Making Tough Decision

I almost titled this post "The Bitter Pill" but thought better.

The Senate has voted in favor of a $700 Billion bailout of Fannie Mae/Freddie Mac. Wow. $700 Billion is a lot of money no matter how you view it. What do the taxpayers get in exchange? We get to be in the mortgage investment business corporately (as in we're all in this thing together). We will own $700 Billion worth of mortgages which are secured by about $560 Billion worth of real estate (assuming a 125% of value mortgage).

Once we own those mortgages what will we do with them? The first hope is that we could re-sell them on the open market. That could be a problem. The one's the government will own are the one's no one else wanted in the first place. Will we foreclose on the properties for those mortgages that are non-performing? Hmm -- I have a hard time seeing that happening although it does in small doses already. FHA has been foreclosing on real estate for a long time.

Let's say that we eventually will recover about half of the $700 Billion by either selling the mortgages or the foreclosed properties. That means about $350 Billion will be non-recoverable debt -- that will be made up from taxes. That's what makes this such a bitter pill to swallow.

But, let's look at the other side of this. What happens without a bailout?

First, we have a bankrupt Fannie Mae and Freddie Mac. Their assets are liquidated by the court and the net result to the economy will still be a loss of about $350 Billion. But we also have all of the $5.3 Trillion in mortgages that were guaranteed by Fannie Mae/Freddie Mac whose guarantees are now worthless. Any of the mortgage based securities sold to various financial institutions and individuals that are non-performing are now worth considerably less than their previously guaranteed value.

In the case of securities held by individuals, it is a matter of writing down their value, taking the loss and moving on. In the case of those held by financial institutions there is suddenly a huge problem. When the securities are written down, the financial institutions must then "classify" those assets as non-performing. Those classified assets offset the capital of the financial institution and cause many to drop below the minimum threshold required by the FDIC or other regulatory bodies. It also drops the available funds for lending to borrowers even though they may be well-qualified borrowers. In other words, the credit market dries up and many banks fail.

What happens when the credit market dries up? Business comes to a halt. Grocery stores can no longer stock their shelves. Auto dealers can no longer extend credit because somewhere behind that dealership is a bank or other financial institution underwriting the loan. In fact, many businesses will fail if credit becomes tight. When businesses fail, people lose their jobs. When people lose their jobs in an economy which is contracting due to unavailability of credit, there is little hope of finding a new job. We enter into a Depression.

This financial disaster is NOT a Wall Street problem alone. It is a Main Street problem. It affects the stock market because corporations must have credit to operate. The real problem though is the impact on the credit markets. Without credit, our economy comes to a halt. The taxpayers are going to be hit whether a "fix" is passed or not. The hit will be much harder and much more severe without a fix. No fix means Depression and huge loss of equity in retirement plans and many other assets. A fix means buying time to come up with a longer-term solution.

I applaud those Senators, like John Cornyn, who voted in favor of the fix. They knew that it was not the popular thing on Main Street. But, they also know that it is sometimes necessary to make tough decisions. I mention Senator Cornyn because he is up for reelection this year. His opponent can make political hay of this vote and if he's smart, will do his best to make the Senator appear to favor Wall Street over his constituents. In fact, it's the other way around. By making the tough call, Senator Cornyn is siding with the people of Texas. I pray that he will have opportunity to present legislation that will begin the process of fixing the underlying problems that created the financial meltdown in the first place. We need to send him back to Washington for another term.

The Common Sense Fix

Dave Ramsey has a proposed solution to the current financial crisis that I believe merits the attention of our Congressional leaders. It is called The Common Sense Fix. Read it by clicking on the link and then go to this page to see how you can take action. This is critically important to our future.

A Failure of Socialist Measures in the U.S.

Many are touting the current financial crisis in the U.S. as a failure of capitalism. That is wrong. It is a failure of socialism. The crisis is a result of socialist tending policies implemented by our legislators.

The current $700 Billion “bailout” of the financial industry is a case in point. In 1977 the Community Reinvestment Act became law. It was intended to “encourage” financial institutions to provide credit to moderate and low-income individuals. It was meant to stop the practice of “red-lining” which is not making loans into neighborhoods that were considered poor credit risks.

The Federal National Mortgage Association (Fannie Mae) was started in 1938 as part of FDR’s New Deal. It was a government sponsored enterprise until 1968 when it was converted to a private corporation. It was designed to purchase mortgages from private financial institutions and then to re-sell them in “packages” as mortgage-backed securities. It became the vehicle for lenders to meet the requirements of the Community Reinvestment Act. As of 2008, Fannie Mae owned or guaranteed about half of the U.S.’s $12 Trillion mortgage market. The loans held by Fannie Mae as of August, 2008, amounted to approximately $700 Billion – the estimated cost of the bailout.

