Detroit needs a bankruptcy

In an attempt to bribe Michigan voters, both parties supported some government aid for the auto companies. Finally, a $25 billion package was approved. This is the last thing the auto companies need.

The U.S. auto companies are encumbered with costly union agreements and a complex dealer network. They cannot walk away from these obligations as long as they are regular, functioning companies. The U.S. auto industry needs a bankruptcy to clean house. If they are not viable, let them shut down. Let some of their assets disappear, let some of their employees move to other industries, let other car companies buy some of their factories and employ some of their people.

Ronald Reagan was stupid enough to bail Chrysler out many years ago; now, the government has repeated the mistake.

Now, GM wants to buy Chrysler but doesn't have the money. They say the cash they're getting from the government is not enough for such a purchase. So, GM is lobbying for the government to help them buy Chrysler. Sigh.

Social Security's Trust Fund

The Social Security's Trust Fund is a fiction. Basic problem: it is not a fund in the first place.

Joe Sixpack (or is it Joe Plumber?) might create a "home down-payment fund". He does this by putting aside some money and not spending it. The bank is his "lock-box". Imagine that he did something else: he loaned the money to himself and treated the IOUs written to himself as if they were a fund! For all his protestations that he owes money to himself, we would have to tell him that he has spent it, and the fund is fiction. The same with social security.

So, it really irritates me when newspapers who ought to know better, gloss over this, and pretend that this fiction is real. For instance, this New York Times story says:

If no changes are made, the Social Security trust fund is projected to deplete its reserves in 2041 and will begin paying out more than it collects in benefits even sooner, starting in 2017.

Both these dates are bogus. Firstly, there is no fund. Secondly, Social Security has already reached the point where collections are much neared payout levels than "fund" accounting would show. That second fiction is maintained through another ruse: over the original IOUs that Joe Sixpack wrote to himself, each year he write brand new IOUs to pay himself interest! The New York Times adds this fictional interest to the fictional inflows, to calculate a total collection that is significantly larger than it really is.

Summary: The first step toward reforming social-security is to be honest about what it is, and not to use terms like "fund" and "interest" that only obfuscate.

Appendix: Detailed numbers:

The Social Security administration (see page 2 on this PDF), shows the following for 2007:

• "Fund" Income $ 772 billion
• Outflows $ 624 billion
• Surplus = $ 158 billion

However, about $95 billion of the inflows were fictional "interest" on the fictional "fund". Subtract that, and one gets an inflow of about $677 billion and the surplus comes down to $53 billion. (Aside: Out of these non-government receipts, $18 billion comes from "taxation of benefits". This is money that is taken from retirees who had the wsdom to get rich enough not to depend totally on social security.)

Gathering Storm Clouds

If Obama is President, with a Democratic house, what economic damage would be added to our woes? I think such a government would focus on changes that do not increase the deficit too much. Within that theme, there are lots of bad possibilites:


Social security: Obama wants to raise the tax. This will fund the system, which recently slipped into deficit. On paper, this will also show the so-called "fund" increasing, thus appearing to push social security problems further into the future. With the recent stock-market collapse, alternatives like privatization would be laughed at. So, politically, there's a good chance this will pass. Also, the Dems might claim this is friendly to retirees. Florida is going to be important in 2012.


Unions: Democrats have been trying to push through a "card-check" system that would make it much easier for unions to move into companies like Walmart. In addition, there may be some subtle moves toward protectionism. These would likely be selective, seeking to protect unions in Ohio and perhaps in Michigan. With the dollar already low, U.S. exports are looking more attractive around the world; chance are the government will make some small protectionist moves and claim that the growing exports are their doing! Instead of restrictions on imports, expect hidden subsidies for U.S. companies -- something that will not be too cut-and-dried if other countries protest to the WTO. Expect things like the recent $25 billion guarantee to auto-companies.

Carbon Cap and Trade: Some scheme seems almost certain, since both candidates are pushing for it. The government might try to combine this with giving special offsetting favors to industries in Ohio (and maybe Michigan). Carbon caps can be structured to give existing companies a monopoly advantage. So, expect ertain businesses and unions, to be supporting the environmentalists.


