Tuesday, September 30, 2008

Canada Life insurer in JP Morgan longevity deal

(Reuters) The UK division of insurer Canada Life (CL_pb.TO: Quote, Profile, Research) emerged as the institutional investor which sealed a deal to hedge 500 million pound ($901 million) of longevity exposure with JP Morgan Chase & Co.

A JP Morgan spokeswoman confirmed to Reuters on Monday that a deal involving "long dated" longevity swaps had taken place, but did not identify the insurer.

"While there are no details available from Canada Life, we can confirm that they are the UK insurer involved in the longevity deal with JP Morgan," a spokeswoman for Canada Life said on Tuesday.

In February, JP Morgan signed another deal with insurer Lucida, which specialises in taking on longevity risk and corporate pension schemes.

The nascent longevity swap market could see a lucrative future as pension schemes, whose assets are valued at above $20 trillion, seek to hedge their longevity exposure -- the risk that people on live longer on average than expected.

A longevity swap helps pension schemes and insurance companies manage the risk of increasing life duration by enlisting a counterparty to pay pensions.

In return, the scheme pays the counterparty an agreed stream of cash, which is generally an estimate of the future pension payments by the counterparty, based on an assumed future level of improvement in longevity.

Monday, September 29, 2008

How bad was Monday, really? From long-term perspective, Monday plunge isn't unique

(MarketWatch) Monday's market plunge may have been the worst point drop ever for the Dow Jones Industrial Average, but in percentage terms it came nowhere close. It dropped 7% on Monday, or just one-third as much as the 22.6% decline in the 1987 crash.

In fact, there have been 16 other occasions since the Dow was created in 1896 in which the Dow's percentage drop was greater than it was Monday. That works out to an average of every seven years.

It furthermore has been almost exactly seven years -- Sept. 17, 2001 -- since the last time the Dow dropped by a greater amount than it did on Monday.

From at least one statistical perspective, this all adds up to Monday's drop being overdue.
Several years ago, researchers at New York University and Boston University derived a complex formula for calculating how often drops of a particular magnitude will occur over long periods of time (measured in centuries). Read study.

According to their formula, 7% declines will occur, on average, every 4.3 years. Going into Monday's session, the market had been going 2.7 years longer than this without that big a drop.
To be sure, the S&P 500 index dropped by more than the Dow did on Monday -- by 8.8%, in fact. And, according to the researchers' formula, drops of that magnitude should occur only once every 10 years, on average.

But the last time the S&P 500 dropped by more than it did Monday was in the 1987 crash -- more than 20 years ago.

So, from this perspective, the S&P 500 was more than a decade years overdue for a decline like the one we saw Monday.

This doesn't make Monday's losses any less painful. But the researchers' data serve to remind us that big drops are an inherent part of stock-market investing.

If we didn't know that going into Monday, we surely do now.

Hoyer Says Senate May Consider Crisis Bill This Week

(Bloomberg) -- U.S. House Majority Leader Steny Hoyer said the Senate may take up legislation to address the financial crisis as early as Oct. 2, following the House's rejection today of a $700 billion bank-rescue plan.

``The Senate will be in Thursday,'' Hoyer said. ``The Senate perhaps can pass something. That is a possibility, and send it back to us in which case we would then take it up. We're not out of business until this is addressed.''

He said he has spoken with House Republican Whip Roy Blunt and both agreed they are committed to continue working together on a compromise.

``We're all going to be working on the phone, maybe here, to see if we can reach some agreement on how to move forward,'' Hoyer said.

Hoyer said the House will meet on Oct. 2, though it ``has not been determined'' whether it will take up legislation on the economic crisis, Hoyer said in a statement this evening. Following the House rejection of the bill, U.S. stocks plunged today, with the Standard & Poor's 500 Index dropping the most since the 1987 crash.

``We will continue to work around the clock in a bipartisan manner to forge a solution to the serious threat confronting the economic security of millions of families,'' Hoyer said.

McConnell, Reid

Senator Mitch McConnell, the Republican leader, declined to comment on how the Senate would proceed next, saying he was consulting with Democratic Leader Harry Reid. Reid's spokesman, Jim Manley, declined to comment.

``We are going to stay here until we get the job done,'' McConnell told reporters. ``No action is not an answer.''

Some West Coast lawmakers were on their way home after the final 228 to 205 vote was announced today, eliminating the opportunity for the House to immediately reconsider the bill, Representative Jim Moran said. The Virginia Democrat said Democrats might draft their own bill and come back to work Oct. 2 after the Jewish holiday.

``We hold the cards now,'' Moran said. ``We gave them every opportunity.''

House Republican Leader John Boehner said after the vote, ``I don't know that we know the path forward at this point.'' He said Democratic and Republican leaders would have to work to persuade more of their members to back a rescue.

Representative Barney Frank, a lead negotiator of the legislation, said lawmakers ``have to wait and see what happens'' and how the economy reacts to the vote.

Frank said he was persuaded by the arguments of Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke that there is a serious problem that requires government intervention.

``I would like nothing better than to be proven wrong,'' he said.

New Servicer Targets Needs of Distressed Mortgage Investors By: PAUL JACKSON September 29, 2008

(Housing Wire) Add another firm to a growing number of special servicers targeting the so-called “high-touch” segment created by distressed asset investors looking to aggressively modify acquired loans. Dallas-based Wingspan Portfolio Advisors, LLC, announced on Monday that it had opened its doors for business, and that it would announce its first major client relationship next month.

“High-touch” special servicing has become an in-demand item for investors looking to recoup their investment on sub- and non-performing loans, and a fair number of special servicing firms have publicly announced their intentions to pursue this market in recent months. One such firm, for example, is Dallas-based Aqcura Loan Services, which began targeting the specific needs of lenders, hedge funds and investors in distressed debt back in April. Even giant servicing operation Residental Capital LLC signaled in August its desire to build up a third-party special servicing business targeting distressed asset investors.

But for all of the interest investors now having in third-party servicing arrangements, the space remains relatively wide open, according to various fund managers that have spoken with HW.

Wingspan is led by Steven Horne, a lawyer and servicing industry veteran who perviously was a director of Servicing Risk Strategy with Fannie Mae (FNM: 1.56 -14.75%). He also spent nine years as a partner with Sherman Financial Group, as well as serving as a director of default servicing for Ocwen Financial Corp. (OCN: 7.91 -1.37%). Wingspan’s senior management team includes industry veterans with decades of proven default servicing success at many leading companies.

“There are very few specialists out there with the tools and skills needed to cure these nonperforming mortgages, and so many times these loans, and especially the ones with low equity or low balances, are given up on,” said Horne.

Horne suggested that traditional servicing methods rely on net present value (NPV) to arrive at decisions, and said that doing so creates an assumption that loans outside the loss mitigation model can never be saved.

“We don’t arrive at the decision that a loan is lost before we completely understand the situation,” he said. “That means using advanced analytics that consider each factor affecting the loan and exploring every servicing strategy open to us.”

Horne said that the company is structured to focus on loss mitigation: 50 percent or more of the income earned by loss mitigation specialists at the company is tied directly to bringing loans back from the brink of foreclosure to paying status.

“Once they’ve accomplished that, we switch the case over to other specialists whose jobs entail keeping the payments flowing until the loan is contractually current,” Horne notes.

“We even monitor call times to make certain a sufficient amount of time is spent with each borrower. That’s another departure from traditional servicing methods, but our borrowers need that extra attention if they are going to have a chance to succeed at bringing their mortgage current.”

For more information, visit http://www.wingspanadvisors.com.

