Thursday, September 25, 2008

Two Days of Hearings Bring Me to Two Questions

OK, its Fall of 1929 (or maybe 1888 for you total finance junkies) only this time the powers that be actually want to try to avoid the closing down of credit markets and the cascading failures of banks and brokerages. So, I have two questions. And I would really like those of you are smarter than I am about these things (and that's most of you) to tell me if I'm even close with the answers. First, rather than some stupid formulaic limit on CEO pay or dividends, why doesn't the government just put a condition on the money requiring that any money received to buy an institution's assets may only be used by the institution to make loans or otherwise do business? Second, am I missing something or does buying up mortgages and mortgage-backed securities at a deep discount almost guarantee that the Feds will make a profit?

First, the Feds could easily put limits on the use of our money and on any profits earned with our money. Limits on the use of the funds could remain in effect for the remainder of the institution's current fiscal year and its next five fiscal years (unless Congress determines that the crisis is over sooner).

The institutions get to count bailout money as good capital, thus allowing them to borrow other funds at lower rates, meet capital requirements and get a higher credit rating from the rating services. But what the institution may not do is to use the federal money or any earnings on it to determine the size of the executive bonus pool or shareholders' dividends. Don't let anyone who says there's no way to account for cash flows in such a micro level. Brokerages and investment banks do it all the time to calculate things like their cost of funds.

It seems to me that requiring the money only be used for loans would achieve the main goal of opening up the credit markets. Not allowing it to be used to calculate executive compensation would enable Congressmen to say that no one is getting personally rich on taxpayers' money (though, of course, they will but that's really the point and possibly the subject of another blog). And, for shareholders, while their dividends won't go up, the rise in the share price that will follow the improved balance sheet and increased revenues will more than make up for a lower dividend. Besides, it beats the heck out of bankruptcy or a federal takeover of the institution's equity.

Second, buying up mortgages and mortgage-backed securities at a deep discount almost guarantee that the Feds will make a profit. The Federal government's cost of funds to buy the assets is about 3 to 4% at current Treasury market rates (or even less if they just print the money). OK, so let's say they buy assets at 50 cents on the dollar. This would be a substantial premium over the mark-to-market or "fire sale" value of this garbage, so the institution will be glad to sell, but the discount below face value would leave plenty of room for the Feds to make a profit. Why? Well, despite all the gloom and doom, the default rate of "prime" mortgages (mortgages that were made to people who could actually afford to repay them) is now in the 6 to 8% range. This is two or three times "normal" default rates, reflecting the economic downturn. But that means that 92 to 94 percent of these mortgages and any securities backed by these mortgages are going to paid in full and on time. Assuming that the interest rates on these things run is the 4 to 6% range (and I think I may be low) the Feds' real rate of return will be 8 to 12%, because the paper was bought at half of face value. As for the bad paper, Fannie and Freddie can step in and renegotiate most if not all of the defaulting mortgages to rates that the borrowers can afford. Same deal with the subprime paper only more so. The dirty little secret in this crisis is that about 80% of subprime the loans are still being repaid. If you assume that the ARMs have reset to the 10 to 12% range, the Feds' rate of return could be in the 17 to 21% range (that's buying at half face value and subtracting a 3% cost of funds). As for the 20% in default let these be renegotiated to 30-year fixed rate mortgages in the 4 to 6% range, depending upon what the borrower can afford. The Fed still makes a tidy (albeit smaller) profit and the politicians can truly claim (just a few weeks before election day) that they OK'd a plan which allows borrowers duped by evil lenders to keep their homes.

So what's wrong with my "logic"? And, if I'm right, why isn't Paulson saying this, slowly and with small words so even a Senator or Congressperson can understand it?

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