Nathan R. Jessup

TARP Alternative By Lt. Daniel Kaffee (Guest Author)

In Congress, Finance, Government Lies, living free, Obama, Socialism, US Senate, World News on February 3, 2010 at 3:27 pm

A refreshingly unique perspective by Lt. Daniel Kaffee. Daniel Kaffee, a life-long friend,  has an extensive background in finance and will be guest-authoring at the Raw Deal from time to time. I am honored to share his practical insights with you, my loyal reader.

Key Facts & Assumptions

◆ The TARP has been an unabashed disaster, and must be subject to a redirection and reallocation of resources in order to more effectively stabilize our economy in the long run, not just a focus on ‘tomorrow’.

◆ The high level solution is decentralization of the financial system, like the tech industry, which will lower systemic risk, foster competition and yield better ideas, services and companies. In order to alleviate the current financial market problems, it is important to understand and address the root causes – not just the symptoms and peripheral issues. Topics such as executive pay, bonus schemes, mortgage application fraud, regulatory fraud, credit derivatives and investment mis-selling all need addressing in time, however the primary concern for now must be to stabilize the global financial system and have it reopen for business.

◆ TARP does not insure that those banks and brokers that receive bailout aid will increase lending. There has been no discernible nor measurable uptick in consumer or B2B lending since the advent of the TARP program. The reality is the market is hoarding liquidity and these banks are doing the same. More importantly consumer lending has been a small, often insignificant part of their business. They made money by trading and through securitization of debt. We are talking about a seismic shift in the business model of multi-national institutions, and this will not happen over night. Banks must be viewed on the same plane as utility companies – not mega-centers for corporate profit. They have generally become massive trading houses and hedge funds with a small consumer-deposits component allowing them ready access to a cheap source of capital.

◆ The Wall Street model of securitization and extreme leverage is obsolete. Big banks and brokers made most of their earnings over the past several years in trading, not consumer lending. And now their derivatives are THE problem. Derivative devaluation does not directly affect the general public except for reducing the bank’s capital position to the point that they’re unable to lend. We must segregate the derivative write-downs from the portion of the bank subject to regulatory capital requirements.

◆ There is a fundamental lack of liquidity in financial markets as too many assets (bonds) are looking for long term homes. There is no single solution to this problem however a number of different processes can aid in freeing up markets. A central mandate of any government action must be to encourage private sector price discovery, without the crutch of a Federal Reserve or Treasury backstop or guarantee. There is a price at which buyers and sellers will conduct business. We must expedite the discovery of that price, not hinder it.

◆ Many home owners paid too much for their houses. Time, inflation and economic growth will eventually solve this problem as long as markets are stabilized and we prevent massive forced foreclosures and liquidations. Efforts to ‘prop up’ home prices are misguided, and we must return to historical levels of wage-to-price ratios, and price-to-rent ratios. Robert Schiller has published ample material about where housing prices should be and will likely stabilize – the question is simply how much money will we burn trying to prevent the inevitable from occurring?

It is necessary to create a new system parallel with the existing dysfunctional system in order to mitigate the inevitable economic and financial damage and to facilitate, as seamlessly as possible, the transition to a functioning financial system or new model of credit and banking. One hundred billion dollars of capital plugged into the balance sheet of Citigroup in order to offset declining derivative valuations would be far better spent capitalizing a New Bank with a clean balance sheet to step into the lending space Citi would have to vacate.

◆ TARP’s objective is akin to ‘saving everyone’, including financial institutions that the Government should triage, break up, and sell off to healthier institutions. The methodology is tantamount to bailing out Univac, Digital Equipment, etc, in the eighties, which would’ve retarded the development of Dell, Microsoft, Intel and other nascent technology companies.

◆ It’s wasteful & foolish to put more money in an obsolete non-functioning system. Warren Buffett is quoted is saying “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks”. This quote is prescient in light of our current course of action ‘plugging leaks’ at rickety financial institutions.

◆ If you want to get money to the consumer: the less middlemen, the better.

Steps Pertaining to Banks, Accounting & Recapitalization

◆ Directly recapitalize banks by the US government allocating $250 Billion into a plan for local and community-type banks to increase capital in partnership with the government.

◆ The government would match existing or some percentage of existing bank capital. Place a limit of $500 million per bank. This brings this plan home to “Main Street” and eliminates the perception of this bill as a “Wall Street” bailout. This would create $2.5 trillion of credit and lending power at conservative 10 to 1 leverage, or approximately $5.0 Billion of new lending power per bank that is eligible for the maximum contribution.

