Rand Paul on Civil Rights - A Simple Mind

Rand Paul states that he's vehemently opposed to racism practiced by government institutions but argues that private institutions should be allowed to be segregated if they so choose. He states that he himself will never part take in such an institution but nevertheless its not government's place to dictate. He further claims that this discussion which was settled about 60 years ago is an intellectual discussion to bring back into the fore.

At the onset I must state that this is not an intellectual discussion but that of very simple minds. That stated, I allow myself to wallow in mud...

This simple idea of defacto equality which is to say that if white institutions serve whites and blacks do blacks, then things are still equal misses a fundamental albeit simple point: numbers. There can't be defacto equality unless there's equality in numbers. A business that caters to whites who are the majority is still a viable business. A business that caters to blacks only intrinsically suffers from fewer patrons as blacks are in the minority. A white, as business owner doesn't have to think hard to place a "No Black" sign but it isn't a simple thought process for the "equal" black business owner. This is the basic economics of supply and demand. This inequality in numbers will lead to - in an ungoverned system - blacks serving whites while tolerating not being served by whites.

The reality of the day is that segregated communities are very common in today's America and statistics do show that properties in minority neighborhoods are valued below comparable properties in white neighborhoods even if they are truly comparable in proximity to amenities, existence of schools at par, similar crime rates and economic opportunities. The reason is again simply numbers. A home in a minority neighborhood by its lack of appeal to whites is simply under minority demand and therefore less in value. A home in a white neighborhood does not suffer from a similar lack of demand as its available to the larger pool. Values go down on sale and go up on a buy. So very simply, the value did go down but not due to the proud black man who's buying in but the prejudiced white man who's selling out.

Without government interference minority economy will suffer from lack of white participation if comparable services are offered exclusively to them at comparable prices. That's the substitution principle. A closed minority economy on the other hand is simply unsustainable due to its minimality and therefore blacks will be dependent on whites.

None of the above discussion is beyond simple math and so not an intellectual discussion. Rand Paul's presentation of this as an intellectual discussion is simply a cloak to get people into a frame of mind where they feel that discussion of this topic is fair and un-hurtful in civil society much like what the President of Iran is trying to do on the topics he wants to discuss.

Finally, Rand Paul repeatedly states that he's offended by the long practice of discrimination in the south and would have loved the opportunity to walk with Martin Luther King Jr. He's so abhorred by institutional racism that was perpetrated for so long by the government. So one question is fair to raise then, will he lead the charge in passing a constitutional amendment apologizing for institutional racism? If he does that then perhaps his black patients will forgive him for being seen only on 'whites church day'.

The False Choice between Spending and Saving

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.

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.

Analyzing Obama's Foreclosure Prevention Plan

The fact sheet on the foreclosure prevention plan released by the Obama Administration is at http://www.treas.gov/initiatives/eesa/homeowner-affordability-plan/FactSheet.pdf. In this post I'm providing an analysis of this plan but will stick to the ones that are in sufficient detail.

The first proposal of providing low cost refinancing to responsible borrowers is to appease everyone who's probably going to be upset with the rest of the plan and I'll get to this in a minute. It is interesting however that this non-problem area is the first thing that's addressed in the plan. The “I come in peace – wink wink” approach.

The second proposal is the real meat and so let's dissect this. This is basically very much like a 401K plan where an employer matches up to a given percentage of the employee's contribution. If the bank is willing to reduce the mortgage down to 38% of the borrower's income (net or gross is not specified), then the government will pitch in and match dollar-to-dollar a further reduction down to 31%. Seems like everyone's got skin in the game.

Let's do some numbers based on the median income of about $45,000. Let's also say this was the kind of borrower who bought too much house, say 10% more than the 38% mark that the bank is now required to bring it down to. That would make it 48% of his income and a loan payment of $1,800 a month. This is equivalent to a loan amount of 250K. For the banks to bring this down to 38% that would mean a payment of $1,425 a month or a loan amount equivalent to 200K. So the bank has to take a 50K loss before they qualify to play the match game. This game would cost the bank an additional 20K and the government 20K. The total loss for the bank is 70K netting the bank 180K. Assuming this borrower had put 10% down then this house was worth $275K when the loan was made. Assuming the bank can get 65% in a foreclosure auction that would have net the bank about 180K. So that's a wash.

