Tuesday, September 23, 2008

Why We Need the Bailout & Regulations Would Not Have Worked

I wrote about the housing crisis a while back. My opinion then is the same as it is now. The banks and borrowers were the ones to blame, and they are the ones who are now paying the price. This is how capitalism works. There seems to be this opinion in the media that the overall economy is in the tank, that regulations would have prevented this, and that the bailout is not a good idea or will not work. There is also Obama saying over and over that the economic policies of the Republicans are “failed”, and that some new economic paradigm is required to get us out of this massive mess. Well, I am sorry, but the media has it wrong, and so does Obama. Let me address each issue.

Why Regulations Would Not Have Worked

I actually think regulations could have worked, and will be required going forward. The problem is the regulations that would have been required would have never been passed with the economy booming and real estate prices going up. A regulation that would have prevented this mess would have been to require a 20% cash down payment on ALL housing purchases, and ALL home refinancing. Assets could be put up instead of cash, but bottom line is the home buyer needs to be on the hook for the first 20% of value lost on a house. That’s the way things worked in the not so distant past, but things changed with this bubble. In rapidly appreciating markets the down payment requirement should be even higher (20% + ½ of gains in the last three years). There is no way in hell a regulation like the would have been passed though. That type of regulation discourages home ownership, and puts a cap on house price appreciation. It basically kills demand, which would have prevented both the rise and fall of real estate prices, averting the meltdown that we have now. At the time though, a regulation like that does not go through. It would have been fought tooth and nail. Now after getting burned bad, we may be able to put a regulation like that in place to discourage demand for housing.

In the absence of a regulation like that, and with a bubble in housing rapidly forming, the free market economy for housing in the U.S. broke down. Housing has a limited supply, and demand was very high while the bubble was forming. With high demand for housing, lending standards should have tightened. Lender fees should have increased, interest spreads should have increased. It should have become more and more difficult to qualify for a loan and buy a house, and those supplying the loans should have made a huge risk premium for funding a risky market. The opposite ended up happening. Lending standards dropped. Zero down and option payment mortgages were pushed. Liar loads were made. Basically the banks screwed up royally here in their search for profits. And the banks are now paying for this. Many banks will go under based on these mistakes and the ones that survive will lose most of their stock value. So the stock holders and employees of theses banks that screwed up will pay a huge price. This huge price should force them to not make these same massive mistakes again. Another housing bubble like this will probably not be seen far a long time (30+ years), as we will learn from these mistakes, and hopefully not repeat them in the near future.

Who Is To Blame For All This?

The blame falls equally here between the lenders who pushed risky loans without receiving an appropriate risk premium, and the borrowers who took out loans that they could not afford to pay back, and who had no problem walking away from their signed commitments when prices went south. When you factor in that the economy has been growing throughout this crisis and interest rates have remained flat as well, borrowers have no excuses for missing payments. They are not facing higher payments because interest rates shot up. They are not in general facing a horrible economy where they can’t find a job. They are simply skipping out of their obligation to repay a loan because the underlying asset value is depreciating, and they do not hold enough equity to stay in the loan. It’s the banks fault the borrowers do not have enough equity to commit to the loan, but the borrowers are the ones in default for very selfish reasons. What ever happened to personal responsibility? Since when is it OK to make a 30 year commitment to pay a loan off, and then walk away 2 years later for no real reason.

Who Really Profited From All Of This?

The media loves to beat-up the banks here, as if making a bunch of crap loans is a long term profit driver. It is not. Two classes of people profited the most from this mess.

1) Existing Home Owners Who Sold During The Bubble
Let’s face the facts here. The housing bubble artificially inflated house prices to way above what they should have been. House prices have a lot further to fall to get back down to fair value. If you owned a house and sold it at an inflated price you profited from this. I see nothing wrong with this and you simply can’t blame the home owners for booking a profit when prices were high.