Buying the Bad Stuff: Implementation Considerations for the Paulson Plan

(NERA) In the midst of the ongoing US financial crisis, NERA experts Dr. Chantale LaCasse, Dr. Marcia Kramer Mayer, Dr. Arun Sen, and Dr. Elaine Buckberg have written a paper examining implementation considerations for the Paulson Plan. The paper focuses specifically on the reverse auction process and the key economic issues to consider when designing auctions to purchase troubled assets. (http://www.nera.com/image/PUB_Buying_the_Bad_Stuff_FINAL.pdf)

Treasury intends to rely on auctions to price the mortgage-related assets for which it will be a purchaser. Treasury is and has long been a frequent and massive seller of US government securities at auction. It obviously has extensive experience in implementing auctions in which it stands alone on one side of the market. Is the only difference between the usual Treasury auctions and reverse auctions for mortgage-related assets the side of the market where Treasury stands?


The authors argue that multiple factors distinguish the nature of the auctions that we can expect in this new realm from those routinely used to market new issues of Treasury securities. This paper highlights some of these key factors.

For further discussion, please refer to our brief,
The Paulson Proposal: Economists' Views, which presents a summary of current thinking by academic economists and reviews the proposed Paulson Plan as well as alternative plans intended to stabilize the financial system.

Fortis, Bradford & Bingley, Hypo Real Estate Rescued as Bank Crisis Widens

(Bloomberg) European governments stepped in to rescue Fortis, Bradford & Bingley Plc, and Hypo Real Estate Holding AG as tremors from the U.S. credit crisis reverberated around the world.

The U.K. Treasury seized Bradford & Bingley, Britain's biggest lender to landlords, while governments in Belgium, the Netherlands and Luxembourg threw an 11.2 billion-euro ($16.3 billion) lifeline to Fortis. Germany guaranteed a loan to Hypo.

The interventions exposed how fallout from the crisis that drove Lehman Brothers Holdings Inc. into bankruptcy and prompted a $700 billion U.S. bank-rescue package has gone global. It also added urgency to negotiations among European policy makers as to how they deal with banking collapses.

``The precarious global environment means the weakest links in Europe are now falling,'' said Mamoun Tazi, an analyst at MF Global Securities Ltd. in London. ``If banks continue not to lend to each other we'll see more failures.''

Shares of Dexia SA, a lender based in both Brussels and Paris, fell as much as 33 percent in Brussels trading after Le Figaro said the world's biggest lender to local governments may soon announce a plan to raise capital. Iceland agreed to buy 75 percent in Glitnir Bank hf, the island nation's third-largest bank by market value, for 600 million euros.

European equities and U.S. stock-index futures fell today. Euro-area economic confidence dropped this month to the lowest since the aftermath of the Sept. 11 attacks amid concern that the U.S. plan will fail to stem the crisis. The pound tumbled by the most against the dollar in 15 years and the euro slid.

ECB Auctions

The European Central Bank said today it will make additional funds available to banks through the end of the year in ``special'' auctions to ease tensions in money markets. The cost of borrowing euros for three months soared to a record 5.24 percent today. The Libor-OIS spread, a gauge of cash availability among banks, widened to a record 219 basis points.

Tightening credit is casting a pall over the European economy with U.K. growth the weakest since the early 1990s and the 15-nation euro-area on the edge of its first recession. The risk is of a spiral in which the credit crisis and the economy begin to feed off each other, resulting in costlier borrowing and even weaker expansion.

``The extreme dislocations in European money markets are both a symptom and a source of serious stress in the financial sector, exacerbated by the rapidly deteriorating growth environment,'' said Marco Annunziata, chief economist at Unicredit MIB in London.

Fortis Rescue

To head off the collapse of its biggest bank, Belgium agreed to buy 49 percent of Fortis's Belgian banking unit for 4.7 billion euros, while the Netherlands will pay 4 billion euros for a similar stake in the Dutch business, the governments said in a statement late yesterday. Luxembourg will provide a 2.5 billion-euro loan convertible into 49 percent of Fortis's banking division in that country.

The talks to rescue Fortis involved European Central Bank President Jean-Claude Trichet. Former Bank of England policy maker Willem Buiter said today on his blog that the rescue of Fortis showed ``the ability of the euro-area fiscal authorities to coordinate on a bailout for a bank with not only strong cross-boundary operations, but indeed with a strong multi- national identity.''

Santander Purchase

Bradford & Bingley was saved as tighter credit made it impossible for it to operate. Deposits at the bank amounted to slightly more than half of its loans outstanding, forcing it to depend on frozen capital markets for support. Banco Santander, Spain's biggest lender, will pay 612 million pounds ($1.1 billion), including a transfer of 208 million pounds of capital, to buy its branches and deposits.

Hypo Real Estate, Germany's second-biggest commercial- property lender, received a 35 billion euro loan guarantee to fend of insolvency. The rescuers of the bank will pay the guarantee cash in two allotments of 14 billion euros and 21 billion euros, a government official said, speaking on terms of anonymity.

Roskilde Bank A/S, the lender bailed out by the Danish central bank because of mortgage writedowns, said today it sold its branches to Nordea Bank AB, Spar Nord Bank A/S and Arbejdernes Landsbank A/S.

Bush Package

Acting in the aftermath of Lehman's collapse and government rescues of American International Group Inc. and mortgage lenders Fannie Mae and Freddie Mac, President George W. Bush and congressional leaders said yesterday that they reached agreement on a rescue package aimed at reviving moribund credit markets.

The U.S.'s woes have been transmitted abroad as investors focus on how much capital banks have on hand and as financial companies hoard cash for their own needs, shutting off funding for those whose access to money is limited.

Fortis dropped 35 percent last week in Brussels trading on concern the company would struggle to replenish capital depleted by the 24.2 billion-euro takeover of ABN Amro Holding NV units and credit writedowns.

``Markets thought that they were over-leveraged,'' Dutch central bank governor Nout Wellink said. ``What's happening in the U.S. is having an impact on the rest of the world.''

The bailouts add to concern that Europe's patchwork of banking regulations will hinder coordinated response. While European Union officials are drafting legislation aimed at strengthening how large banks are monitored and what capital they must hold, governments have agreed only to knit supervisors closer together and pledged to cooperate in managing a crisis.

Rejecting Paulson Plan

Unwilling to commit taxpayer money up front, they have resisted calls to devise a plan for splitting the bill should a bailout become necessary. German Finance Minister Peer Steinbrueck and France's Christine Lagarde last week rejected a plea from U.S. Treasury Secretary Henry Paulson to follow the U.S. in erecting similar bailout mechanisms, arguing their banking systems aren't at risk of a systemic breakdown.

Still, of the $554.3 billion losses and writedowns recorded by banks since the start of 2007, 42 percent are accounted for by European institutions.

Daniel Gros, director of the Brussels-based Center for European Policy Studies, said in a report this month that the largest European banks have a leverage ratio -- which measures shareholders' equity to total assets -- of 35 compared with less than 20 for the biggest U.S. counterparts.

``Europe is under greater pressure to act now as it's still not ready for a major banking crisis and the worst fears of policy makers are coming true,'' said Nicolas Veron, an economist at Bruegel, a Brussels-based research organization.