◆ Only banks that meet some pre-specified metric, such as a Texas Ratio of 50+, are eligible.

◆ Give the banks a tax rate of 15% on consumer and commercial lending for 5 years and the right to buy out the government shares at some premium.

◆ Immediately reduce dividend payments on common shares and possibly even existing preferred shares to .01 dollars for participating banks. This will lead to a significant ‘recapitalization from within’ of thousands of financial institutions. By maintaining a miniscule dividend payment institutional investors, pension funds, and many mutual funds will not have to dump the shares as they would if dividends were eliminated entirely. The 20 largest banks pay out over $40 Billion per year in dividends. This amount redirected towards capitalization would be significant.

◆ Allocate $100 Billion towards the seeding of mutual banks. The US government would contribute money to 435 new banks (say $250 million to each), one for each congressional district, with the provision the government’s stake could be bought out at 1.5x what it put in. The government would have a preferred dividend of 3 month LIBOR plus 5% or so. See Addendum A for a detailed description of this plan. The employment opportunities generated by this bank seeding would be significant.

◆ Allow banks to create very tightly regulated Special Purpose Vehicles to enable holdings of specified securities to be accounted for using standard credit techniques – not securities market valuations. These SPV’s remain on balance sheet and securities transferred into them stay there.

◆ Valuation for the aforementioned SPV’s is linked to default rates and expected losses given default of the actual loan pool. An independent body needs to be established to provide valuations of these securities and mandated loss provision requirements to the holders, and these marks will apply to all banks participating in the program. The owner of an asset must reflect actual losses that have occurred from foreclosure and liquidation and make provisions for loans currently in default.

◆ Rescind the 2004 Order allowing leverage greater than 12:1 for financial institutions. Mandate a 12:1 leverage cap for all financial institutions that take consumer deposits or make consumer or commercial loans, to take effect within 180-270 days. Force these institutions to reach this 12:1 leverage cap by selling their toxic assets within 180 – 270 days via a FDIC. The FDIC will be the Auctioneer but will not bid for assets. Suspend regulatory capital requirements for a specified period of time for any ‘bad bank’ spin-offs that these lending institutions will require in order to comply with this order.

◆ To help the big banks, allow them to create a Consumer & Commercial Lending Facility with the 15% tax rate benefit. This should entice private equity and sovereign funds as well as Wall Street remuneration that was garnered over the past decade or so.

◆ Immediately enact legislation reversing the decision to forbid Private Equity (and SWFs) from buying more than 20% of a bank w/o submitting the whole firm to regulation as a bank holding company. That should be waived to allow more private capital to flow into the system.

◆ Prohibit trading, especially derivatives, in Consumer & Commercial Lending operations. Pure hedging would be allowed.

◆ In order to ease liquidity problems we need to create ‘homes’ for the pool of securities currently clogging up financial markets. Allow for the creation of tax exempt, retail and institutional closed end Exchange Traded Funds to purchase these securities with maximum allowable gearing of 3 to 1. The funds purchase these securities in the secondary market. Income and capital gains are tax free, however investors will wear the burden of any losses, which will be tax deductible. Those that have behaved prudently and saved can benefit from these investments, rather than just footing the bill from tax payer bailouts. These will be ‘one-off’ closed end funds.

◆ Create standardized CDS products that trade on an electronic exchange. All non-standard CDS products should be liquidated in the OTC market or swapped into standardized CDS products prior to the commencement of the new CDS exchange. The exchange will commence within 180 – 270 days. This is currently in process, with multiple exchanges and broker/dealers involved in its creation.

Pertaining to Housing, Foreclosures & Real Estate

In order to halt the continuous downward spiral in property prices and social disruption from foreclosures the process needs adapting. A form of the 30/20/10 proposal by Barry Ritholtz of Fusion IQ should be adapted. This is a far superior solution to the ‘cram downs’ that is currently being proposed in congress, and should garner substantial support in lieu of the alternatives being proposed.

To understand pricing of homes prices in a historical context, we need to consider several different metrics. Economists traditionally employ a variety of ratios to compare where housing prices are relative to traditional pricing and affordability measures. The most reliable of these look at the ability of a purchaser to service a mortgage via salary, forming a ratio of annual median income to median home prices. This can be analyzed nationally, or on a region by region basis.

Yet another methodology compares the cost of purchasing a house versus the cost of renting a similar house. Numerous other measures involve factors such as mortgage rates, inflation, housing supply, new home construction, etc. For our purposes, we will use the two metrics above, as they provide the greatest insight into price and value.