2) Employees Who Made Abnormally High Pay During The Bubble
Employees of banks made a ton of money during the bubble, and were probably overpaid in most cases for this work. The extra cash they made over market rates is a bit of a windfall. I don’t have problems with the employees profiting here, as this is capitalism at work. I do have a problem with management using the bubble to pump up the stock and then cash out. Any company taking a bailout needs to void all pay and stock options promised to executives as a condition of the bailout. Ultimately these same employees and management will pay a high price. Those that held stock in their companies found there portfolios devastated. Also, many will lose their jobs over this.

Why the Bailout Is Required

I am a free market guy, so I hate the idea of bailouts in principle. This one is different. The banks and borrowers share equal blame here. If you cash out refinanced in the last 5 years you are part of the problem. If you walked away from a home loan, because the value of your house went down you are to blame. Lots of people are to blame here. It serves no purpose calling this a bank bailout, when it is an economic bailout. The simple fact is that tons of loans were made on assets with inflated values. A huge portion of those loads are bad. Housing prices have further to go down and will not see those high prices anytime soon. If something is not done, our entire financial foundation for the economy could be destroyed. The banks screwed up, the government screwed up, and the borrowers screwed up. It is time to pay the piper. We need to act fast here. We can go round and round about who is to blame, but that will not stop the collapse of our economy. The democrats do not want the bailout to go through because they require a bad economy to get elected. Obama’s platform is basically that he can get us out of the current bad economy. If the economy gets fixed do we still need Obama? So the democrats will fight the bailout, stall, and add ridiculous provisions to it to keep it from passing. The Democrats will destroy our economy so that the voters will give them a chance to fix it. That’s pretty messed up IMO.

How Bad is the Economy? Have Republican Policies Failed?

The U.S. economy is doing just fine. We are not in a recession. Q2 GDP growth was a solid 3.3%. Unemployment is at historical lows. Inflation is still pretty low. The dollar has been strengthening in a big way this year. All of this is signs of a solid economy. When Bush took over in 2000 the economy was strong as a result of the stock market bubble. The bursting of the bubble and that attacks of 9/11 destroyed our economy, but tax cuts and stimulus checks got the economy going again. Then worldwide demand caused oil to spike to $147 a barrel, causing inflation to become an issue. The fed lowered rates, a second round of stimulus checks went out, and the economy is still fine. Bush faced huge economic issues, and has navigated us through them about as well as possible. Lower taxes help the economy. Higher taxes hurt. This has been proven over and over again. Obama wants to raise taxes to fix the economy. The biggest issue with Bush is that he is a spender. He is a tax cut and spend Republican which is not good for our deficit. We need somebody to come in and cut government spending while keeping taxes where they are. So we have a president who has faced huge economic issues three times, and navigated through them with success every single time, yet the spin is that his economic policies did not work. The spin is that we need bottom up socialism in America. Give me a break.

Why The Bailout Will Work

We can either sit on our hands while Rome burns or we can try to do something about it. It seems to me that the Paulson has a plan that could work, and nobody else has a plan. The democrats will debate this to death vs. acting on anything. Obama, the thinking man, will need to carefully consider his response while the economy goes under. I trust the republicans on economic issues. Doing nothing would be a huge mistake. So if the bailout gets approved the government will buy up mortgage backed securities for pennies on the dollar. There is no market for these things right now, so as the only buyer we will have significant power. This will not cost the tax payers $700 Billion dollars. We will probably end up profiting form this just like the last time something similar was done during the S&L crisis. Mortgage backed securities are not worthless. There are actual housing assets that underlie them. Unless the value of housing in the U.S. goes to zero, the houses underlying the securities are worth something. So we jump in and pay 50c on the dollar for assets that are worth 60c on the dollar, but are only currently getting 5c on the dollar due to a lack of buyers. The government then rides out the crisis, rents out foreclosed houses, and then liquidates the assets when the housing market recovers. As a result many banks like WaMu get to stay in business, and the credit markets start to function again. Worst case, we take a bath on the assets, and the bailout costs us 100-200 Billion. When you look at the AIG bailout it is a 2 year loan with an interest rate of 11.5%. We also get 85% of the equity. AIG was not bailed out, it will be liquidated and not exist in its present form. The U.S will also profit from this bailout. Again this is not a bailout for those who profited the most (Home Owners Who Sold) from this mess. It is a bailout of our financial system so it can function properly. Many bankers will lose their jobs. and have their portfolios crumble. A few high paid CEOs profited sure, but that is a whole different issue. So the bailout will get problem assets off of the books of banks and improve their financial health enough that they can lend again. Doing nothing will just let this cancer on financial institutions fester until it is too late.