Clusterstock's bailout summary

What's in this massive bailout Congress wasted the whole weekend negotiating? We just wasted our Sunday evening reading all 110 pages to find out. (If you want to do the same, click here.)Key points below:
  • Creation of an "Office of Financial Stability." The bailout will be run via a new government office, which henceforth will be known here and elsewhere as The Bailout Office.
  • "Preventing Unjust Enrichment": Treasury can't pay more for the crap assets than the banks bought them for (a horrifying possibility, given that most of the securities have already been written way down). This provision, however, doesn't apply to banks who acquired the assets via mergers or to banks in bankruptcy or conservatorship. It also means that the Treasury can and will pay far more than market value for this garbage (and, thus, go against the advice of Warren Buffett and Bill Gross, among others, who recommend paying market prices).
  • Includes the silly "insurance" option the GOP insisted on--whereby the banks pay the government a fee to guarantee the performance of the toxic securities and then sells them to private-market buyers. The banks won't use the option because the payments would be onerous, and Paulson won't use it because he hates it. Go, GOP!
  • The Treasury is supposed to consider a bunch of factors when making its decisions, including:
    • Limiting how much the taxpayer gets screwed
    • Not wasting money buying assets from banks that will croak anyway
    • Save jobs, life savings, house values, etc
    • Try to save small banks that got blown up by Fannie/Freddie collapse
    • Protect retirement savings by buying the crap assets of pension funds, too
  • Oversight: Must report back to Congress after 60 days and then every 30 days thereafter. Must send Congress a report after every $50 billion spent.
  • Helping homeowners. Must try to work with homeowners to modify loans if/when appropriate to avoid foreclosure. Must encourage mortgage servicers to try not to boot people out of houses, instead working on ways to avoid foreclosures (toothless provision).
  • Executive compensation at bailed-out companies. Toothless: The plan ostensibly prohibits golden parachute payments to CEOs and other "C-level" execs at bailed-out companies. However, it really only prevents payments on severance deals that are struck AFTER the bailout (specifically, it prohibits these deals completely). There is nothing about cancelling the severance payments that the executives are ALREADY contractually entitled to. What this means in practice is that bailed-out companies will have trouble hiring the best talent...because why would you work at Bailed Out Company A when you could go across the street and get a fat severance deal? It also doesn't mean the companies can't pay their CEOs $500 million a year. IN ADDITION: There's another absurd section that makes all compensation above $500,000 for the three highest paid employees at the company not tax-deductible for the company. This is LUDICROUS. It means the company can pay the executives anything it wants and that the penalty for this will be exacted on the company and its shareholders. (Unless we're mistaken, Americans are furious that CEOs make $50 million a year for running companies into the ground, not that the $50 million is tax deductible).
  • The Treasury has complete discretion over the prices it pays for crap assets (the most important provision in the whole document as far as the taxpayers are concerned). "The Secretary make such purchases at the lowest price that the Secretary determines to be consistent with the purposes of this Act." Translation: If the banks persuade me they won't sell for anything less than a sweetheart price, I can give them that price. The only good news: The Treasury has to publicly detail the prices it pays. So if the Treasury is paying grossly inflated prices, the taxpayer has a chance of finding out about it.
  • Equity/warrants: The Treasury MUST be granted warrants or debt instruments (senior debt) from public companies in exchange for more than $100 million of bailout money. No specific language on how significant this warrant or debt position must be, except that it must "provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation in the case of a warrant, or a reasonable interest rate premium, in the case of a debt instrument." AND...must provide additional protection against taxpayer losses. This is an important and just provision. The tension will be between the government wanting to take enough equity to offset the risk without scaring the bank away.
  • Size: Treasury gets $250 billion now, and another $100 billion when the President tells Congress it is needed (i.e., now). If $350 billion isn't sufficient, the President can tell Congress he/she is authorizing another $350 billion, at which point Congress can issue a "joint resolution" to block it. In other words, the default amount is $700 billion, and Congress could conceivably block the second $350 billion (the rules for blocking it are complex and doing so wouldn't be a cinch).
  • Ability to stop the madness. Congress can seek a preliminary or permanent injunction from a court to stop the program.
  • TIME LIMIT: The authority under the plan lasts until the end of 2009. Congress can then extend for another nine months or so (max 2 years from the date of signing).
  • Oversight: A bunch of oversight provisions, including appointment of Special Inspector General.
  • VERY STRANGE AND POSSIBLY ALARMING: The SEC has the ability to suspend mark-to-market accounting for financial institutions when it thinks doing so is in the public interest. The SEC will also be launching a "study" of mark-to-market accounting. Mark-to-market has been fingered as one of the villains in this collapse. It isn't, but it sounds as though the SEC may have been persuaded that it is. Without mark-to-market, there's a lot more risk of a Japan-type scenario, where banks live in denial for years about how far up the creek they are.
Financial industry might have to pay for any taxpayer losses--emphasis on "might." Upon the expiration of the 5-year period beginning upon the date of the enactment of this Act...the President shall submit a legislative proposal that recoups from the financial industry an amount equal to the shortfall in order to ensure that the Troubled Asset Relief Program does not add to the deficit or national debt.

Roubini loves the Paulson plan (not!)

(Roubini's Global EconoMonitor) Whenever there is a systemic banking crisis there is a need to recapitalize the banking/financial system to avoid an excessive and destructive credit contraction. But purchasing toxic/illiquid assets of the financial system is not the most effective and efficient way to recapitalize the banking system. Such recapitalization – via the use of public resources – can occur in a number of alternative ways: purchase of bad assets/loans; government injection of preferred shares; government injection of common shares; government purchase of subordinated debt; government issuance of government bonds to be placed on the banks’ balance sheet; government injection of cash; government credit lines extended to the banks; government assumption of government liabilities.

A recent IMF study of 42 systemic banking crises across the world provides evidence on how different crises were resolved. First of all only in 32 of the 42 cases there was government financial intervention of any sort; in 10 cases systemic banking crises were resolved without any government financial intervention. Of the 32 cases where the government recapitalized the banking system only seven included a program of purchase of bad assets/loans (like the one proposed by the US Treasury). In 25 other cases there was no government purchase of such toxic assets. In 6 cases the government purchased preferred shares; in 4 cases the government purchased common shares; in 11 cases the government purchased subordinated debt; in 12 cases the government injected cash in the banks; in 2 cases credit was extended to the banks; and in 3 cases the government assumed bank liabilities. Even in cases where bad assets were purchased – as in Chile – dividends were suspended and all profits and recoveries had to be used to repurchase the bad assets. Of course in most cases multiple forms of government recapitalization of banks were used.

But government purchase of bad assets was the exception rather than the rule. It was used only in Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay. Even in six of these seven cases where the recapitalization of banks occurred via the government purchase of bad assets such recapitalization was a combination of purchase of bad assets together with other forms of recapitalization (such as government purchase of preferred shares or subordinated debt).

In the Scandinavian banking crises (Sweden, Norway, Finland) that are a model of how a banking crisis should be resolved there was not government purchase of bad assets; most of the recapitalization occurred through various injections of public capital in the banking system. Purchase of toxic assets instead – in most cases in which it was used – made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).

Thus the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer - the common and preferred shareholders and even unsecured creditors of the banks. Even the late addition of some warrants that the government will get in exchange of this massive injection of public money is only a cosmetic fig leaf of dubious value as the form and size of such warrants is totally vague and fuzzy.

So this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the financial firms (not just banks but also other non bank financial institutions); with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.

