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September 30, 2008

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Jason

Even the Financial Accounting Standards Board’s couldn't figure out how to deal with the mark-to-market accounting shortly after the Enron debacle. Even the Arthur Andersen accounting firm had problems with it which led to its failure too. Enron filed for bankruptcy 2001. The Financial Accounting Standards Board’s has had 7 years and they did nothing. nomedals.blogspot.com

Theodore Seto

Dear Jason,

Could you be more specific about the difficulties you envision? We use mark-to-market in a number of places in the Internal Revenue Code. Oddly enough, taxpayers seem to have no difficulty with it when it is to their advantage.

I have no axe to grind here. What I want is a solution that works -- Republican or Democratic. Note that I have written in support of a plan proposed by a Republican Secretary of the Treasury and supported by a Republican President, even though I am not a fan of Mr. Bush. The proposal to eliminate mark-to-market was rejected by a Republican SEC Chair. If you think eliminating mark-to-market accounting and thereby allowing companies to overstate the value of their assets would help solve the problem, please explain why.

suburbancorrespondent

One question: why do businesses need short-term money to pay their employees? Shouldn't they be managing their businesses well enough to not have to borrow for day-to-day expenses? It seems to me that the real problem is an overreliance on credit.

Caleb Standafer

Why does a business need short-term money to pay employees? Products are made before the customer purchases them. In order to make the products, employees have to work, and expect to be paid. There is a lag between the time when employees must be paid, and the customer pays. For an business which is expanding, the cash receipts continue to lag the expenditures necessary for making the product. Short-term borrowing fills the cash-flow needs in the interim.

David M

Interesting but with errors. The advent of teaser rates came far earlier. I was burned in 1984 by one I took in 1982 in Houston. They had 32,000 foreclosures annually for two years. I used one to my advantage in 2000 knowing I could manage it if I was wrong on the direction of rates.

The toxic facillitator of this was the Frannies. Their lobbying took the FHLB's out of the attempt to diversify the market at about 2002-2003. Their bought congressmen block reform pushed every year by this administration and by Larry Summers late in the Clinton years.

john

Great explanation of the issue. I might also that some of these firms are in trouble because the SEC drastically lowered the amount of money that several of the failed firms had to keep on hand in case of emergency (the "haircut" they took)

To answer the question posed by the other commentors, from what i remember of my Corporations Law course, businesses are encouraged to be somewhat leveraged, meaning that they should take out loans and be in debt. I recollect that there were a few reasons for this, but one reason was so that they can be a less attractive target for a takeover. Businesses which have a lot of cash sitting around are ripe for the plundering. I think another reason was that businesses normally hope that their operations have a higher rate of return than the prevailing interest rate at which they borrow money, so they borrow as much as they can in order to produce more.

Clark Taylor

Just wanted to say thank you for this great post. I have been trying for a while to figure out exactly what the problem is that the "bail-out" is supposed to fix. This is the first source I have found that actually explains it in some detail.

Thanks!!!

Jason W

Even if the teaser rates are a huge part of the problem, you seem to discount the role played by Fannie Mae and the Democrats that blocked efforts to regulate and shrink it down to size. Would that toxic waste have spread like that if there was no implicit govt guarantee? I think not.

Buford Gooch

Nice post, but you lost a lot of objectivity with "Teaser-rate mortgages first became widespread after Mr. Bush took office in 2001." As a previous commenter points out, this was going on long before Bush. Partisanship occludes rationality.

mark l.

wouldn't it be fair to say that the rate of lending increased, as the rate of mortgages increased, and that there exists a 'lending bubble'?

Since our sytem was built on inflated lending, shouldn't I expect a decline when the lending bubble burst?

Greg Marquez

Couple of questions.
- You say: "In parts of the country, more half the homes offered for sale are now foreclosures. Banks are desperate to get those homes off their balance sheets and are dumping them much faster than the market can absorb them."
Where are these parts of the country and how many homes are invovled? As far as I can tell here in our southern California rural county that is not at all the case.

- Why didn't the banks renegotiate the loans rather than foreclosing on the loans? It seems kind of counter-intuitive unless the banks thought they could get more of their money back by foreclosing.

VRWC

This is a very good post but I have to disagree with two portions of it. The Community Reinvestment Act may have started in 1977 but it was massively expanded in 1995 and the full weight of the Federal Government and media pressure were brought onto banks that did not lend sufficient amounts of money into formerly "redlined" areas.

Banks avoided these customers because their credit was lousy, but they were accused of lending with a racist bias and threatened with penalties if they did not find ways to loan to more minorities.

The Wall Street Journal did dozens of editorials about this at the time.