Health Care: The government is going to try to push something through. They probably won't mess with the current employer-sponsored scheme for a while, but we can expect at least some tax on businesses that do not provide health-care. Perhaps they might come up with some rules that raise costs on places like Walmart, by claiming that Walmart let's the government subsidize their health-care costs. I don't think Obama will push to take over private insurance. The country is not ready, and he won;t want those costs on the budget in his first term.

Summary: Those are the most obvious moves that I could think of. The theme will be: important changes, but nothing that requires a tough political fight; only things where today's left-tilting electorate has been well-prepared.

I figure one might as well prepare one's activism and one's portfolio for these things today!

Public Retirement Deficit -- another $700 billion?

Once the housing-related crisis is history, what other un-budgeted government payouts loom ahead? The big ones are Social Security and Medicare; but people know about those. One that is not as much on the radar is the shortfall in state government pension funds.

According to a PEW study "Promises with a Price" , "states’ retiree ... benefits ... due over the next [three] decades that can be conservatively estimated at $2.73 trillion. That includes about $2.35 trillion for a wide range of employee pensions, including those for teachers, and an additional $381 billion for retiree health care and other non-pension benefits for state employees only, excluding those for teachers and a handful of other groups. ... ... To their credit, states have socked away enough to cover about 85 percent of the pension bill. But there is very little put aside for non-pension benefits. All told, states face about $731 billion in unfunded bills coming due. "

Assumed Rate of Return: One major assumption is: how much will pension funds earn on their investments. Today, the plans assume a return of a little over 8% p.a. This is far from conservative for a pension-fund. As Berkshire's Charlie Munger's remarked (Wesco shareholder's meeting, 2008) pension funds rather take on more risk, than admit they cannot make 8% over the long term, which would mean an adjustment (requirement for new "top-up" funding) today.

A news-story about San Deigo shows some of the short-sightedness that goes on. The city was assuming an 8% return. Obviously this means that some years will be higher and others will be lower. The wise folk who run the city decided that in any year that they make more than the average 8%, they would use the "surplus" to re-calculate a more generous retirement package!
Similarly, during the late 1990's, when the stock-market boomed, some states skipped their funding, declaring a pension-funding "holiday".

If the recession we're currently in, and the government's shenanigans that promise big structural impediments to the markets, leads to a 6%-7% stock-market growth over the next decade or two (some would say I'm being optimistic), pension fund deficits will be significantly higher than $360 billion.

Assumed COLA: It appears that public pensions do get cost-of-living adjustments (COLA). Fortunately (for the government budgets) these seem to be decided by ad-hoc union bargaining, rather than by a strict formula linked to CPI. Nevertheless, if inflation ratchets up in the 2010's, we can expect calls for more COLA, and a higher bill.

Summary: $360 billion pension shortfall, and $370 billion) retiree health-care shortfall. If the stock-markets grows more slowly, the pension shortfall could be higher. If inflation grows faster, both the pension and healthcare shortfalls could be higher. A trillion might be a nice, round, conservative figure.

Tomorrow's Sub-Prime Losers

Many have stopped giving mortgages to poor, high-risk borrowers. No surprise there. Indeed, in the current climate of fear and searching for new capital, the pendulum has swung to being extra-cautious.

Does this mean that poorer borrowers who might have otherwise been able to convince good lenders to give them a mortgage will have to wait a few years? No... it might have... in a free-market, but the Federal Housing Administration (FHA) has ridden to the rescue.

According to Bloomberg, over the next three years, the FHA will underwrite $300 billion worth of high-risk mortgages. How good are these mortgages, according to the Congressional Budget Office (not some free-market think tank, skewing the numbers): "The Congressional Budget Office estimates that 400,000 households will get FHA- insured loans and about one-third of those will fall behind again on their new loans."

Once more, fact trumps fiction!

Why aren't millions writing angry letters to Congress, protesting this bailout of Main Street?