A simple comparison of the median US income versus the median home price nationally is quite insightful. As we have shown previously, as home prices rose in response to ultra-low rates, the median US income failed to keep up. As prices began to slide downwards – they are off 16% from the 2006 peak as of September 2008 – they still remain significantly higher than had been historically relative to income.

Houses may be cheaper than they were two years ago, but they are by no means “cheap” on a historical basis. Indeed, prices remain quite elevated, which is one of the reasons sales are off 30-40% from the 2005-06 peak.

Key Issues:

◆ Home prices remain elevated.

◆ Artificially propping up home prices is counter-productive.

◆ Any solution to clear the real estate market must entail hiking income, which is very difficult, or allowing prices to drop to levels that the average American can support. This helps average Americans, not the big banks and investors stuck with overpriced mortgages.

◆ “Home owners” (no equity, 100%+ debt) who are in houses they cannot now, and never could afford, are going to have to move to homes or apartments they can afford.

◆ The banks that made these bad loans to unqualified borrowers should suffer write-downs. Taxpayers should not have to bailout borrowers who are in over their heads, or lenders that made these bad loans.

The current bailout proposal would have the FHA refinance mortgages at 85% of their present value, or would simply have Uncle Sam overpay for them, taking them off of the books of the lenders or speculators who currently own them. This effectively rewards lenders who made irresponsible loans, as well as rewarding the buyers of homes who could not afford them. It effectively punishes every taxpayer who was prudent, every American who tried to live within their means, and any homeowner who behaved in a fiscally responsible manner. It is the very definition of mortal hazard, and is very likely to have negative consequences for decades to come.

Let’s consider a different type of solution, one that can be effectuated by a combination of policies and actions via Congress, banks, and private equity, with the loan servicing industry participating.

“30/20/10” solution to the housing crisis:

30: Takes up to 30% of any current delinquent mortgage and separates it from the “main” mortgage; it goes into a 2nd, interest free-balloon mortgage, and stays on the books of the present mortgage holder;

20: The plan’s goal should be saving at least 20% or so of the current delinquent and potential foreclosure properties; Of the 5 million homes that may be late in making payments, (the first step along the road to delinquency, default and foreclosure) the process should make 20%, or 1 million homes eligible;

10: The Balloon payment comes due in 10 years, and will be treated as a 2nd mortgage, with interest charges only accruing as of October 1, 2018; it can be refinanced or paid off in full.

The 30/20/10 option allows the lending entity (or its equivalent) to pull aside up to 30% of the mortgage as a separate interest-free balloon payment. The remaining mortgage is refinanced at a fixed rate for 30 years. The balloon payment will “restart” fresh in 10 years. Between now and then, there will be no interest costs or penalties for this separate loan.

Consider the advantages of this plan: It would prevent a significant number of foreclosures from further roiling the markets; it takes bad loans and avoids the write down so long as they are performing; and it allows many people to stay in homes they can afford. Moral Hazard poses no problem in this plan.

Here are additional specifics: At least 70% of the existing mortgage becomes a new, refinanced, fixed rate, 30 year traditional mortgage. And, a loan payment for up to 30% of the original mortgage, not accruing interest, with repayment of principal and interest due beginning 10 years hence, makes the present house affordable. In other words, this would look like an ordinary mortgage plus a balloon payment, one that would not begin accruing interest until year 10.

Congressional action is required to exempt the balloon payment from causing a tax issue, as this is essentially an interest free loan might be a taxable event.

The securitization of mortgages creates its own additional difficulties in attempting to resolve defaults and delinquencies. Residential mortgages get bundled into RMBS, which were then sold and resold to various Wall Street purchasers. One of the current problems in resolving the situation is identifying who is the actual owner of the mortgage in question. This can be resolved with a clever little act changing notification provisions, requiring further Congressional approval.

Any entity that identifies a potentially problematic mortgage, i.e., delinquent and in risk of default, can start the process by evaluating the property value and the borrower’s ability to repay the loan. If they believe a mortgage would be suitable for a 30/20/10 workout, they would then send notice to the current recipients of the mortgages interest and principal payment. This entity would have 30 days to reject the workout, and failing to do so in that time Is deemed to be an approval.

In our solution, it is the financing party – a private equity firm, a real estate fund, or even a US capital pool created for this purpose – that can make this request for a 30/20/10 solution. Notice is sent by to the current loan servicer, i.e., the firm processing the mortgage payments, and forwarding them to the mortgage owner. The servicer is in the best situation to send the 30 day notice, and if no written objection is received, from the whoever currently owns the mortgage – be it bank, mortgage pool, or other securitized owner – the refinancing process begins.