Indeed, the plan also does not address the need to recapitalize those financial institutions that are badly undercapitalized: this could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; via suspension of dividends payments; via a conversion of some of the unsecured debt into equity (a debt for equity swap). All these actions would have implied a much lower fiscal costs for the government as they would have forced the shareholders and creditors of the banks to contribute to the recapitalization of the banks. So less than $700 billion of public money could have been spent if the private shareholders and creditors had been forced to contribute to the recapitalization; and whatever the size of the public contribution were to be its distribution between purchases of bad assets and more efficient and fair forms of recapitalization (preferred shares, common shares, sub debt) should have been different. For example if the private sector had done its fair matching share only $350 billion of public money could have been used; and of this $350 billion half could have taken the form of purchase of bad assets and the other half should have taken the form of injection of public capital in these financial institutions. So instead of purchasing – most likely at an excessive price - $700 billion of toxic assets the government could have achieved the same result – or a better result of recapitalizing the banks – by spending only $175 billion in the direct purchase of toxic assets. And even after the government will waste $700 billion buying toxic assets many banks that have not yet provisioned for such losses/writedowns will be even more undercapitalized than before. So this plan does not even achieve the basic objective of recapitalizing undercapitalized banks.

The Treasury plan also does not explicitly include an HOLC-style program to reduce across the board the debt burden of the distressed household sector; without such a component the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.

Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown. It is pathetic that Congress did not consult any of the many professional economists that have presented - many on the RGE Monitor Finance blog forum - alternative plans that were more fair and efficient and less costly ways to resolve this crisis. This is again a case of privatizing the gains and socializing the losses; a bailout and socialism for the rich, the well-connected and Wall Street. And it is a scandal that even Congressional Democrats have fallen for this Treasury scam that does little to resolve the debt burden of millions of distressed home owners.

Sunday, September 28, 2008

Official Summary of the "Emergency Economic Stabilization Act of 2008"

The Emergency Economic Stabilization Act of 2008 (EESA) provides up to $700 billion to the Secretary of the Treasury to buy mortgages and other assets that are clogging the balance sheets of financial institutions and making it difficult for working families, small businesses, and other companies to access credit, which is vital to a strong and stable economy. EESA also establishes a program that would allow companies to insure their troubled assets.

Homeownership Preservation

EESA requires the Treasury to modify troubled loans - many the result of predatory lending practices - wherever possible to help American families keep their homes. It also directs other federal agencies to modify loans that they own or control. Finally, it improves the HOPE for Homeowners program by expanding eligibility and increasing the tools available to the Department of Housing and Urban Development to help more families keep their homes.

Taxpayer Protection

Taxpayers should not be expected to pay for Wall Street's mistakes. The legislation requires companies that sell some of their bad assets to the government to provide warrants so that taxpayers will benefit from any future growth these companies may experience as a result of participation in this program. The legislation also requires the President to submit legislation that would cover any losses to taxpayers resulting from this program by charging a small, broad-based fee on all financial institutions.

No Windfalls for Executives

Executives who made bad decisions should not be allowed to dump their bad assets on the government, and then walk away with millions of dollars in bonuses. In order to participate in this program, companies will lose certain tax benefits and, in some cases, must limit executive pay. In addition, the bill limits "golden parachutes" and requires that unearned bonuses be returned.

Strong Oversight

Rather than giving the Treasury all the funds at once, the legislation gives the Treasury $250 billion immediately, then requires the President to certify that additional funds are needed ($100 billion, then $350 billion subject to Congressional disapproval). The Treasury must report on the use of the funds and the progress in addressing the crisis. EESA also establishes an Oversight Board so that the Treasury cannot act in an arbitrary manner. It also establishes a special inspector general to protect against waste, fraud and abuse.

TARP Draft is available for your viewing pleasure

And it can be downloaded here...

(Calculated Risk) On suspending Mark-to-Market:
(a) AUTHORITY.—The Securities and Exchange Commission shall have the authority under securities laws (as such term is defined under section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or oder, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer (as such term is defined in section 3(a)(8) of such Act) or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.
And on allowing banks to earn interest and maintain a "zero reserve ratio":
Section 203 of the Financial Services Regulatory Relief Act of 2006 (12 U.S.C. 461 note) is amended by striking ‘‘October 1, 2011’’ and inserting ‘‘October 1, 2008’’.
Here is the previous text (hat tip Falcor):
Financial Services Regulatory Relief Act of 2006 - Section 203.

"Interest on Reserves and Reserve Ratios

"Federal Reserve Banks are authorized to pay banks interest on reserves under Section 201 of the Act. In addition, Section 202 permits the FRB to change the ratio of reserves a bank must maintain relative to its transaction accounts, allowing a zero reserve ratio if appropriate. Due to federal budgetary requirements, Section 203 provides that these legislative changes will not take effect until October 1, 2011."
Here are some parts on pricing mechanism:
(d) PROGRAM GUIDELINES.—Before the earlier of the end of the 2-business-day period beginning on the date of the first purchase of troubled assets pursuant to the authority under this section or the end of the 45-day period beginning on the date of enactment of this Act, the Secretary shall publish program guidelines, including the following:
(1) Mechanisms for purchasing troubled assets.
(2) Methods for pricing and valuing troubled assets.
(3) Procedures for selecting asset managers.
(4) Criteria for identifying troubled assets for purchase.
So it's all up to the Secretary to establish the rules. Same with Warrants - it's up to the Secretary to negotiate.

Here is the section on transparency:

(a) PRICING.—To facilitate market transparency, the Secretary shall make available to the public, in electronic form, a description, amounts, and pricing of assets acquired under this Act, within 2 business days of purchase, trade, or other disposition.

(b) DISCLOSURE.—For each type of financial institutions that is authorized to use the program established under this Act, the Secretary shall determine whether the public disclosure required for such financial institutions with respect to off-balance sheet transactions, derivatives instruments, contingent liabilities, and similar sources of potential exposure is adequate to provide to the public sufficient information as to the true financial position of the institutions. If such disclosure is not adequate for that purpose, the Secretary shall make recommendations for additional disclosure requirements to the relevant regulators.
At least transactions will be made public online.

Tentative bailout deal reached

(WSJ) Top U.S. policymakers emerged from hours of tense negotiations just after midnight with a tentative agreement on a deal to bail out U.S. financial markets and began working Sunday morning to commit the legislation to paper.

Treasury Secretary Henry Paulson, House Speaker Nancy Pelosi, (D., Calif.) and Senate Majority Leader Harry Reid (D. Nev.) were flanked by key negotiators in the Capitol as they announced that a $700 billion plan to have Treasury buy up toxic assets had been all but finalized after days of exhausting negotiations involving members, staff and representatives from the Bush administration.

"I think we're there," an obviously tired Mr. Paulson said, a sentiment echoed in the statements of negotiators such as House Financial Services Chairman Barney Frank (D., Mass.) and Senate Banking Committee head Christopher Dodd (D., Conn.).

Those present said the bailout plan still needs to be drafted in its final form, a process staff members were expected to continue throughout the night in what one aide called a "marathon drafting session" in Speaker Pelosi's office just off the rotunda in the Capitol building. A formal announcement is scheduled for some time Sunday, though an exact time and location was not immediately available.

A summary of the tentative agreement released by Sen. Pelosi's office said the plan "gives taxpayers an ownership stake and profit-making opportunities with participating companies; puts taxpayers first in line to recover assets if a participating company fails; (and) guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit."

The $700 billion would be available in phases. The first $250 billion will be "immediately available" to the Treasury Secretary, and $100 billion available "upon report to Congress," and $350 billion "available only upon Congressional action," according to a summary from the office of House Minority Whip Roy Blunt (R., Mo.), the No. 2 House Republican who was at negotiations.

A summary from Sen. Pelosi's office said the final deal included "cutting in half the administration's initial request for $700 billion and requiring Congressional review for any future commitment of taxpayers' funds."