Main Street vs. Wall Street (Part 2): Illustrated :)

In a previous post, I said that "Main Street vs. Wall Street" is an incorrect way to think of our current financial problems.



The issue is not money, not the $700 billion... but something more fundamental: the role of government. This might be a turning point (hopefully temporary) where the U.S. goes through a phase of relatively-increased class-warfare and (resulting) government control.



To understand the money involved, contrast this bail-out to the recent "stimulus checks". If I remember right, that was a government outflow of $150 billion. In contrast, the "bailout" is an outflow of $700 billion, of which much will flow back when the paper is sold. Even if we assume that the $700 will become $1 trillion; there's a good chance that a large chunk of that will be repaid by the mortgage holders. It all depends on the prices at which the government buys the paper, but it's pretty reasonable to assume that the net outflow will not be much more than $200 - $300 billion. (Even Paulson's assertion that there may be zero net outflows is not total hogwash.)



Yet, there is such a ruckus about the bailout, while many people I know ("Main Street" folk) were glad to get the stimulus checks. Why? Because it is not the amount, it is about the perceived unfairness. This perception is creating an environment where voters are more disposed toward socking it to the rich. This structural change has more serious consequences than the bailout itself.



Here's an illustration: On the left is Wall Street, consisting of good guys and bad guys. On the right is Main Street, with both good and bad. In both places, there is more good than bad (the illustration does not do that enough justice).

Using this map, the politicians want the battle to be fought left to right (Wall Street vs. Main Street). The real battle ought to be fought top to bottom. If the responsible home owners and borrowers and the responsible bankers team up, they do not have to subsidize the irresponsible.

The politician fears that: they will not need him any more. instead, he looks at this and sees lots of money on the left and lots of votes on the right. So, that is the battle that he promotes, because only he has the legal power to take that money from the left and hand it over for votes on the right.

Emergency Legislation we really need

There is one piece of emergency legislation that we really need right now: temporary suspension of CRA-related review of bank mergers and acquisitions.

I'm politically savvy enough to know that the CRA isn't going to be repealed any time soon. However, political pressure can be brought so that the government temporarily suspends (they might call it "give a lower weight to") past CRA compliance, when approving buy-outs.

This will allow sound banks that have money to bid for poor banks, even if the sound bank has not done what the government wanted under CRA. There is a large example of that right now. The government told Wachovia to merge with Citibank, and as part of the deal, the government underwrote some of the riskier Wachovia assets.

Now, Wells Fargo -- probably the best bank among the super-large, national ones -- has offered to buy Wachovia for more, and without requiring the government to underwrite risky assets. It is imperative that the government does not stand in the way of this merger. If Wachovia has made some commitments to Citi, let the courts decide that; but, the executive and legislature must not favor one over the other for CRA reasons... let the higher bidder win.

An activist group from Florida is up in arms about the Wells Fargo offer. Here is their criticism: "[Wells Fargo] has virtually no CRA presence in Florida. It exists mainly to fulfill objectives derived from its California headquarters with little or no input from Floridians. They have showed total disregard for Florida’s minority and under-served communities... ”

It is sick that these cannibals aren't happy they devoured their previous golden geese; they want the old parasitical rules to apply to those who are still standing. In the spirit of "emergency" the government may go light on a CRA-review and let the deal go through. I intend to write to to the President and my legislators, telling them I'd like to see a formal emergency suspension of CRA reviews.

Wall Street vs. Main Street - Faulty conceptualization

The "bailout" is being framed as "Wall Street versus Main Street". Bush, Paulson, Obama and McCain, all say this package is not for Wall Street, but really for Main Street. Detractors say they don't want Main Street bailing out Wall Street. The battle of the two streets is the battle of class-warfare.

However, our problems were not caused by the rich to be paid for by the middle class. Primarily, this is a government-caused problem: caused by messing with the economy, distorting the price-mechanism, and the risk-tolerance of market-players. Even secondarily, it is not the rich (Wall Street) who took advantage of this (or were led astray); nor was it the middle class (Main Street) who were left out of the craziness. No, that is faulty categorization.