And there is a direct correlation between the rise in housing prices and the expansion of the CRA. Look at housing price versus inflation charts and you will see that housing prices track inflation year after year until about 1997 when they ramp up sharply without inflation just a few years after the expansion of the CRA.

Second; Separating mortgage originators from banks is pointless. Every mortgage and refi I've ever done was written by the same independent loan broker, but his money all came from SunTrust Bank and all of his loans counted for or against SunTrusts "affordable" housing quota, whatever the government said that quota was.

William Porter

This is without a doubt THE BEST explanation of the current crisis that I've found anywhere. Thank you so much for taking the time to explain this important issue - and to do so so very well.

mongoose

While you are correct about the teaser rate and adjustable rate mortgages being a source of the problem, the primary reason that they became the source of the problem was that the Fed increased interest rates over the period from 2003-2004 through 2006-2007 by about 5 points. Most of the teaser rate and adjustable rate mortgages were tied to increases in the Prime Rate or other interest rate sensitive indices.

Personal Comment

Very informative. The posting at least describes in understandable detail what was the apparent reason for the bailout -- even why it was a bailout -- and why it was being done.

It has been pointed out but teaser mortagages existed for a long time. I think they used to be referred to as 'adjustable rate mortgages' (or ARMs) usually with low initial rates and an adjustment afterwards.

dan

Great post with two asides:

1. No one can value the 'Toxic Waste' in part because the federal government is toying with buying large parts of it at some arbitrary amount. Who would sell if they think there's a chance the Gov is going to offer a better price sometime in the next week?

2. I also agree that this anaysis doesn't adequately address Fannie Mae's and Freddy Mac's role in the crisis.

Yahonza

It does seem strange that your entire explanation (which is much appreciated) doesn't mention Fannie Mae and Freddie Mac. I was led to believe they had something to do with this mess...don't they?

JeffA

I find the partisan comments here interesting. There are too many people in both Parties at fault here for Americans to be partisan. Lending to low-income, higher risk people did not create this crisis. Selling their mortgages as an investment did. Investors gambled homes wouldn't depreciate and lost. Anyone paying attention to the automaker's 0% financing, teaser lease options, and special mortgage deals with no money down could spot a crisis was coming from a mile away, just like the internet bubble. America, if it can survive the unraveling of this debt-ball, must live within its means again. Starting with paying back the 10 Trillion in Debt by running surpluses for decades to come. Everything must come under consideration for cuts, and that mean Defense as well. Homeland Security should take precedence over a global military presence. We'll save hundreds of billions simply by bringing our troops home from Germany, Japan, Korea and Iraq.

sparky

Greg Marquez: You said "Why didn't the banks renegotiate the loans rather than foreclosing on the loans?"

The author incorrectly dismissed sub prime loans. The simple fact is that vast amount of mortgages were granted to people who had little chance of repaying them no matter what the interest rate.

I live on Long Island (NY). The foreclosures are highly concentrated in poorer areas. The simple fact is that buyers should not have gotten the mortgages in the first place. There have been sporadic news stories of people "buying" houses in these areas and never making a single mortgage payment.

Of course, the ease of mortgages in these poorer areas drove the prices up - more so than the better areas - because the houses were still cheaper than in better areas. Now many of those foreclosed properties are worth only half of what they sold for - a price that is actually closer to their true value.

Under normal circumstances these houses would be gobbled up by people looking for fixer uppers as investments and/or young buyers looking for affordable homes. However, the bad schools and high crime in these areas makes them very unattractive. When they're auctioned the bank always ends up as the buyer because the bids are so low or, in many cases, nonexistent.

seen it all

One point not addressed in your explanation (which, otherwise, is quite good) is that the provision is only an *indirect* attempt to bring back short-term credit.

In effect, the powerpointed proposal is:

(1) due to the amount of toxic waste banks don't trust each other enough to be comfortable making short term loans to each other

(2) we'll use the bailout money to buy the toxic waste for more than it's arguably worth, thereby (a) partially recapitalizing troubled banks and (b) partially removing the source of interbank distrust

(3) ...and, of course, the newly-recapitalized banks will trust each other sufficiently to go back to "normalcy" in terms of short-term lending

The gap between (2) and (3) is where a lot of the *informed* opposition of the specific bailout proposal arises from:

(1) it's not entirely implausible that the proposed bailout would remove enough toxic waste from the system to get it running smooth-enough to be worthwhile

(2) but the historical experience is mixed (japanese banks tended to take their bailout capital and sit on it; it helped balance sheets but did little to ease their credit markets over the kind of timeframes that matter for "urgent" situations)

(3) and it's not at all clear that we wouldn't be better served by a bailout that more-explicitly targeted the short-term commercial loan market

So the problems that could arise should there be "no bailout" are not in question; the fact that the actual language of the bailout is too vague to make short-term commercial lending its goal leaves a lot of us very uneasy.