About the incentives to servicers: There seems to be an attempt to make them do the right thing by giving them more rewards if the borrower stays current but given the $1000 fee for just doing the initial rewriting, most servicers are going to consider the rest gravy and simply try to pile people on to the rewriting wagon. We all know how aggressive servicers can get. The up to $5000 incentive to borrowers is something that should upset the tax payer. Is bailing them out not good enough an incentive to these borrowers?

Now, let’s talk about the ‘refinance for all’ proposal. In short this will allow people to waive the 80% LTV requirement for refinances and benefit from the low interest rates. Let's do some math again with the median income albeit responsible borrower this time. She would have purchased a 200K home with 20% down and a mortgage of 160K. If her property has depreciated 10% since she bought it now she can get a loan for 180K lowering her skin in the game by 50%. Wasn’t over-leveraging the systemic problem to begin with? We have taken a responsible borrower and made her a potential bailout risk.

Finally about investing $400 billion in Fannie and Freddie: Do the MBS investors really care if the reason their returns are down is due to the foreclosures not generating cash flow or due to these newly negotiated lower payments? Each of these mortgages is structured such that out of the payment made by borrowers, the investors get steady returns. If those payments are going down, so must the returns. So not sure, if lowering the attractiveness of MBSs to the investors and sinking an additional $400 billion into the same vehicle in the same proposal is a wise thing to do.

The Myth of the American Job

Understandably these days you hear this a lot - American Jobs for American People. American People is defined by the constitution but what's an American Job? Is that a job that's at an American company? Okay, so what's an American company then? Is that one that is physically located in the United States? Like BMW or Nokia or IKEA? That doesn't sound right? So is it one that has a US mailing address registered with the government for tax purposes? That would make Haliburton - our largest defense contractor - unamerican. So what is an American company? We have to be able to define this to define an American job.

A reasonable definition might be - an American company is one that has most of its operations in the United States. By operations we mean they produce in the United States by employing Americans and they sell to Americans. So let's look at some giants then. Take GM - the mother and apple pie American company. Their plants in China have come under a lot of scrutiny but what about their global sales. GM sold more cars outside the United States than inside the United States in the last several years. 64% of sales was in foreign markets in 2008 and 59% in 2007. By our definition then GM is no longer an American company and hence their jobs no longer American. Well, GM simply has to be American and so may be our definition is wrong. Selling in other countries don't count - they don't make a company unamerican. Okay but why not? We want to protect jobs in GM plants from being outsourced but selling GM cars in other countries and thereby taking a bite of their production and displacing their jobs doesn't raise an eyebrow? I think I'll stick to my definition and declare GM unamerican. Let's move on.

And we are moving on to the housing sector. The good old construction jobs that the illegal immigrants are stealing. They should be good American jobs. Okay, so why is Iceland and Norway upset at us now? Oh, they bought a bunch of CDOs - those notorious derivatives of mortgage backed securities that are not worth the paper they are written on now. Foreign money was responsible for about 40% of the liquid capital that caused the housing boom and kept those good American jobs afloat. So may be those illegal immigrants did not get their fair share - after all they were not 40% of the entire housing market's job force - the builders, the brokers, the bankers, the realtors - were they?

How about good old "neither snow nor rain..." government jobs? Are they American jobs? What's that? China owns our debt? 25% of our debt is owned by foreigners and of that 40% is owned by China and Japan. Raising the FDIC insurance to $250K caused a run on foreign banks that funded our banks. What does all this mean? It means that the RMB and the Yen are paying a portion of our mailman's salary.

So, if you work for a large corporation with sizable foreign revenue, or if you work in the housing sector or if you even work for the government your job is not as American as you think it is. So ask yourself these questions. Do I not want my company to capitalize on the global growth but deal only in the saturated United States market? Do I not want the US dollar to be the reference currency of the world? Do I not want foreign investments in US banks making credit available to US borrowers? If you answered "No. I do not", then you have the right to an "American Job".

The point here is not to be heartless but it is in our hardest times that we must not shy away from the truth. We are intertwined beyond recall on this spec of dust in the universe and we must find global solutions to our real problems not succumb to political rhetoric.