The fallen: People who took advantage of, and were misled by, government actions came from both places: on the one hand they were people who were buying more home than they would have if the government had not engineered artificially low interest rates and artificially low risk-premiums. And, then there were investors who bought into the same "reality".

The responsible: Meanwhile, people who stayed away from the fray also came from both Wall Street and Main Street. Many banks kept their distance from the madness, and some investors started selling Fannie and Freddie stock when those two began delving into sub-prime paper. On Main street too, many people did not use their homes as piggy-banks; and even today one in three U.S. homeowners own their homes 100%, with zero mortgage debt. Even among those who can get loans (incomes over $150,000 a year), 20% do not carry mortgages.

The tab: It is also false to say that Main street picks up the tab. The rich pay taxes too!

In summary: The Main Street vs. Wall Street classification is misleading. It would be clearer to use a different distinction.

Bonus: Here's a transcript of an interview with John Stumpf, CEO of Wells Fargo, a bank that has not made the news because it is safe and sound. It's boring today, and was not sexy yesterday. These are the types of people that make America great.

Wealth Redistribution

After bailing out Bear Stearns' creditors a few months ago, this weekend the U.S. government decided to bail out the creditors of "Fannie Mae" and "Freddie Mac".

The government's argument goes like this: these firms -- Bear, Fannie & Freddie -- are solvent but not liquid. Since they are solvent, their assets will finally be realized, and will be enough to pay off their liabilities. However, today, there is no market (or a poor market) for some of their assets. So, they cannot meet their short-term liabilities today. The situation, the government says, is analogous to a run on a well-capitalized bank, where the bank cannot meet 100% of its short-term liabilities on demand, but could if given some years.

Also, the argument goes, failure will have a "domino effect". If the government does not bail out Bear Stearns, the confusion that could ensue would bring down much larger firms. Then, one might be faced with the government bailing out someone much bigger, say Fannie Mae or Freddie Mac. Oops, they just did, anyway!

That's the pro-intervention argument. However, if these firms are so obviously in good shape, then why doesn't some other company step in. True, J.P. Morgan did step in to take over Bear Stearns, but only with the government guaranteeing about $29 billion in credit.

Who is the government though? It is you and me. However, in terms of tax-money, it is the big taxpayers in the country: the rich pay most of the taxes. So, consider this: Warren Buffet used to be a large shareholder in Fannie Mae. Then, back in 2000/2001, he sold out almost all his shares in the company. Commenting that he was uncomfortable with the risk, he said, "We're never sure if there is an iceberg situation or not. We figured we'd never see it until it's too late."

Well, Mr. Buffett, you thought you were getting out of Freddie and Fannie, but we voters are putting you right back in. Except, while we use your tax money to take the risk you refused to take, if things work out, we'll spend the profits on "No Child Left Behind".

No, I'm not sympathetic to Buffett, because he buys into this crappy philosophy as well. However, I use him to illustrate wealth-redistribution. Take from Buffett and other rich tax-payers, and pay to shareholders and creditors of Bear Stearns, Freddie and Mac. For the xenophobes among us, remember, this means paying to lots of Japanese and Chinese who thought that these U.S. companies were solid.

As for the "common man" like me, I probably won't be hit much more on taxes, but the when government creates new money, the deficit goes up and inflation rises. Inflation acts like a tax.

Unintended Consequences

Sometimes actions have unintended consequences. However, many unintended consequences should have been anticipated by reasonable men, with a reasonable grasp of the particular area of action. Next time you hear a politician say his actions resulted in "unintended consequences", translate that to mean he's saying he is ignorant and negligent -- the odds favor that explanation. Here are some examples:

Congress creates incentives that divert corn from food to fuel. The unintended consequence: higher corn prices!

Rising food prices mean that farmers in India can get higher revenue. Instead, the Indian government bans export of rice, limiting the demand to the poorer Indian market. However, the farmers are still paying higher prices for inputs like gas, fertilizer (and seed). The unintended consequence: farmers planting less rice!