I think a lot of otherwise astute observers of the crisis who support the bailout are falling into this trap:
- they do understand the problem if the credit markets seize up
- they don't think many other people understand the problem
- they can see that there's a need to do something
- ergo, they are in support of the bailout
- and, b/c most of the anti-bailouts don't mention the dangers of credit markets seizing up, they don't take the anti-bailout outlook seriously

Some of us would take the bailout more seriously if it clearly targeted restoring the credit markets, rather than having to rely on our faith in Paulson's goals.

Greg Marquez: mortgage securitization makes mortgage rewrites problematic.

The old model: you took out a loan from a local bank or s&l, and the local loan originator usually held the loan to maturity. If you needed to renegotiate the only interested parties were really you and that local originator.

The new model: you take out a loan from a local loan originator, that then sells the loan on (often multiple times!) before it is aggregated with ~1000 other mortgages and then that aggregate is sliced into what are basically different products (called tranches).

So to renegotiate a mortgage you'd now have a situation where there may be several different parties each with some ownership interest in the mortgage, and with conflicting incentives. N-way negotiations are much more difficult, and the holders of the "aggregated" mortgages (who have partial ownership interests in thousands of mortgages) may not want to set a precedent (because they are potentially going to be engaged in 100s or more such negotiations if they start allowing them).

seen it all

To clarify one thing: I was trying to keep it simple here, but made something that some might take as a gaffe.

There's several distinct steps in the mortgage aggregation process:
- aggregating into a big pool
- slicing pool into tranches
- (sometimes) dividing tranches into smaller-denominated securities

It's possible for parts of a particular mortgage to be involved in multiple tranches and additionally possible for a tranche to have multiple partial owners; both have the potential to increase the number of interested parties in a mortgage renegotiation.

DavidW

JeffA

Your comment is incorrrect

"Lending to low-income, higher risk people did not create this crisis. Selling their mortgages as an investment did."

The root of the problem is people NOT paying back money tehy borrowed.


If the mortgages were not packaged and sold as investments then there would have been no money to lend in the first place. Where do you think that money comes from? Do you think there is some magic mortgage money pot from which money to buy houses springs forth? All mortgages are an investment by someone in the borrower with the home as collateral. Fannie and Freddie with their implicit and now explicit government guarantees) subsidized a huge wash of liquidity in the mortgage business creating a housing bubble. When President Bush and John McCain in separate proposals, proposed reining in their excesses Fannie/Freddies bought and paid for friends in Congress killed any chance of that happening. They bought people on both sides of the aisle but it is matter of record who took the most.

JP

You don't really believe "the beast" has been starving for the last X number of years, do you?

And the problem wasn't just teaser loans. It was offering loans at no money down, sometimes negative money down, which makes it efficient to walk away when prices go down, even if you CAN afford to pay.

Tom Maguire

I think a lot of otherwise astute observers of the crisis who support the bailout are falling into this trap:
- they do understand the problem if the credit markets seize up
- they don't think many other people understand the problem
- they can see that there's a need to do something
- ergo, they are in support of the bailout
- and, b/c most of the anti-bailouts don't mention the dangers of credit markets seizing up, they don't take the anti-bailout outlook seriously...

Well. Some of the anti-bailout criticism does not deserve to be taken seriously.

But I would add that a lot of supporters of the bailout figure that between them Bernanke and Paulson have a tremendous amount of personal expertise as well as access to vast information and expertise.

Not that we are trusting of authority, but in this case we have experts offering a plan that *might* work opposed by critics offering not much.

The Republican "insurance" scheme was absurd - either they will only collect "premiums" (called "taxes" when a Democrat suggests it) from bad bonds, in which case where does the money come from, or they slap an ex post tax on good, performing bonds. Why is that fair and non-intrusive?

And Nancy Pelosi's vision of a world in which everyone in default on their mortgage was a victim requiring government assistance was hardly one that would encourage people to borrow responsibly and pay their bills. Quite the contrary, in fact.

Removing some of the toxic waste might unclog the system and encourage private capital to re-enter the financial services system. If not, its on to Plan C. Or D. Or whatever - we have 26 letters before we even get to numbers.

Celebrim

"One question: why do businesses need short-term money to pay their employees? Shouldn't they be managing their businesses well enough to not have to borrow for day-to-day expenses? It seems to me that the real problem is an overreliance on credit."

Bingo.

We've taken out debt based on expectations of a certain amount of economic growth (personally and collectively). That economic growth didn't materialize. Lots of prices inflated at rates faster than the economy was really growing. It was all illusionary growth in wealth. To cover our loses, we took out bigger debts based on other promises of future growth and the past illusionary collateral.

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