asset which is the house is now possessed by the bank. The bank auctions the house and typically recovers about 65% of its market value. The investors get no share of that as they don't own any rights to the secondary asset. So this is the key point where we introduce the first aspect of fakeness of the current problem. Given that the investors have nothing to do with the house asset itself why should the fall in home values affect investor returns? It should not.
Now let's look at a performing loan. Even if the home value goes down the borrower is still required to pay back the money he borrowed. The asset value of the loan is disconnected from the asset value of the home. This is the protection that investors had, making these investments quite immune from the trends of the housing market and hence quite safe.
So in both the performing and non-performing case the investor's returns and the house value per se are totally disconnected.
So what happened? Why the trouble? Why did these assets become toxic? There's a law on the books called "Mark to Market". This means that if you hold an asset, the book value of that asset should be what someone will pay for that asset in the open market TODAY. Note that we are not talking about the house asset itself but the mortgage paper asset. The banks were required to mark the mortgage paper asset value based on the current value of the underlying secondary asset. This is an error. As we have seen before this underlying asset is completely disconnected from the investor's returns and investor returns truly dictate the value of the paper asset that the income is generated from. Using the collateral to value the primary asset is the same as treating all loans as failures given that that's only when the collateral is in play. So in a depressed housing market even the paper assets for the performing loans are written down in value making the banks seem lot more insolvent than they really are. So if you never understood how a small percentage of foreclosed homes caused this calamity - this is how.
Now let's talk about the second aspect of fakeness. When a house forecloses the asset that's really toxic is the house itself - if you believe mold harms you! The condition of the houses - many of them are deplorable. So to suggest that a foreclosed home causes your home value to go down is for the most part pure nonsense. First, the quality of your home makes it market ready. The quality of the foreclosed home is not market ready. An asset that's not market ready simply does not have a market value. Home value appraisers are required to use comparable sales. A comparable to your house would be similar homes that sold under non-distress conditions called "orderly" or "arms length" transactions. Even if you place the quality argument aside, the foreclosure was not a "sale of free will" and hence not a valid comparable and hence cannot establish or impact the value of your home. What if the foreclosed house is in a really good condition? Well, buy it!
If you are with me that these problems are fake, then let me share with you what scares me the most: Obama's solutions are making these problems real. Let's look at the parts.
First the part about allowing homeowners who are paying their mortgage to refinance if their house is "underwater" meaning they owe more than what the house is worth. What would happen if you require banks to modify these loans? You would cause the paper asset to be valued based on the underlying secondary asset making the application of mark to market no longer an error. It would transfer the toxicity of the home (the mold) to the paper asset and investors will flee for sure.
The second part is reducing monthly payments to 31% of borrower's income even where borrower has shown no signs of delinquency. Note that the investor's returns are based on the cash flow that the bank gets every month. Reducing that reduces returns and so now legitimately reduces the value of the paper asset generating the income - again transferring the toxicity.
Third, investing hundreds of billions of dollars in Fannie and Freddie has allowed them to basically monopolize this lending market. Newly released Fannie Mae guidelines require appraisers to not exclude foreclosures as they compute market value for your non-moldy home. So now if your neighbor could foreclose you are better of allowing Obama to bail them out with your tax dollar. What do you value more - your home value or your tax bill?
Normally I would be comforted by the profit motive of the banks to not make stupid moves regardless of what the government wants. However, seems like the smart bank leaders if they ever existed have long gone and the profit motive these days is to get more bailout money. That with the incentives for services in Obama's plan we may actually see this fake disaster really explode.
When you buy a house with a mortgage there are two distinct assets - not one. One is the house you bought and another is the mortgage document itself. Why is that the case? The house is your asset and the mortgage paper is the banks. So what's the connection between these two assets? If the mortgage asset ever gets into trouble the house asset is the collateral. That's all. The house is the secondary asset. It does not get into play unless the primary asset of the mortgage is in trouble or "non performing".