Or take the government trying to address economic problems (in part) by sending out "stimulus checks". The unintended consequence: future inflation that takes back what it gave.

Understanding the Sub-Prime Rate Freeze

Recently, the U.S. government announced a 5-year "freeze" in sub-prime ARM mortgage rates. This is not a law. Ostensibly it is a voluntary decision of various private companies, with the government bringing the parties together. Whether government pressure was involved, I leave mostly to your imagination. [See, ARI's Press release] However, one way to guess, is to understand the terms of the deal, and to judge if it appears like a sound business decision.

Before going on to the details, it's important to point out two things. First, a deal like this would be legitimate if it were truly voluntary. Second, many firms had been calling for an industry-wide standard, voluntary compromise framework. The devil is in the details, though.

Legitimate if Voluntary: Some forum discussions have pointed out that giving poor borrowers a break penalizes the more reasonable borrowers. This is true. However, if the lenders make voluntary accommodations with borrowers, it would be perfectly legitimate. If this announcement was fully voluntary, one would not ask the government to stop it, even if it meant that there would be some consequences that would negatively affect others (e.g. by keeping prices higher than otherwise).

Was it Voluntary? The American Securitization Forum represents many companies in this business. They had previously been calling for industry-wide standards. They wanted standards to deal with the abnormally large number of sub-prime mortgages that will reset in the next two years. Servicers are allowed to act as agents for the investors. They may make accommodations with borrowers. However, they wanted to come to some industry-wide agreement on what types of accommodations would be reasonable. Part of the motivation is that, having such a agreement would reduce the risk that lenders would start suing their agents, either for being too lenient with borrowers, or for being too strict. [For more on mortgage securitization, see my earlier post.]

So, the companies involved in this business have been contemplating a standard. The government's role has been to push them toward a final framework, and -- I suspect -- to ensure that the framework is more lenient on the borrowers than it otherwise might have been.

The Framework: The new framework relates only to sub-prime loans. It is for borrowers who did not have great credit to start out. Either, their credit score was not in the top ("prime") range, or they could not document their income. Also, the framework only relates to adjustable rate mortages (ARMs) with current low "teaser" rates rising to a higher rate in the next two years or so.

Three segments: Broadly, the new framework classifies sub-prime borrowers with ARMs into three segments:

• Good borrowers: Those who can afford to refinance or to pay the higher rate [e.g. they have enough equity in their homes, or their credit scores have improved since the time they took out their mortgage]



• Bad Borrowers: Those who cannot afford to pay even the introductory rate [e.g., people who are already delinquent, even though they're on the low teaser rate]



• Those in the "middle" ("Segment 2"): they've paid so far, but may not be able to pay the higher rate

The announcement does not apply to the "good" and "bad" groups. The "good" group will be expected to refinance of pay the higher rate, as agreed. The "bad" group will face regular servicing procedures: either foreclose, or an individual deal; no standards have been laid down. The group in the middle is large, estimated to be as high as 1.8 million borrowers!

Criteria: The group "in the middle" is identified as follows.

• They have been able to pay their low teaser rates, thus far
  
• They have credit scores of 660 and below,
• Their credit has not improved much since they took out their mortgage.
• They owe a large amount, relative to the value of their homes (they have equity of 3% or less), making refinancing difficult, and making it less likely for foreclosure to be profitable to the lender

So far, so good. As such, these are good enough criteria to start to identify borrowers whose ability to pay is in doubt. The next question is: what should be done about this segment?

The solution for "Segment 2": The framework says that these doubtful borrowers will see a freeze in their rates for 5 years. Servicers will not investigate each loan individually. Instead, the servicers will assume that these people, as a group, cannot afford to pay the previously-agreed higher rate. The servicers will freeze their rates at the teaser rate for 5 years. Anyone who is paying "interest only" will start paying principal as well; but, the interest component will remain unchanged.

A drink to the alcoholic: For some borrowers, this "solution" is like giving a drink to an alcoholic, or five more years of liquor!Yes, there will be some borrowers who will be shocked into reality, who will wake up and start to prepare for the day 5 years down the line when their payments go up.