The Pelosi summary also said the legislation will expand the range of firms that can sell troubled assets to the government to include pension plans, local governments and community banks serving "low- and middle-income families." (See Ms. Pelosi's summary.)

A House Democratic aide said the government would be able to receive warrants it could hold until maturity from financial firms on assets received either through auctions or through direct purchases.

The summary also said the legislation would institute new executive compensation requirements for participating companies, including "no multi-million dollar golden parachutes," limits on compensation generally, and the ability to recover "bonuses paid based on promised gains that later turn out to be false or inaccurate."

President George W. Bush spoke with Sen. Pelosi earlier in the evening about the discussions, and the White House welcomed news of the deal. "We're very pleased with the progress tonight and appreciate the extraordinary bipartisan efforts being made to stabilize our financial markets and protect our economy," White House spokesman Tony Fratto said.

The next step will involve selling the deal to rank-and-file lawmakers, who have been unhappy over signing on to a giant bailout package just weeks before the November elections. Rep. Blunt said that he planned to talk to colleagues and get reactions.

Lawmakers entered a new round of meetings shortly after 7:30 p.m. EDT, with pizzas headed to one office and a platter of cold cuts from sandwich chain Cosi being delivered into the House Speaker's office. By roughly 11:30 p.m., what Reid described as a "breakthrough" came in the form of an idea from Pelosi that was enough to advance talks.

"She took over at the last minute," a House staffer familiar with the talks said Sunday morning. "The last hour-and-a-half she really brought things together and made it possible to reach this point."

Pelosi also apparently found middle ground on a plan to allow the federal government to recoup money for taxpayers if the asset-purchase program isn't making money after a certain amount of time. A House leadership aide said early Sunday morning that details were not immediately available. But the general concept was to provide Congress with a mechanism that would be triggered perhaps within five years to allow lawmakers to offset some, if not all, of the bailout costs.

Offers and counteroffers were flowing back and forth all night. Among the offers extended by Democrats: an agreement to drop a proposal to devote 20% of potential profits to an affordable housing fund, according to a Senate staffer close to the talks.

A House staffer reached after the deal announcement was made confirmed that lawmakers did decide to drop the affordable housing fund proposals, which would have potentially directed billions to state and local governments to fund housing projects.

One of the biggest sticking points involved concerns that executives at troubled financial institutions would wind up benefiting with handsome pay packages as the government took on more risks. But Democrats emerging from the talks said a whole array of issues related to executive pay had been addressed, including issues involving "golden parachutes," the big pay packages that are sometimes awarded to departing executives.

Sen. Dodd told reporters that protections against golden parachute awards had made it into the final deal, along with an insurance component sought by House Republicans as an option for the Treasury to use if necessary and requirements that Treasury seek to mitigate and reduce foreclosures where possible.

Overall, staff said they expanded Treasury's original 2 1/2 page proposal. The agreement will include significant oversight of the asset purchase program, executive compensation restrictions, the potential for equity stakes in firms that participate in the asset-sale program, and other taxpayer protections.

As for foreclosure prevention measures, Pelosi's office said the legislation would allow the Treasury to work with cash-strapped homeowners whose mortgages are purchased by the federal government to refinance into a more affordable mortgage.

Other foreclosure-prevention measures include an extension of the tax holiday for homeowners who face foreclosure, as well as a tax break for community banks that held shares of Fannie Mae and Freddie Mac. The rescue plan will allow affected banks to take an immediate tax deduction on losses from investments in the two firms, which were taken over by the federal government earlier this month.

It also includes a bipartisan oversight board appointed by members of both parties in Congress, an inspector general to monitor Treasury decisions, and regular audits from the Government Accountability Office. Treasury will also have to post publicly and online transactions made through the troubled asset program. Unlike the original Treasury proposal, which would have given the department legal immunity in the program, the tentative agreement reached Saturday allows for judicial review of Treasury decisions.

Sen. Barack Obama (D. Ill.), the Democratic Party presidential nominee, said the tentative deal appears to embrace key principles he favors: better oversight, the potential for taxpayers to receive profits from the workout, CEO compensation limits and foreclosure protections.

"When taxpayers are asked to take such an extraordinary step because of the irresponsibility of a relative few, it is not a cause for celebration," Obama said in a statement Sunday. "But this step is necessary."

Republican nominee Sen. John McCain, interviewed by ABC's "This Week," said, "This is something that all of us will swallow hard and go forward with."

In a sign of how sensitive Congress is to market reaction, lawmakers stayed in touch with outside experts during the negotiations, including talking to billionaire investor Warren Buffett.

House Speaker Pelosi's summary of draft bailout legislation

Significant bipartisan work has built consensus around dramatic improvements to the original Bush-Paulson plan to stabilize American financial markets -- including cutting in half the Administration's initial request for $700 billion and requiring Congressional review for any future commitment of taxpayers' funds. If the government loses money, the financial industry will pay back the taxpayers.

3 Phases of a Financial Rescue with Strong Taxpayer Protections

  • Reinvest in the troubled financial markets … to stabilize our economy and insulate Main Street from Wall Street

  • Reimburse the taxpayer … through ownership of shares and appreciation in the value of purchased assets

  • Reform business-as-usual on Wall Street … strong Congressional oversight and no golden parachutes


    Democrats have insisted from day one on substantial changes to make the Bush-Paulson plan acceptable -- protecting American taxpayers and Main Street -- and these elements will be included in the legislation

    Protection for taxpayers, ensuring THEY share IN ANY profits

  • Cuts the payment of $700 billion in half and conditions future payments on Congressional review

  • Gives taxpayers an ownership stake and profit-making opportunities with participating companies

  • Puts taxpayers first in line to recover assets if participating company fails

  • Guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit

  • Allows the government to purchase troubled assets from pension plans, local governments, and small banks that serve low- and middle-income families

    Limits on excessive compensation for CEOs and executives

    New restrictions on CEO and executive compensation for participating companies:

  • No multi-million dollar golden parachutes

  • Limits CEO compensation that encourages unnecessary risk-taking

  • Recovers bonuses paid based on promised gains that later turn out to be false or inaccurate

    Strong independent oversight and transparency

    Four separate independent oversight entities or processes to protect the taxpayer

  • A strong oversight board appointed by bipartisan leaders of Congress

  • A GAO presence at Treasury to oversee the program and conduct audits to ensure strong internal controls, and to prevent waste, fraud, and abuse

  • An independent Inspector General to monitor the Treasury Secretary's decisions
    Transparency -- requiring posting of transactions online -- to help jumpstart private sector demand

  • Meaningful judicial review of the Treasury Secretary's actions

    Help to prevent home foreclosures crippling the American economy

  • The government can use its power as the owner of mortgages and mortgage backed securities to facilitate loan modifications (such as, reduced principal or interest rate, lengthened time to pay back the mortgage) to help reduce the 2 million projected foreclosures in the next year

  • Extends provision (passed earlier in this Congress) to stop tax liability on mortgage foreclosures

  • Helps save small businesses that need credit by aiding small community banks hurt by the mortgage crisis—allowing these banks to deduct losses from investments in Fannie Mae and Freddie Mac stocks
  • Saturday, September 27, 2008

    Key Congressional Players in the Bailout Debate (WSJ)


    New IMF Study of Banking Crises Contradicts Bailout Bill Premise and Details

    (Naked Capitalism) The IMF just released a study that analyzed 124 banking crises, and I wish everyone in Congress (well, at least their staffers), the Treasury, and the Fed read the paper. It provides insight into what worked and didn't work in past banking crises, and gives an idea of what we might expect from various policy measures.

