Why the “Newest” FDIC Foreclosure Relief Plan Is Likely to Fail But Another Concept Based on Alexander Hamilton’s “Assumption Plan” Might Well Succeed18 min read

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Before I write about mortgage relief based on Hamiltonian principles, I wanted to note recent developments.

First, earlier this week, Bloomberg carried a piece showing why LIBOR was a total and complete sham. In addition, it now turns out like dummies Mutual Funds are buying at the same exact time – like clockwork -Hedge Funds are selling. That is not a smart investment strategy either. Given the low volume, that results in high volatility.

Two, on the Credit Default Swap front, it appears that there may finally be an exchange-clearinghouse by the end of the year. Exchange operator Intercontinental Exchange Inc. (ICE) and the Clearing Corp. said Thursday they signed memorandums of understanding to develop a clearinghouse for complex insurance instruments known as credit default swaps.

As part of the agreement, ICE will acquire Clearing and form ICE US Trust and it is scheduled to launch by the end of the year, will have the backing of nine banks heavily involved in the trading of CDS’ — Bank of America Corp., Citigroup Inc., Credit Suisse, Deutsche Bank, Goldman Sachs Group Inc., JPMorgan Chase & Co., Merrill Lynch & Co., Morgan Stanley and UBS. Credit default swaps have played a prominent role in the mushrooming credit crisis that in the past month led to Lehman filing for bankruptcy protection, a government rescue plan for insurer American International Group Inc. and Merrill Lynch & Co. selling itself to Bank of America Corp. As we know, since the market for the swaps is so much larger than the initial loans they were meant to insure, credit default swaps have magnified risk exponentially.

Having been vindicated on those issues, as I want to discuss the “newest” FDIC mortgage foreclosure relief plan and why this is not likely to work but one that is being bandied about might. As I have noted in prior postings, while the problems associated with residential foreclosures are real, dealing with them is not easy. Unlike the old days where individual mortgages were traded in a secondary market, mortgages re now securitized such that they are so sliced and diced figuring out to unwind them is a major headache until the foreclosure happens. I should add that because investors could no longer put a value on the securities which were backed by pools of mortgages that spread the problem.

And, yesterday, Bloomberg reported that Federal Reserve Chairman Ben Bernanke acknowledged that the market for mortgage-backed bonds will require some form of government support through either guarantees or insurance programs to weather times of heightened stress. Bernanke continues to believe that securitization, the process where home loans are packaged together into a bond and sold to investors, is important because it allows banks to distribute risk and provides a wider pool of capital to finance mortgages. Bernanke believes – and the Rescue Law envisions this as to pre March 2008 securitized instruments – that it may make sense for the creation of a government bond insurer which would allow issuers to obtain a government guarantee for their bonds for a fee.

Bernanke also discussed the option of covered bonds. Covered bonds offer banks a way to raise money for new mortgages without either selling the loans or packaging them into securities. Instead, a bank issues bonds that are backed by a dedicated and regularly updated pool of loans, which stay on the bank’s balance sheet.

Almost 20 percent of U.S. mortgage borrowers owed more on their loans during the third quarter than their house was worth as foreclosures depressed prices and the economy weakened. Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac rose to 6.46% this week, up from 6.04% the previous week and 6.0% on January 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy remains dim.

Here is what we do know. One, real estate values have tanked. Two, more than 4 million American homeowners with a mortgage were at least one payment behind on their loans at the end of June, and 500,000 had started the foreclosure process. That is probably a historically high 1 in 10 “problem loan” rate. Over the past 10 weeks, Fannie Mae says it has received more than 40,000 defaulting loans and stopped 80% of them from going into foreclosure. And, three, 20% of U.S. mortgage borrowers owe more on their loans during the third quarter than their house was worth as foreclosures depressed prices and the economy weakened.

According to press reports, government agencies were contemplating using around $50 billion from the rescue law to guarantee about $500 billion in mortgages but only for 5 years. If they are talking a bout a 5 year period where all loans are in effect rewritten that might make sense but that is not what is under discussion. There have been so many leaks on this and questions it’s important to ask if these folks know what they are doing.