However, it's my guess that many risky borrowers, will simply be in the same position 5 years from now. Some will be shocked out of their ignorance, many will not. The ones who were actually evading the fact that they could not pay, probably won't change.

I think a better solution would have been to start turning the screws. For instance, instead of a freeze, the borrowers could have been asked to pay rates that increased slowly, instead of at a single jump. Rates could increase over the next five years, reaching the agreed-upon rate in the sixth year. Or, freeze the rate, but insist that they pay something toward principal each year, increasing every year. (Those who are on interest-only could have had a slightly modified version.)

Five years of equity-building: The lenders do hope that home prices will stabilize in the next few years, and that 5 years from now, home prices would have risen. Hypothetically, suppose home prices go down 10% in the next year, then stay stagnant for a year, and then rise at 2%, 3% and 5% for the next 3 years. In the fifth year, the average home will end up 5% higher than today. With that, the average borrower will be in a slightly better position to refinance; also, foreclosure will be less of a loss for the lenders. Many of these borrowers had been counting on rising home-prices. So, from that perspective, it makes sense to wait out some period when one can reasonably expect some appreciation.

Inflation: Recently, there have been increasing fear of inflation. If the government ramps up inflation ever so slightly -- say by 1% or 2% a year -- the 5 year scenario will appear even "better". The 5% appreciation will end up closer to 12%. (Of course, this acts as a tax to everyone else in the economy.) Since the Fed is in the beginning of an "easing", slightly higher inflation expectations seem reasonable (even if one does not like it). So, keeping this in mind, it actually does make sense for lenders to wait things out a bit.

In summary: Servicing companies do have the authority to accommodate bad borrowers. In the current situation, it seems reasonable for lenders to clamp down on the truly bad borrowers, to let the good ones pay, but to tide over the next few years with the doubtful ones in the middle. I think a reasonable lender would have tried to separate the wheat from the chaff using a plan that ramped up rates slowly, or something similar. It is my guess that the government put some pressure on them to be more lenient in that regard. However, the framework is probably not way off from what the industry might have reached on its own.

However, just as a few pennies in gas tax is objectionable, having the government push lenders a toward a framework that is not what they would have come to voluntarily is also objectionable. The good guys do end up paying. Also, on the housing front, this framework is probably just one of many things the government will do. I've already mentioned increased inflation. Also, the Federal Housing Administration is touting some new loans for people with poor credit, and obviously there's a tax-payer funded subsidy hidden in there. Also, for tax-year 2007, a new law allows sub-prime folks who pay mortgage insurance (PMI) to deduct it, while they were not able to do so before. If the housing slow down drags on, Congress will likely pass more such laws. It is relief with a thousand band-aids for sub-prime borrowers, death by a thousand cuts for others.

Legal status: There is one more thing to add about the legal status of this new framework. Even though it is not a law, it does carry legal weight. Most servicing contracts allow a servicer to make accommodations with bad borrowers, as long as these are reasonable and customary. Suppose some Japanese holder of US mortgages tries to sue, this new framework basically details new rules that are now "customary". The framework says explicitly: "...upon adoption ... by a substantial number of loan servicers... the fast track ... will demonstrably constitute standard and customary servicing procedures... " (page 10 of the framework). As a non-lawyer I wonder how valid that is: could the Japanese third party expect the standards that were in place when he did the deal and reasonable changes to those, or can he be deemed to have agreed to any new standard as long as it is customary? As for "reasonable", it will be interesting to see what happens if someone sues. The servicers can be assured that the government will declare that they are being reasonable.

P.S.: Oh yes, if you happen to be a sub-prime ARM borrower, with a loan resetting in 2008/2009, do the opposite of what you did when you took out your loan. Where you tried to appear credit-worthy then, try to appear unworthy now. Make sure not to be delinquent. However, do not pay more principal. Do that and a "brother's keeper" will give you a break. [This last bit is tongue-in-cheek.]