Buying Time...

by Richard K. Brawn, CCGA, MPA | September 29, 2008

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The Pied Piper is waiting to see what is under the shell that Secretary Paulson is lifting…very, very slowly.

In the Senate Hearings on Tuesday, did you notice what happened when Secretary Paulson was asked if the urgency was being dictated by the housing market or the Credit Default Swaps? He assiduously avoided even using the word Credit Default Swap in his answer. That kind of answer lets the cat out of the bag. Credit Default Swaps are the real reason for needing $700 billion. Housing is serious but it is a cover story. Of course the economy will be constricted if housing continues to lose value. But as I pointed out in the past, collateral behind loans is irrelevant as long as the loan is being serviced/paid. Certainly, loan defaults are evidence that people will not spend, and therefore business will not spend because people are not buying, etc. That is a believable cover story but not a $700 billion story. The counter argument is that housing will go down until house prices reach equilibrium with wages. Those with long term experience in real estate know that home buyers are at their statistical limit when around 33% of their income is spent on housing. We went miles beyond that limit. The $700 billion does nothing to increase wages so housing can be afforded. Surely government should insist that banks stop paying dividends before the government bails them out. So while declining house prices will wipe out a lot of paper capital just like the dot com bust did, it is not the real worry. What really worries Paulson and Bernanke is that the government has no mechanism to handle a CDS default debacle.

Here is the deal.

Libor rates are now at 3% or slightly higher on 3 month borrowing. If you can pay, you can borrow. What has really happened is that those with capital are refusing to lend at rates set by the government that does not allow for a risk premium. I would not lend my money at rates set by a political institution like the FED or the ECB or any other institution. I will lend money only if I can cover my risks. The advent of Credit Default Swaps (CDS) allowed money to be lent at central bank rates because the product allowed risk to be close to zero. That kept Libor rates with CDS insurance near the no risk category. What nobody seems to have realized is that the CDSs are like a balloon payment. The payment is the risk premium all saved up until the underlying financial instrument defaults. The CDS market skimmed the risk premium and did not use it to set up a float. Now the FED and Treasury realize the balloon payment is coming due as the CDSs are called. So, as the housing market declines the Pied Piper has been tendering the CDSs, armload after armload. People with capital to lend are not accepting CDS insurance in lieu of real risk premiums.

Let’s go back to the FED and the housing market.

The suppression of interest rates by the FED in order to keep the housing boom going juiced the entire economy. It was a full voiced echo of the era prior to the Dot Com bust. Back then, the sales pitch was that cell phone companies would make tons of money in countries that lacked land line infrastructure. The cell phones would increase productivity and thus increase GDP by X% which would boost sales of cell phones by many times the GDP increase. The CDS sales pitch was also a theory. It theorized that the transfer of risk of default could really happen and just like the theory that cell phones, low cost money would increase GDP by X%. This theory was convenient to the government policies of pumping up the economy and magnified by the artificially low interest rates used by the FED. Why was this not seen? Let’s not forget that the people making the government decisions had no experience in real estate. Take Alphonso Jackson, Secretary of Housing and Urban Development as an example. He had virtually no knowledge of commercial real estate. His knowledge was so slim that he wanted to eliminate staff real estate appraisers from the HUD staff reviewing FHA loans. But those who knew real estate were well aware that 30% of a family income is all that can be used to service a mortgage if default rates are to be kept manageable. Beyond that point, risk increases exponentially. The rating agencies added to this euphoria by conveniently failing relate risk to income.

So now, the Pied Piper is showing up. Capitalizing the gap between the 30% of income that people can pay with low default rates and the rate allowed by regulators adds up to a huge capital loss. Then there is the balloon payment of all the CDSs that covered not only the real estate losses but losses in businesses that would be susceptible to an economic downturn. Not only does the cost of that government economic policy have to be paid, the government faces tax reductions that will come with a recession.