Initial reports where that the money would go toward covering future losses on loans that are modified according to standards established by the government. The program is intended to entice more mortgage servicing companies that handle billings and collections to reduce payments for homeowners by lowering interest rates, writing down loan balances or changing other loan terms. As one commentator noted, if $500 billion in loans are modified under the program, 25 % of them re-default and losses on those loans total 45%, the government would spend $28.1 billion (half of $56.3 billion). If re-defaults are 40% and losses 55%, the government would spend $55 billion.

While the FDIC wants to move ahead on a guarantee proposal, the Treasury which actually runs things is very nervous and the President may yet have to make a decision on this. Business Week had a story last night that the program would require banks, savings and loans, investment funds, hedge funds, and other holders of mortgages to restructure the loans based on a homeowner’s ability to pay lower monthly mortgage payments. Given the capitol injections into the banks, foreclosure relief is not unreasonable if done right. Per news leaking out from the FDIC, the government would somehow guarantee a second loan on the home, so banks and other lenders would not lose any money in a mortgage modification. The homeowner would get lower payments for the five years. And if the homeowner defaulted and went into foreclosure anyway, the government would have to make good to whoever had issued the loan.

As Business Week noted, “Exactly how that would work isn’t clear. The government could guarantee a loan that pays off part of the principal, thus lowering the payment. Or it could guarantee a loan that replaces the original mortgage—a prospect that could raise thorny legal issues (Business Week, 10/15/08) because of the way mortgages have been sliced and diced into securities. Other key details also have not been disclosed. It’s not known to what levels borrowers will be able to reduce their mortgages. It’s also unclear who would be eligible for the loans. Eligibility could be based on such factors as how big the mortgage is relative to the homeowner’s income or how up-to-date their mortgage payments are. “

As the story further noted, “Some analysts say such a program based on government guarantees ultimately won’t work. For one thing, it would fail to fix the underlying problem: borrowers’ inability to pay. Many homeowners are in trouble because they’ve lost their jobs or will be losing them as the recession picks up steam. For them, paying off a mortgage even at lower rates may be impossible. The proposal’s success could hinge on unrealistic expectations of an economic recovery, wage increases, and a recovery in home prices. After five years, homeowners may need to refinance or sell their homes at a higher price.”

Any FDIC program is doomed to failure unless the existing loans are gone and turned into new fixed 4% loans. Why? Because these “unusual loans” with slight changes would still be in effect!!! Rule 1 in fixing a problem is making sure it does not arise again. But Rule 2 is to fix the immediate problem swiftly but carefully.

In terms of Problem 1, on a going forward basis there is a consensus on what has to be done specifically and generally both tax policy wise and regulatory wise. On tax policy – and keeping in mind that all of the Bush Tax Cuts expire in 2011 – for instance, people have finally figured out that stock issuance is better than debt and to encourage that dividends have to be given better tax treatment on the corporate end – albeit there are distinctions in means.

In fact, I saw in a “slightly left of center” blog posting argument for immediately removing the double taxation of dividends, allowing companies to take the same tax deduction for dividend payments as they take for interest payments. This would decrease the incentives for companies to assume more debt than is absolutely necessary, increase the incentives for companies to pay dividends; increasing federal tax revenue as a result of taxes paid on shareholders’ dividends; and transform the U.S. economy from a culture of debt to a culture of savings and equity. The dividend tax change incidentally would cut the marginal corporate tax rate – something that both McCain and Obama favor.

The Blogger noted: “This reform would begin to reverse the quarter-to-quarter mentality of business. Companies would no longer be judged by a PE (Price Earnings) ratio that can be manipulated, but by a DE (Dividend Earnings) ratio that cannot; no accounting sleight of hand can hide how much a company pays out in dividends. This reform would allow the individual investor, 401k plan holder, IRA holder, and the like to make investment decisions based on companies’ actual dividends rather than on some number that is subject to manipulation.”

It is clear that until the 2003 dividend tax cut – and I would argue it is still the case – because interest is deductible, the favorable treatment of debt financing encouraged companies to become more heavily leveraged. As we all know, a heavily leveraged company is more likely to fail during an economic downturn such as the United States economy is presently experiencing, or in a period of rising interest rates. On the other hand, a company that uses equity financing has the flexibility to deal with business fluctuations by raising or lowering the dividends they pay out.