Instead of a foreclosed property, the former mortgage holder is left with an interest free, 10 year balloon on up to 30% of the mortgage. They also have a lien on the property, and no write-down on the delinquent mortgage for at least 10 years.

There are other details that need to be worked out — the priority in case of sales, what happens if there is an eventual default, how to avoid fraud, etc.

The end result of the 30/20/10 workout would be the following: Homeowners who can afford to make payments on the refinanced home get to continue living in them. Neighborhoods are spared the negative impacts that foreclosure has on property values and the blight of abandoned houses. Lenders get to avoid writing down up to 30% of suitable but problematic mortgages. The balloon payment stays on the books as a liability, but it is not written down until, if and when it defaults 10 years later.

The upside of this proposal is that it serves a variety of interests with a minimum of congressional market interference. Those homeowners that can afford to stay in their house with a little bit of help avoid foreclosure. Banks and mortgage holders get to avoid writing down delinquencies that could be avoided. Neighborhoods are spared the negative impacts that foreclosure is known to have. Loan servicers can expand their business to processing the 30/20/10 workout papers. I would expect a variety of private equity funds will leap into the void and begin looking for mortgages to rewrite as 30/20/10s.

Congressional action required would be to:

◆ Eliminate the tax issue for the interest-free portion of these loan.

◆ Create a Legal standing and guidelines for this notification and waiver policy. The goal here is to insure that the complexities of determining who actually owns a a mortgage dozen not interfere in its work out.

◆ Create any required exemption for banks and lending entities to avoid taking a write-down during the period of the 10 year balloon forbearance.
Exhibit A

A Proposal for Mutual Banks

by David Merkel, CFA

If the government wants to leverage its efforts in encouraging credit in the US economy, it should consider seeding mutual banks. The US government would contribute money to 435 new banks (say $250 million to each), one for each congressional district, with the provision the government’s stake could be bought out at 1.5x what it put in. The government would have a preferred dividend of 3 month LIBOR plus 5% or so.

The mutual banks would attract deposits, because the institutions would be healthy.  With the leverage from deposits, these new mutual banks would make loans that many current lenders would shun because their balance sheets are compromised.  They would be smaller institutions, not large like Fannie, Freddie and the FHLBs. Depositors would own two thirds of the banks, with the government’s preferred stake getting one third of the votes. These banks would pay dividends to depositors above any interest paid, in proportion to the profit earned on balances deposited. (CDs being a higher cost source of funds would not get much of a dividend.)  The dividends would be paid out of profits in excess of what is needed to maintain the bank’s capital levels.

The mutual banks must remain mutual for 10 years, after which, they can be de-mutualized, with shares going to existing depositors in proportion to the cumulative profit earned off of each account for existing depositors.

That allocation system, similar to what is done with mutual insurers (”the contribution principle”) solves a lot of problems: people rushing to deposit when they hear about a de-mutualization, or, small depositors that think they will get a biggish slug of stock. Sorry. This is yet another area where the insurance industry is a lot brighter than the banking industry, and why? Actuaries. Actuaries are the best kept secret in business. This insures fairness in who gets equity, and how much.

Now, this provides a much sweeter deal to depositors than what they currently have at their banks. It is almost as good as a credit union, except these are subject to taxation. (As the credit unions should be.)

This raises the objection: What of our current banks? Will you let them go bust?  Why not prop them up?

This is one of the stupidities of how the current TARP was set up. We reward incompetence.  Better we should allow the institutions to fail, wipe out the common, preferred, sub debt, etc.  After that, transfer the deposits and clean assets to the new mutual banks in the vicinity, and let the FDIC reconcile the crud through a new RTC.

This would set the incentives right. Failure gets punished. Depositors get rewarded for depositing in healthy institutions. The government makes no big promises, but the interests of depositors are protected.

This Alternate Proposal has been drafted by the Author, and was inspired by and aggregated from the various works of David Merkel, Bill King, Stephen Bowles, Barry Ritholtz, Nouriel Roubini, and John Hussman. The Author does not claim the aforementioned ideas strictly as his own, but has assembled various ideas from the most viable alternate proposals written by the aforementioned authors.

UPDATE: Gateway Pundit reports Congressional pay-freeze until budget is balanced

UPDATE: HotAir discusses unemployment

UPDATE: Michael Graham at The Natural Truth discusses Obama’s reckless spending

UPDATE: Amy Proctor covers Obama’s $3.8 trillion plan

  1. great article, thanks… recommend sending along to Washington policy makers? ta

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