    I've only skimmed it, and key bits stick out. Page 6:
    Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

    Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.

    Now of course, one can argue that the IMF is biased and this paper is merely a defense of the cold-water remedies it imposed in the Asian financial crisis of 1007-1998, which produced a great deal of dislocation (business failures, rises in unemployment, riots, changes in government). But one reason the US would not suffer as badly is that we have the reserve currency. In Indonesia and Thailand, what made a bad situation worse was that companies had borrowed in foreign currencies, so that when the home currency plunged in value, the debt burden rose sharply, sinking a lot of businesses.

    The paper contains other useful warnings that appear to be getting little heed. For instance:
    All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

    And this:
    Special bank restructuring agencies are often set up to restructure distressed banks (in 48 percent of crises) and asset management companies (AMC) have been set up in 60 percent of crises to manage distressed assets. Asset management companies tend to be centralized rather than decentralized. Examining the cases where AMCs were used, we find that the use of AMCs is positively correlated with peak non-performing loans and fiscal costs, with correlation coefficients of about 15 percent in both cases. These correlations may suggest some degree of ineffectiveness in AMC’s, at least in those episodes where asset management companies were established. In line with these simple correlations we find Klingebiel (2000) who studies 7 crises where asset management companies were used and concludes that they were largely ineffective.

    So much for the idea that taxpayers might show a profit.

    We have been advocating direct recapitlization of banks, and the research finds that even though it has larger up-front costs than some other options, economies that go this route fare better:
    Another important policy used in the resolution phase of banking crises is recapitalization of banks. In 32 out of the 42 selected crisis episodes, banks were recapitalized by the government. Recapitalization costs constitute the largest fraction of fiscal costs of banking crises and takes many forms....

    On average, the net recapitalization cost to the government (after deducting recovery proceeds from the sale of assets) amounts to 6.0 percent of GDP across crisis countries in the sample, though in the case of Indonesia it reaches as high as 37.3 percent of GDP. Recapitalizations seem to be associated with lower output losses. The correlation between recapitalizations and output losses is about -15 percent. A rationale behind this correlation is presented in Valencia (2008), who shows—in a rational expectations bank model—how a persistent credit crunch can generate significant output losses, following a shock to bank capital. Therefore, by replenishing banks’ capital, the supply of credit returns to normal sooner and the output losses become smaller.

    These programs DO NOT pay for themselves:
    Fiscal costs, net of recoveries, associated with crisis management can be substantial, averaging about 13.3 percent of GDP on average, and can be as high as 55.1 percent of GDP. Recoveries of fiscal outlays vary widely as well, with the average recovery rate reaching 18 percent of gross fiscal costs

    As we have suggested, there is no free lunch:
    There appears to be a negative correlation between output losses and fiscal costs, suggesting that the cost of a crisis is paid either through fiscal costs or larger output losses.

    The New York Times' Dealbook discusses a Merrill Lynch write-up of the IMF report:
    A look at Japan’s financial crisis in the 1990s is instructive, the Merrill report said. Like the current American crisis, Japan’s banking turmoil included the rescue and disposal of home-loan companies and the bankruptcy of a big securities firm — although the crisis in the United States seems to be unfolding much faster than Japan’s, possibly accelerated by the magic of securitization.

    Judging from previous crises, Merrill’s economists suggest that the United States should move quickly to declare certain banks “survivors” and put the others out of their misery.

    Doing so, they said, would end the “who’s next?” game that has gummed up the credit markets:
    The Asian crisis teaches us that it is imperative that U.S. policy makers tell us which financial institutions will survive; and which not. This could possibly involve blanket government guarantees to unfreeze money markets. Until this uncertainty is resolved, financial institutions will be reluctant to deal with each other.

    Financial Markets in Crisis: Silence on the Rescue Deal Is Golden

    (Gibson, Dunn & Crutcher Financial Markets Crisis Group) In contrast to yesterday's public display of political and policy wrangling, today's activity was largely behind the scenes as designated negotiators worked to hash out the details of a rescue plan. Though congressional leaders reported yesterday that they had reached a compromise agreement, Republicans announced that they had developed a competing proposal late Thursday night. House Minority Leader John Boehner wrote Speaker Pelosi today to express concern that the Democrats had not addressed many of the issues Republicans had raised about the proposal before declaring that the two parties had reached a consensus. He said that he and many other Republican members could not support Secretary Paulson's plan until more taxpayer protections and free market principles had been incorporated into the legislation. Members from both sides of the aisle, however, have announced that they are working together to reach an agreement quickly.

    The Republicans’ alternative proposal purports to place less risk on taxpayers than the Treasury and Democrats’ proposals and to incentivize private companies to finance much of the recovery. The plan would entail the government insuring mortgage-backed securities, as opposed to purchasing them outright. Holders of the MBS would be required to pay for the insurance premiums rather than placing that burden on taxpayers, and holders of the troubled assets would pay a higher risk-based premium. Through tax incentives and regulatory measures, the proposal is designed encourage private companies, instead of taxpayers, to inject capital into the markets.

    Like the Democrats’ plan, the Republicans’ proposal calls for more transparency and oversight than did the initial Treasury request. Participating firms would have to disclose the value of their mortgage assets to Treasury, as well as the value of bids within the last year for those assets and their most recent audit report. Under the plan, the SEC would audit failed companies and would review the performance of the Credit Rating Agencies. The Republicans also seek to impose greater restrictions on government sponsored enterprises, forbidding them to securitize any unsound mortgages. Finally, the Republican plan would create a blue ribbon panel to assess the country’s financial situation and to suggest reforms for the market by January 1, 2009.

    Republicans also have suggested including a "pay to play" provision, which would require participating firms to pay a set amount of money based on the amount of assets Treasury purchases, as well as creating an independent government corporation to purchase the troubled assets instead of Treasury, which would have congressional accountability and would minimize taxpayer exposure.

    Key Points in the Latest Draft

    A new draft of the rescue bill, dated September 25, 2008, includes new provisions and adds texture and detail to provisions of earlier drafts. Key provisions in this draft include the following:

    • limit participating financial institutions to United States institutions, meaning that they must be organized under United States law and must have significant operations in the States;
    • defines the “troubled assets” eligible for Treasury purchase as those assets based on or related to residential or commercial mortgages which were originated or issued on or before March 14, 2008;
    • creates an Office of Financial Stability within the Office of Domestic Finance of the Department of Treasury, through which the Secretary will implement these programs;
    • requires that the Secretary publish program guidelines either within two days of exercising this authority or within thirty days of enactment of the legislation. These guidelines will define how the assets will be priced and purchased and how asset managers will be selected;
    • establishes the Financial Stability Oversight Board, which will review the Secretary’s exercise of authority and will be composed of the Federal Reserve chairman, the Federal Deposit Insurance Corporation chairman, and the SEC chairman, as well as two other members who are not governmental employees, one of whom will be appointed by the majority leader of the Senate and Speaker of the House, and one of whom will be appointed by the Senate and House minority leaders;
    • requires the Secretary to report to Congress 60 days after the programs are initiated and every 30 days thereafter, as well as to make public the total amount of assets purchased and sold each week;
    • mandates that the Secretary review the financial markets and submit an improvement plan to Congress by April 30, 2009;
    • requires that at least 20 percent of any profit realized from the program be deposited into federal programs: 65 percent of that amount will be deposited into the Housing Trust Fund, and 35 percent into the Capital Magnet Fund;
    • authorizes the Secretary to contract for services through a streamlined process not subject to the Federal Acquisition Regulation. Sets out principles for awarding contracts, including contracts to asset managers. The principles require the Secretary:

      • to solicit proposals from a broad range of vendors;
      • to ensure the inclusion of minority- and women-owned businesses in the contracting process;
      • to consider the FDIC in the selection of asset managers.
    • requires the Secretary to develop conflict of interest standards;
    • charges the Secretary with a duty to assist homeowners and reduce foreclosures and requires the Secretary to alter mortgage terms when such requests are “reasonable”;
    • implements corporate governance and executive compensation standards that would be effective for two years after a corporation enters the program. These standards leave much to the Secretary’s discretion, placing limits on compensation which will exclude incentives for officers to take risks that the Secretary deems “inappropriate” or “excessive. The standards also prohibit golden parachute;
    • implements additional corporate governance standards for those institutions from which the Secretary makes a direct purchase, including proxy access for any shareholder or shareholder group representing 3 percent or more of the institution’s equity securities and a mandatory opportunity for shareholders to cast a non-binding vote on the institution’s executive compensation during any annual proxy solicitation and shareholder vote;
    • requires the Secretary to maximize the taxpayer investment by using market mechanisms, such as auctions or reverse auctions, but allows the Secretary to make direct purchases where appropriate;
    • requires the Secretary to obtain a warrant giving the Secretary the right to receive non-voting common stock from any institution from which the Secretary purchases troubled assets, which the Secretary may transfer freely, and which are protected from dilution by stock splits, distributions, dividends, or corporate reorganizations;
    • limits the Secretary’s purchasing authority to $700 billion, which will be granted to the Secretary in tranches. The initial authority will be limited to $250 billion; after a request to Congress, the authority will be limited to $350 billion; and after a final request and written report to Congress, the authority will be limited to $700 billio;
    • grants the Comptroller General of the United States oversight of the TARP program;
    • establishes the Office of the Special Inspector General for the Troubled Asset Relief Program;
    • raises the public debt limit to $11.315 trillion;
    • authorizes the Secretary to establish a temporary guaranty program for money market mutual funds; and
    • limits tax deductions for participating institutions for executive compensation to no more than $400,000 a year per executive.

    We note that, it's not clear who supports this draft as it now stands. What is clear is that this draft will change – indeed, likely has changed – before it is voted on by the House and Senate.

    Timing and Procedure

    There is a desire among bill negotiators and others to reach agreement by the end of the weekend. One scenario would have the House and Senate voting on a rescue plan – either as a standalone measure or as an amendment to the Continuing Resolution (CR) – this weekend or possibly Monday morning. Another, perhaps more likely at this point, would have Congress coming back after Rosh Hashanah to finish up on Wednesday.

    Various sources have reported that Treasury hopes to have the program functioning within 3-4 weeks.

    On a procedural note, Senator Majority Leader Harry Reid filed cloture on the motion to proceed to the Continuing Resolution (CR) yesterday. Cloture will ripen tomorrow. This is significant in terms of timing because that means the CR may well serve as the vehicle to move (or at least vote on) the rescue bill (as will a second "stimulus" package).

    TARP: Right Solution for the Wrong Problem?

    (Avinash Persaud @ Vox) It is hard to come up with the right solution if you are addressing the wrong problem. Which is why Hank Paulson’s US$700bn, Troubled Asset Recovery Plan (TARP) is the wrong solution for US credit woes. The best thing that could be said about it is that in these febrile markets agreeing to any plan may help to restore confidence and buy policy makers enough time to find a better solution that would cost tax payers less and be more likely to succeed.

    What is the problem we are trying to solve it and what is the better solution?

    After an eighteen month cycle of write downs of assets, forced sales and further write downs, banks have travelled from illiquidity to the borders of insolvency. Banks asset values can no longer support bank liabilities. Capital is insufficient. Swapping troubled assets for cash - the essence of the TARP - may strengthen asset quality, but by crystallising the current distressed price of assets, it does nothing to address the problem of asset levels being too low relative to the level of liabilities. This was the right course 18 months ago, but not now. It is fighting the battle of illiquidity not insolvency.

    The TARP prayer is that by strengthening asset quality, banks would be able to raise fresh capital, but there is no guarantee of this. Investors will be mindful that even if the quality of the existing assets improves, banks are on the edge of insolvency, their current business models of securitisation, mortgage lending, equity short-selling and prime brokerage need to be rethought and other investors with as deep pockets as the sovereign wealth funds are nursing large losses for stepping in early. Tax payers may easily find themselves on the hook for another round of cash. Recall that Lehman Brothers, one of the smaller investment banks, went bankrupt with US$639bn of assets.

    TARP also manages to save the blushes of bank creditors by putting tax payers at risk. This is not the time for moral outrage to cloud clear thinking, and it should not be forgotten that policy makers share much blame in this crisis, but it does seem a little perverse to protect those that were paid to take the risk of banks failing, and instead to tax those that were not.

    The appropriate analogy is a Chapter 11-type debt restructuring of a bankrupt country or company. By swapping a bank’s debt for equity, and hence reducing bank liabilities to match the lower level of assets, a bank can stay in business without State control or money. It is done all the time for insolvent companies, though I am not underestimating the difference of today’s crisis in terms of the systemic nature of the loss of confidence in the financial sector and the sheer pace of developments. Moreover, corralling creditors to abandon their contractual rights is not easy at the best of times.

    Debt for equity swaps: A better plan

    When all creditors are desperate for cash, none may be willing to give up a bit to ensure all end up with something. However, as Anne Gelpern of Rutgers University points out, loan agreements are sacred but they are not suicide pacts. In my plan, once a bank declares that its minimum regulatory capital level is in danger of being hit, it can appeal to the government to facilitate a debt re-organisation where debt is swapped for equity so that bank liabilities fall back below back assets with some buffer.

    The government can apply a carrot and a stick to support agreement and confidence that the problem will be solved. Where debtors refuse to swap sufficient debt into equity, the central bank’s extended liquidity arrangements could be withdrawn for that institution. I am not convinced that it is required, but if it would support confidence in the debt markets, the government could also offer to co-invest in the equity with the creditors, through a parallel purchase of preference shares up to a maximum level that would put tax payers in hock for $70bn, say, rather than $700bn. Under this plan, managers and shareholders take the largest proportional hit. Bond holders share in the pain. The government’s principal role is as facilitator of debt re-organisation, not as the guarantor. Losses by creditors will help to re-introduce investment discipline, not reward indiscipline. Those with a capacity to diversify risks through time are not forced to crystallise losses today. In a world that has become capital-short, fresh capital is not required. By closing the asset-liability gap, the Damocles sword of potentially large asset sales now is removed, supporting the market recovery. And creditors and tax payers may even end up gaining from their investment in stability as the equity of these smaller, s recover.

    Valuing US Mortgage Assets: Help From Black-Scholes

    (Daniel Gros @ Vox) A key issue for the $700 billion bail out plan now being finalised is the pricing of the ‘toxic assets’ the US Treasury should buy. The main target of the Paulson plan is the market for securities based on low quality mortgages (sub prime and ‘Alt A’ mortgages). This subclass of the general universe of RMBS (residential mortgage-based securities) has become illiquid. How should these securities be priced? In the few market transactions still taking place their value has often been less than 50 cents to the dollar of face value. But it is difficult to establish a reliable market price. Are there any other ways to assess their value?

    This column discusses a simple way to thinking the valuation of mortgages and the establishment on fair prices for these securities. Preliminary calculations suggest that the value of securities based on lower quality mortgages might indeed be very low.