So who does the mortgage perform for? When you pay a mortgage it does two things - principal reduction and interest payment. Principal reduction is yours and interest payment is what the bank shares with the investors. What investors? They are a block of people who bought small pieces of rights to your mortgage's performance. This means when you pay your mortgage and the interest gets collected on time, these investors get paid a portion of that profit. This enables banks to not have to wait the term of the loan to get their money back and benefits all in the game.
So what happens if the house forecloses? The primary asset now becomes non functional as the bank is not getting any money. The investors who bought rights to the proceedings from the primary asset lose. This should be fine given that any investment has a certain risk. The secondary asset which is the house is now possessed by the bank. The bank auctions the house and typically recovers about 65% of its market value. The investors get no share of that as they don't own any rights to the secondary asset. So this is the key point where we introduce the first aspect of fakeness of the current problem. Given that the investors have nothing to do with the house asset itself why should the fall in home values affect investor returns? It should not.
Now let's look at a performing loan. Even if the home value goes down the borrower is still required to pay back the money he borrowed. The asset value of the loan is disconnected from the asset value of the home. This is the protection that investors had, making these investments quite immune from the trends of the housing market and hence quite safe.
So in both the performing and non-performing case the investor's returns and the house value per se are totally disconnected.
So what happened? Why the trouble? Why did these assets become toxic? There's a law on the books called "Mark to Market". This means that if you hold an asset, the book value of that asset should be what someone will pay for that asset in the open market TODAY. Note that we are not talking about the house asset itself but the mortgage paper asset. The banks were required to mark the mortgage paper asset value based on the current value of the underlying secondary asset. This is an error. As we have seen before this underlying asset is completely disconnected from the investor's returns and investor returns truly dictate the value of the paper asset that the income is generated from. Using the collateral to value the primary asset is the same as treating all loans as failures given that that's only when the collateral is in play. So in a depressed housing market even the paper assets for the performing loans are written down in value making the banks seem lot more insolvent than they really are. So if you never understood how a small percentage of foreclosed homes caused this calamity - this is how.
Now let's talk about the second aspect of fakeness. When a house forecloses the asset that's really toxic is the house itself - if you believe mold harms you! The condition of the houses - many of them are deplorable. So to suggest that a foreclosed home causes your home value to go down is for the most part pure nonsense. First, the quality of your home makes it market ready. The quality of the foreclosed home is not market ready. An asset that's not market ready simply does not have a market value. Home value appraisers are required to use comparable sales. A comparable to your house would be similar homes that sold under non-distress conditions called "orderly" or "arms length" transactions. Even if you place the quality argument aside, the foreclosure was not a "sale of free will" and hence not a valid comparable and hence cannot establish or impact the value of your home. What if the foreclosed house is in a really good condition? Well, buy it!
If you are with me that these problems are fake, then let me share with you what scares me the most: Obama's solutions are making these problems real. Let's look at the parts.
First the part about allowing homeowners who are paying their mortgage to refinance if their house is "underwater" meaning they owe more than what the house is worth. What would happen if you require banks to modify these loans? You would cause the paper asset to be valued based on the underlying secondary asset making the application of mark to market no longer an error. It would transfer the toxicity of the home (the mold) to the paper asset and investors will flee for sure.
The second part is reducing monthly payments to 31% of borrower's income even where borrower has shown no signs of delinquency. Note that the investor's returns are based on the cash flow that the bank gets every month. Reducing that reduces returns and so now legitimately reduces the value of the paper asset generating the income - again transferring the toxicity.
Third, investing hundreds of billions of dollars in Fannie and Freddie has allowed them to basically monopolize this lending market. Newly released Fannie Mae guidelines require appraisers to not exclude foreclosures as they compute market value for your non-moldy home. So now if your neighbor could foreclose you are better of allowing Obama to bail them out with your tax dollar. What do you value more - your home value or your tax bill?
Normally I would be comforted by the profit motive of the banks to not make stupid moves regardless of what the government wants. However, seems like the smart bank leaders if they ever existed have long gone and the profit motive these days is to get more bailout money. That with the incentives for services in Obama's plan we may actually see this fake disaster really explode.
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