Compounding that already severe problem is that those who issued CDSs are not insurance companies. They lack of a float that normal insurance companies are required to have. An insurance float is a redundant investment pool that can be used to pay off claims. Lack of a float for Freddie and Fannie allowed that insurance to be used to goose their margins. But it left them having to pay losses from operating income. They could not do so the government had to put them into receivership (and make good on all future losses).

Cascading Effect

The glut of foreclosures is occurring for two mutually reinforcing reasons. First, buyers cannot service their loans. Second, too many foreclosures on homes caused housing statistics to show a generally declining value. For people who would otherwise keep up their payments, the fact of being underwater is a good incentive to exercise the option to walk away.

The follow-on is that the foreclosures are precipitating liquidation of financial assets in order to pay off mortgage insurance policies. Like Freddie and Fannie, the sellers of CDSs are not true insurance companies and have no significant float. In some instances all they have to back up the CDSs they issue is their profit margin. (When profit declines, so does the capitalization. And that sets up yet another vicious cycle.) Beyond simply housing there are all sorts of financial paper insured the same way.

If the economy goes in to recession TOO quickly, the issuers of the CDSs will not be able to divert assets quickly enough to generate the cash to pay their obligations. That is what happened to AGI. The scale of the defaults is already overwhelming banks and that in turn is overwhelming the financial markets with asset sales. The euphemism used for this is “de-leveraging ”, a nice neutral term that totally misleads about the losses such sales entail. Remember buyers are not leveraging up to compensate for all the sales. The combined losses are forcing circumstances that substantially increase the probability of bankruptcy for the CDS issuers. If only 10% of the CDSs had to be paid off, it would cause the liquidation of several trillion worth of assets. Not only would a minor contraction like that be catastrophic to the financial system, but the complexity of the organizations involved would completely clog up the bankruptcy courts. This is where the trouble is that Paulson and Bernanke desperately want to forestall.

The Real Fear

Facing bankruptcy, insolvent issuers of CDSs would simply to duck into court for a Chapter 7 or Chapter 11 bankruptcy. But the mess that would cause would be incredible. The corporations are multinational and subject to different politics and different laws. The same situation in different countries will give different outcomes. This would cause all sorts of international strains that would surely result in serious economic damage to international trade and financing of the US debt. In the meantime, the perpetrators (the top echelons of the FED, Treasury, the Department of Housing and Urban Development, the Congress, and the corporate executives) are all walking away with the booty they gleaned over the years. Exposure of this in the face of the human grief it would cause might easily result in homegrown revolutionary activity.

The government would face a total breakdown of the financial system for which it is unprepared. For example, there is no other check clearing system but through banks. The government is broke except for its ability to tax and print money. With a failed financial system, taxes would dry up leaving only horrendous debt against which the full faith and credit of the US would be pledged.

Evidence available to the Treasury and the FED screamed that this was happening. So this scenario is the basis for a call for a $700 billion bailout. The bailout is intended to somehow get a mechanism set up to deal with the collapse of the Credit Default Swaps and maintain operation of the simple things like money flowing into personal accounts, check cashing, and paying off credit cards, etc. Horrendous as collapse of the collateralized debt obligations and housing prices may be to the capital markets, the damage would be nothing compared to the mess that would occur with the collapse of the financial system. The $700 billion and the flexibility requested by the Treasury Secretary is money needed to cover losses accruing from the housing debt debacle, and somehow create sufficient time and circumstances that would preclude this creating unmanageable losses to insurers of CDSs. They desperately want to allow time for the CDS issuers to raise rates, get rid of some of their obligation, and do everything else necessary to stay out of bankruptcy until the government is ready to handle such an event. That is what I think the $700 billion is really for.

 

Copyright © 2008 Richard K. Brawn
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Richard K. Brawn, CCGA, MPA | Petaluma, CA USA | Email
California Certified General Appraiser (CCGA) | Master Public Administration (MPA)

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