    How to estimate the value of residential mortgage-based securities

    The starting point is a key feature of the US mortgage market, namely that most loans are de facto or de jure ‘no recourse’. This means that the debtor cannot be held personally liable for the mortgage even if, after a foreclosure, the bank receives only a fraction of the total mortgage outstanding from the sale of the house.

    With a ‘no recourse’ mortgage, the debtor effectively receives a virtual put option to ‘sell’ to the mortgage-issuer the house at the amount of the loan still outstanding. Mortgage lenders are ‘short’ this option, but this is not recognised in the balance sheets. In most cases, the balance sheets of the banks report mortgages at face value – at least for all those mortgages on which payments are still ongoing.

    All RMBS, especially all securities based on low quality mortgages, should also take this put option into account in their pricing. It appears that this had not been done when these securities were issued. In particular it appears that the ratings agencies neglected this point completely when evaluating the complex products build on bundles of mortgages. A key input in banks balance sheets and the pricing of RMBS should thus have been a valuation of the put option given to US households.

    Given certain basic data, it is actually fairly straightforward to calculate the value of the put option in a standard ‘no recourse’ mortgage.

    The following calculations are for a mortgage of $100, which has an implicit put with a strike price equal to the loan to value ratio (LTV) because this is the amount for which the owner of the house can ‘sell’ his house to the bank. Most of the key inputs needed for the pricing of this option are in fact relatively straightforward. In the following it is assumed that mortgages run for 10 years, and that the riskless interest rate is 2% and the interest rate on mortgages is 6%.

    It is more difficult, however, to put a number on a key input in the value of any option, namely the (expected) volatility in the price of the underlying asset. Recent data might be misleading, since prices had been steadily increasing until 2006, but then started to decline precipitously. Over a longer horizon the standard deviation of the Case Shiller index has been around 5% per year, but over the last few years the volatility has greatly increased. The figure is about 10%, if one looks only at the years since the start of the bubble (2002/3). The following will concentrate on the low volatility case (5% standard deviation). It turns out, however, that this parameter is not as significant as one might first think. Under the high volatility case (10 % standard deviation) the losses would be under most circumstances only moderately higher.

    Applying the usual Black-Scholes formula to a typical subprime loan with an LTV ratio of 100% yields the result that the value of the put option embedded in the ‘no recourse’ feature is 26.8% of the loan, even in the low volatility case. For a conforming loan (a loan that could be insured by Fannie or Freddie) with a loan to value ratio of 80%, the value of the put option would still be close to 14% (still in the low volatility case). This implies that all sub prime loans (and other mortgages with a high LTV) were worth much less than their face value from the beginning. It is evident that the risk of a mortgage going into negative equity territory diminishes sharply with the loan to value ratio. For example, with an LTV of 60% the put option is worth only 2.8%.

    In reality it is not the case that all mortgages with negative equity (where the present value of mortgage payments is higher than the value of home) go immediately into default since a default on a mortgage (and a subsequent foreclosure) still has a cost to the household in terms of a poor credit record, some legal costs, etc. This fact could be taken into account by just adjusting the strike price by the implicit cost of a worse credit history, etc, maybe by around 10%. However, a foreclosure usually leads to rather substantial costs for the bank, which can be a multiple of the amount of negative equity that is calculated by using standard house prices indices. A sheriff sale often fetches a much lower price than a normal sale in which the time pressure is not that great. The loss to the mortgage lender is often far in excess of 10% of the value of the home. These two effects thus tend to offset each other and the second might even be larger. It is thus likely that the value of the option as calculated here does appropriately reflect the risk for banks, and might even constitute a slight under estimation.

    Given the high value of the put option on mortgages with high LTV ratios (i.e. especially subprime) it is not surprising that the value of the securities build on these mortgages should be rather low. The first loss tranches (e.g. first 10 % loss) are obviously worthless when the put option is worth already close to 28 %. Taking this put option feature properly into account shows why all except the ‘super senior’ tranches of an RMBS based on sub prime mortgages can easily fall in value below 50 cents to the dollar.

    How much are the assets still on the banks’ balance sheets worth?

    Another implication of the approach proposed here concerns the ‘fair value’ accounting of the $3.6 thousand billion of mortgages still on the balance sheets of US banks. The value of the put option granted to US mortgage debtors should reflect approximately the amount of capital the US banking system would need in order to cover itself against further fluctuations in house prices.

    Little is known about the quality of the mortgages that are still on the balance sheets of US banks. It must be assumed that most of them are not conforming to the standards (limits on LTV, documentation, size, etc.) set by the (now) state-owned mortgage financing institutions Fannie Mae and Freddie Mac, since banks could make substantial savings on regulatory capital by re-financing conforming loans. It is thus likely that the mortgages still on the balance sheets of US banks are either jumbo loans (Fannie and Freddie refinance-only mortgages of up to around $400 thousand) or lower quality ones. Assuming a realistic distribution of loan to value ratios, the average value of the put option embedded in all mortgages would be around 9.5% in the low volatility case and 12.7% in the high volatility case (10% standard deviation for house prices). Given that the overall stock of mortgages still outstanding on the balance sheets of commercial banks is around $3.6 thousand billion, this implies that the US banking system would need between $340 and $460 billion just to cover itself against the variability in house prices. Under ‘fair value’ accounting, this is the amount of losses the US would have to book today if they recognised the put option as being implicit in the ‘no recourse’ mortgages on their books.

    The total stock of mortgages outstanding in the US is about $10 thousand billion. However, the market value of these mortgages (whether still on banks’ balance sheets or securitised and embedded in RMBS) is in reality lower by $1-1.2 thousand billion, if one takes into account the value of the put option granted to US households.

    Why was the value of this option not recognised earlier? One simple reason might be that as long as the housing bubble lasted it was generally assumed that house prices could only go up, as they had over the 1990s. The average annual increase in house prices had been about 5% in the 15 years to 2006. If that number is projected into the future the value of a put option even on a sub prime mortgage with an LTV of 100% would have been below 5%, as compared to the 26.8% mentioned above, if one uses the standard assumption that the price of the underlying (house prices) follows a random walk without drift. Viewed from the perspective of ever-increasing house prices, the risk of negative equity seemed minor. Expectations about house prices have now changed completely, however. If one were to assume that house prices will decline by 3% annually over the next decade, the value of the put option would be even higher than calculated so far. For a sub prime mortgage with an LTV of 100% the value of the put option would be over 40% of the mortgage, and even for a conforming loan (80% LTV) the put option would still be worth 30 cents to the dollar. The value of the put options on which the US banking system is short would then be above $900 billion, and the total losses on all US mortgages could amount to over $2 thousand billion.

    If expectations of future house price declines are now appropriate, the value of all the securities built on sub prime mortgages might be close to zero. It remains to be seen what pricing, and thus what underlying hypothesis is going to be used for the $700 billion rescue plan.

    Editors’ note: this first appeared as CEPS Commentary, 23 September 2008 and CEPS retains the copyright.


    Details for the calculation of value of a put option embedded in ‘no recourse’ feature of US mortgages.

    Underlying Price
    Loan to value ratio
    Exercise Price
    Time until expiration
    10 years (mortgages tend to be long term)
    Risk free interest rate
    5 % (low volatility case) and 10 % (high case).

    Distribution of mortgages by loan to value ratio

    Value of put option under low volatility case.

    Value of option (in cents on the dollar) under different expected future house price changes

    + 5 % p.a.
    -3 % p.a.

    Source: Own calculations based on options calculator from www.option-price.com.