This is not new. A study which looked at companies from 1963 to 1998, found that companies that paid dividends provided a higher rate of return (7.8 % versus 5.4%) than those companies that did not pay dividends. In addition, Standard & Poor’s did a study covering the bear market from 2000 to 2002 and found that companies that paid dividends in the Standard & Poor’s 500 Index have maintained approximately the same value while companies that did not pay dividends declined in value significantly. Indeed, the credit crunch coupled with the 2003 tax law changes went a long way towards removing the tax bias of debt financing and help – particularly now – to bring equity financing back to the forefront.

Senator Obama recognized this because he is proposing to maintain the graduated dividend-capitol gains tax rates that Bush got enacted in 2003 [0-15- with a new 20% rate for persons making over 250,000 – which while it sounds complicated is what is the case now with the 0 and 15% rates – indeed unless something is done as of 1/1/2011 the rates will be 10-18%-20%] It appears that McCain wants to do away with that by making dividends less tax favorable – unless he proposes to cut both the dividend tax rate to the same level as a reduced capitol gains tax rate.

Also, last night on Charlie Rose Chuck Schumer had a number of interesting points about centralizing regulatory oversight which both Obama and McCain agree on.

In terms of real estate, sub-prime loans will be barred for a variety of reasons as well as securitization as we know it but that is not enough because it does not deal with existing mortgages. What has to be done is to get rid of the current ARM’s, balloon loans, Alt A loans, high fixed rate loans, etc. and move to affordable 30 year 4% fixed loans, period. However, this has to be done very carefully. The New York Times had a story yesterday that reveals the risks of screwing this up. As many have noted, there are more than 10 million homeowners who are “underwater” but they are not in foreclosure. You do not want to give incentives to persons begging to be foreclosed on. Going into default, to get a loan modification or to get rid of a burdensome house payment is very stupid for a series of reasons.

Indeed, the banks realize radical surgery is required. JP Morgan Chase JPMorgan – now the largest U.S. bank by market value, said yesterday that none of its customers will face foreclosure in the next 90 days while it finds ways to make payments easier on $110 billion of problem mortgages. The bank, which two weeks ago accepted a $25 billion cash infusion from the government, will examine loans and may agree to reduce interest rates or principal amounts. It will also open 24 centers to provide counseling in areas with high delinquency rates.

The JPMorgan program is expected to help 400,000 families with $70 billion in loans in the next two years, the bank said. An additional 250,000 families with $40 billion in mortgages have already been helped under existing loan-modification programs. JPMorgan said it would hire 300 loan counselors to help delinquent homeowners and employ about 150 people to review each mortgage before it’s sent to the foreclosure process.

That brings me to the new concept which asserts that determining who was “naughty” and who was “nice” will NOT work. If you are going to help persons in trouble, then you have to help everyone or else you award moral hazard. At the core of this “new” concept that is the federal government as a condition of TARP participation and in every other case, should buy up all outstanding residential mortgages in the US from the holders and turn all mortgages into 30 year fixed rate mortgages with a 4% interest payment.

This concept would not necessarily entail a reduction in the amount of principal. Lest anyone think this is radical, Fannie Mae, Freddie Mac, FDIC, and FHFA probably own or in effect own 75% of the current mortgages in the US. Pricing this would be difficult and the tax consequences have to be considered – and dealt with – but conceptually it would have a number of advantages. First, and foremost, it avoids picking winners and losers. Two, it would stabilize the foreclosure situation by getting rid of all “unusual” financing mechanisms. Three, assuming restrictions on new refinancing for participants, it would prevent any new real estate bubble. Four, at least in this state these new loans would be recourse loans which would reinstitute moral hazard. And, five, it would reduce monthly mortgage payments acting as a stimulus and likely have a minor tax impact because the reduction in interest payments would reduce the amount of that deduction for itemizers.

This new concept – if it is one – is based on the same principals of Alexander Hamilton’s “assumption plan”, which put the US on a firm financial footing. After the Constitution was adopted in 1789 and George Washington became the 1st President he appointed his former military aide Alexander Hamilton as Secretary of the Treasury with Task 1 to fix the public finances of the US which were in total meltdown.