The size of Fannie Mae backed mortgages has increased through the years to the point that a loan for a single-family dwelling in excess of $400,000 can qualify. It is not just the need for low-income housing that was being met by their guarantees. It was part of the reason for highly inflated housing markets across the country. When that bubble burst due to high oil prices which sent a ripple through our economy, the worthless nature of their guarantees became apparent.

The public belief that Fannie Mae backed loans are guaranteed by the U.S. Treasury is incorrect. Fannie Mae was a private corporation with traded stock. Investors who purchased Fannie Mae backed mortgage securities did so in the belief that the government backed the guarantees of principal and interest on those securities. It does not – or, it didn’t until the current bailout package.

Credit-worthiness should be the primary criteria for loans -- not pseudo-guarantees. The idea that everyone should be able to purchase their home is worthy, the method for accomplishing that through government intervention in the marketplace is not. People need to learn self-reliance, not government reliance. It is time to get the government out of the marketplace.

A Senator Calls for Mortgage Loan Disclosure

As the mortgage scandal rocks on there is at least one call for clarity in disclosure. Let's hope that it passes and let's hope that it goes far enough. The only way to truly know if mortgage lenders are giving preferential treatment is to see the size of the loan relative to market value along with points paid and interest rates (along with average market rate for similar loans at the time of loan initiation). It is a scrutiny that few of us would desire of our personal lives but it is a price of public office.

Mortgage Crisis Bailout at Taxpayer Expense

I suppose that I have some old-fashioned ideas about debt. The first is that personal debt should be kept to a minimum. This would include consumer purchases, cars and homes. Business debt is a different issue but should be based on the business's ability to repay. The second idea is that if you incur debt you pay it back. The money that you borrow was someone else's hard-earned money. If they are willing to lend it to you it is your obligation to pay it back -- if it takes the rest of your life. I guess that's why I really have a hard time with debt forgiveness and bailouts.

Lenders have a responsibility also. They are responsible to their shareholders, their depositors (if they are a depository institution) and to the borrower. They shouldn't be loaning money to someone that is overextended. They should also counsel the borrower about debt.

Part of the mortgage lending crisis has to do with the way that mortgage packages are originated and then sold on a secondary market. The originator collects his fees and then passes on the servicing and ultimately the risk of the loan to someone else. Often, the risk of individual loans is hidden because it is blended into a package consisting of multiple loans.

This secondary market for mortgage loans has some advantage for borrowers in that it usually offers the opportunity for lower interest rates than might be the case if borrowing from an entity that intends to hold the loan. After all, a bank understands the risks associated with lending much better than the general public that might invest in mutual funds or other instruments that are comprised of mortgage debt. That is why they often charge higher rates for loans that they hold.

The downside for the consumer is that they often are encouraged to enter into a larger obligation than they can realistically expect to repay. This is sometimes justified with the idea that 1) on the average they won't own the house for more than about 5 years and 2) since the price of real estate is rising, they will be able to sell the house and pay off their debt. This falls apart in a falling real estate market.

Perhaps a solution to the problem would be a requirement that mortgage originators be required to escrow funds according to some percentage formula tied to risk exposure on a loan package that they are selling. The escrowed funds would then be tapped in the event of defaults within a sold loan package. The funds would be required to remain in escrow until a set percentage of the total value of the package was repaid. This would give them financial incentive to do a better job of underwriting the risk.

Ultimately however, it is the borrower's responsibility to repay his loans. Not mine as a taxpayer.

Financial Incentives Reduce Liklihood of Investigation

I think that the average American believes that most political officeholders gain some financial advantage from their position. It is a logical conclusion. Those who would benefit from legislation have a financial stake in the votes or influence of those in positions of power. The Countrywide Mortgage scandal now overtaking some members of Congress is probably viewed by many as merely the tip of the iceberg on the kinds of benefits afforded to Senators and Representatives.

Further enforcement of this belief by the public is afforded by the reluctance of the officeholders to conduct an in-depth investigation. There is apparent fear that much more will be uncovered.

There is opportunity for preferential treatment in many areas. Things like waiving minimum capital requirements for investment purchases, special rates on insurance policies, reduced interest on loans, reduced collateral requirements for business and investment loans, tips on real estate parcels, tips on litigation, and on and on. It is easy for the public to be suspicious. It is unlikely that there will be real reform. It is refreshing to see a call for investigation at the risk of exposing members of his own party. I wish Representative Hensarling luck in his quest. I hope that it is not merely a low-risk political maneuver. Low-risk because it is unlikely to garner enough support from fellow members to ever occur.