So what does the market/world think about the bailout?

As usual the U.S. is ahead of the curve on the economy. While we take action, the rest of the world watches. As a result our economy will stay strong while the world economy heads into a recession. This will cause more flights to safety in the U.S. Dollar and U.S. assets that will keep the dollar strong, even as we print dollars at a record pace. The U.S. stock market and world markets rallied on the news that we would address our financial issues. When Monday rolled around and the reality set in the democrats don’t want the economy to be good, things went south. Let’s do what we need to do to fix this problem now, that was caused by the banks and the borrowers before it is too late. I trust Secretary Paulson to do what is best.

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At 1:11 PM, Blogger Easycure said...

I usually have high optimism, but you are taking it to a whole new level.

My biggest problem is the $700 billion dollar price tag. Where is that money coming from? The are about $138 million (or so) taxpayers, so that's about $5000 per. And half the taxpayers pay little to nothing, so now we're at $10,000 per. Sorry, but that's too much.

Now, if you (or they) can tell me how the numbers work, I'd be more supportive.

Of course, this ignores the fact that the government historically blows through money at ten times the rate that a citizen would. I personally don't want them running health care, education, or Social Security. So why would I want to support this big ticket tiem?

At 10:07 PM, Blogger jjok said...

Talking to pokerwolf about your post, I have to agree with what you're saying but it still scares the piss out of me.

I think the big caveat of all of this is the unaccountability paulson would receive.

No possible investigations regarding what he does? No oversight? That's just the potential for a big scary mess to me.

At 8:39 AM, Blogger ultrajones said...

't work. Yeah yeah, because there should be a 20% down payment.... um WHAT? Ever here the concept of "premise"? I don't know where you came up with this idea that the regulation would most definitely be a 20% down payment required from buyers, but ... sir... you cannot start an argument by simply jumping to a conclusion! There are SO many ways that this disastrous bubble could have been avoided/regulated/prosecuted/managed etc. In case you didn't notice we have a HUGE deficit and an even bigger trade deficit. Asking the Fed to create Monopoly money... which that in more ways than one... see definition of monopoly... in order to "bail" us out is absolutely ludicrous. We don't need MORE credit and MORE dollars, we need our American dollar to be worth something. Adding more dollars will only continue to force Americans to use credit to buy everything that is worth anything. That sir is the whole problem in a nutshell. Are we in DEEP? Yup, sure are. But digging a deeper, wider hole is NOT the solution. It is the problem. Our economy has become based on the whims of super rich speculating bastards who own the "house" and encourage "Extraordinary Popular Delusions and the Madness of Crowds". That book is supposed to be a warning of what NOT to do in an economy, not a blueprint. Fools. We can't drill through to the other side. We NEED to turn back and feel the pain while it is still a pain we can feel without it destroying us. We owe it to our children, ourselves and the world. And we owe it to the CEO's whose flat out mission was to drive companies into the ground so they were easier to buy out, while they jumped out with golden parachutes. They are Criminals with a capital "C".

Your ideas are great if you subscribe to the way we have been doing things. If you subscribe to the way we have been doing things then you fit the definition of insanity. Yeah, that's right... doing the same thing over and over and expecting a different result. Shake it off.

At 7:51 PM, Blogger Dougist said...

Nope, don't shake, take a bow. I think you've got it just about right.

The farther away from the intersection of Wall and Nassau street the more unnecessary Treasury's plan looks. But that distance only fogs the vision of a banking system ready to fail, with massive implications for our nation.

I wrote about it here: http://dougist.com/index.php?p=36

Lets hope that tomorrow Congress will finally do the right thing and we will never have to find out if I, and ever other finance executive in New York are right about the depths of this crisis.



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