The Continental Congress had run up huge debts to finance the Revolution – almost all of which were apportioned to the States. This included IOU’s in the form of Continental Bonds to soldiers who fought in the Revolution in lieu of wages. Most of these notes were purchased at discount by speculators. However, several states had in fact paid off half or more of their state or “apportioned” debts

Hamilton sought to inspire the confidence of domestic and foreign investors in the public credit of the new nation. After a lot of thought and study, Hamilton proposed that the US Treasury in effect redeem and reissue as federal debt all revolutionary debt owed by the Continental Congress and state revolutionary debt to the current holders of the obligations, which in the case of the States meant that there were winners and losers – one of the losers being Virginia because Virginia taxpayers would in effect be federal paying taxes to pay off other state’s debts. To pay for this Hamilton proposed excise taxes to pay this off which lead to the Whiskey Rebellion but also restored the credit of the US which meant that when Thomas Jefferson and James Madison executed the Louisiana Purchase, raising the money to do so was easy. The various terms and conditions of re-issuance were complicated but no one was stiffed with principal paid in full but interest rates reduced.

Among the provisions of “assumption” was redemption-re-issuance was to reduce the interest rate on the redeemed and reissued debt. Hamilton believed that a rate of 6% would require tax levels the people were unlikely to accept. It was therefore necessary to bring it down to a lower level which he did but as part of a voluntary agreement. The need to secure the consent of the creditors was why Hamilton’s proposal contained SIX different options to creditors to convert their old securities into a combination of new securities, tontines, and western land. Hamilton hoped that creditors would consent to new terms because as enlightened men they would realize that the original terms were not realistic. Heavy taxes were likely to produce tax resistance. The Assumption Act created both a primary and secondary market in securities which exists to this day.

One of the sub-rosa issues in refinancing the public debt was what to do about these IOU’s owed to the speculators – particularly those bought at deep discounts from the soldiers. James Madison initially proposed to give the present holders the equivalent of the highest market price for securities and to give the difference between the market price and the par value to the original holder. Contemporaries debated to what extent it was even possible to determine who the original owners were. Even if feasible it would no doubt have been a time-consuming process and Hamilton knew that decisive action was required – all of which sound familiar.

While Congress endorsed Hamilton’s plan to pay off the $11 million owed to foreign creditors, but initially balked at funding the domestic debt of $27 million and assuming the state debts of $25 million Hamilton proposed that the Federal government would assume all of the debts owed by the states, and it would be financed with new U.S. government bonds paying about 4% interest.

The House initially voted down Hamilton’s assumption plan in April of 1790. However, urged on by President Washington Hamilton cut a deal with James Madison and Thomas Jefferson on June 20, 1790 that gave the future capital to an area along the Potomac River while James Madison as a member of the House allowed passage of the assumption plan. Madison and Jefferson also got a key concession from Hamilton that eliminated $1.5 million of Virginia’s debt under the assumption, a large sum in 1790.

The Assumption Plan passed into law and was an immediate success. It established excellent credit for the Federal government, proved the government could handle its affairs, and inaugurated an era of wide prosperity. When Jefferson as President and Madison as his Secretary of State transacted the Louisiana Purchase, credit and funding were available because of Hamilton’s debt assumption plan which showed that the US was “good for it”.

The Treasury Department quickly grew in stature and personnel, encompassing the United States Customs Service, the United States Coast Guard, and the network of Treasury agents Hamilton had foreseen Hamilton immediately followed up his success with the Second Report on Public Credit, containing his plan for the Bank of the United States – a national, privately-operated bank owned in part by the government, which became the forerunner of the Federal Reserve System. In 1791 Hamilton released a third report, the Report on Manufactures, which encouraged the growth and protection of manufacturing.

Fast forward 218 years. It is very clear that picking winners and loser in the mortgage situation is impossible and unwinding this post foreclosure is very-very stupid. The only way to deal with is to do what Hamilton did which was to “assume” the debts and in effect reissue them – that is what we are really talking about.

Since the mid 1980’s Irwin Nowick has worked for the California State Assembly and State Senate on a plethora of policy issues, most notably firearms legislation. He has been described as “The Assembly’s resident genius” by a former Speaker of the Assembly and is seen frequently in the Capitol hallways and offices assisting legislators in drafting and amending pending legislation.

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