Bailouts

The words “Maiden Lane” evoke two completely different reactions when they are spoken at family get-togethers, like July 4^th:  1) Great joy and excitement on the part of the female family members imagining a shopping spree at San Francisco’s famous Union Square where a street named “Maiden Lane” sports several high end boutiques; 2) Disgust on the part of the family members involved in the financial sector, as “Maiden Lane” is the name of three LLCs established by the Federal Reserve Bank of New York (FRBNY) and used as vehicles to bailout Wall Street.

“Bailouts” seem to be the norm nowadays, not the exception.  Today, the Fed’s balance sheet is pregnant with the results of such bailouts.  Maiden Lane, LLC, the first one established in March, 2008, to bail out the stock and bond holders of Bear Stearns, holds substandard collateral valued at $28.4 billion.  As of July 1, 2010, no cash has flowed to the Fed from this collateral; so imagine how substandard this collateral must be.  The Fed says it values the collateral at “fair value”, which it defines in its footnotes as “the price that would be received upon selling an asset if the transactions were to be conducted in an orderly market” (Federal Reserve Statistical Release H.4.1, 7/1/10, Table 4).  This could be Fedspeak for “mark to model”.

Maiden Lane II, III, AIA Aurora, and ALICO Holdings are the collateral now on the Fed’s books associated with the AIG bailout.  Note that the collateral, valued again at “fair value” ($64.4 billion), is far less than the $182 billion it took to save AIG.  As a reminder, the FRBNY, for reasons known only to God and a few other god-like individuals, decided to pay AIG’s credit

Table 1: Selected Balance Sheet Entries Federal Reserve Consolidated Statement, 7/1/10

default swap counterparties at par despite the fact that the market value was closer to 40%-60% of par (for a complete discussion of the circumstances surrounding these decisions, see The Unholy Washington-Wall Street Alliance, at http://ancorawest.wordpress.com/2009/11/, written in November, 2009).  Table 2 shows who benefitted.  Note that foreign banks received $48.2 billion.  If the assets they held were worth 60% of par value (as AIG was certain to fail), America’s taxpayers involuntarily gave these foreign banks a gift of more than $19 billion.

Table 2: Major Recipients of Par Payment of AIG’s Credit Default Swaps

Table 2 also shows that three major American institutions received $24.9 billion of which $10 billion was a gift from an unaware American taxpayer. (It should also be noted that States received $7 billion as holders of AIG paper.)

The Fed’s Venture into MBS

Looking further into the Fed’s balance sheet, there is an entry for $1.1 trillion of mortgage backed securities.  These are not carried at market values.  The Fed says these are carried at the “current face value of the securities which is the remaining principal balance of the underlying mortgages”.  The reason that the Fed gives for carrying them at face value is that they are “guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae” (H.1.4, 7/1/10, footnote 4).  As a result of not reporting these at market value, the quality of these assets is unknown.  But, what we do know is that Fannie Mae and Freddie Mac are bankrupt.  Late last December (Christmas Eve day), the Treasury announced that they would guarantee Fannie and Freddie debt through 2012.  Without knowing whether such a guarantee will be continued after 2012, it doesn’t appear appropriate to be carrying such mortgages at face value and relying on the bankrupt institutions’ guarantees.  (At this time, it appears that continuing Congressional support is likely, but it isn’t certain, and 2 years can be a long time in the political arena.)  What would the accounting profession and the SEC do to a listed company that carried debts of financially troubled companies at face value when market values exist?

The Ultimate Cost of Fannie and Freddie

Since Fannie and Freddie have now appeared in the discussion, the American taxpayer, to date, has contributed $145 billion to their support.  Technically, Fannie and Freddie have borrowed these funds at a 10% interest rate.  The $14.5 billion annual interest bill amounts to more than their combined revenue streams in their best years.  Estimates for the eventual cost of Fannie and Freddie vary between $290 billion and $1 trillion.  Given the state of the housing industry and its prospects for the next few years, the higher number appears to be more realistic.  Table 3 is a tally of the bailouts to date.  While taxpayers might get some of this back via the collateral and perhaps some eventual debt repayment, most of this is a loss. That is, a loss to taxpayers.

Table 3: Tally of Bailouts

Such losses should have been taken by the stock and bond holders of the financial institutions, the auto companies, and holders of Fannie and Freddie debt (including foreign holders like the government of China).  While on the hook for these bailouts, American taxpayers have received no direct benefits.

A Better Use of Bailout Funds

It is nearly universally agreed that housing led the way into the current economic morass (some blame the Fed for overly easy money and the Congress for pushing Fannie and Freddie to make mortgage loans to those who couldn’t afford them).  Yet, even after the bailouts, CoreLogic reports (February, 2010) that 24% of all homes with mortgages (confirmed in May by Zillow’s 23% estimate) are underwater.  According to CoreLogic, that’s 11.3 million of the 47 million homes.  With no home equity to tap, any underwater homeowner who becomes unemployed or underemployed or has an emergency is highly likely to face foreclosure.  And, in many cases, people who can afford their payments are opting for “strategic defaults”, i.e., just walking away.

Note who benefitted from the taxpayers’ $2 trillion financed bailout – it certainly hasn’t been the taxpayer himself.  In his July 5^th daily Breakfast with Dave blog, David Rosenberg of Gluskin/Sheff indicated that “the amount by which mortgage balances exceed the value of real estate for those in default or near-default could be as much as $2 trillion”.  What if the $2 trillion used for the bailouts had been used to directly benefit underwater homeowners and the financial institutions at the same time?  If, instead of giving the money to Wall Street, each of the 11.3 million underwater homeowners received, on average, a $182,000 reduction on their mortgage, the housing market wouldn’t be in the state it is in today.  (Process: Homeowners apply for the difference between their mortgage balance and an appraisal; Treasury sends the pay down directly to the financial institution.)  This could have prevented most foreclosures and strategic defaults and could have energized the housing market.  Both taxpayers and the financial institutions could have directly benefited.

Some will object that this favors that certain population segment that made a judgment error and took on too much debt.  I argue that this segment is victimized by economic conditions in the same way as those who lose their jobs during recessions are victimized by economic conditions.  This year, we are giving the unemployed $14 billion in unemployment benefit disbursements (BLS forecast, May, 2010).  Furthermore, “earmarks” on legislation channel taxpayer funds to the benefit of very narrow and specific groups.  So, the singling out of a segment of taxpayers to receive benefits isn’t something new.

JPM’s Generosity

In June, one of my clients was forgiven a substantial portion of the loan on his primary residence by JPMorganChase (JPM).  It appears that JPM is doing this for the sub-prime and Alt-A loans it inherited from its FDIC assisted purchase of Washington Mutual (WaMu).  In my client’s case, a $250,000 principal reduction was given on a $937,000 principal balance (originally owed to WaMu).  The mortgage holder did not communicate with JPM or ask for any consideration, and had always been current on the loan.  The existing interest rate was 2.5% (variable rate loan).  In exchange for the principal reduction, JPM asked for a 5.0% fixed rate 25 year amortizing loan.  The client’s monthly payment stayed the same.

Recall that JPM received a large amount of FDIC assistance.  (While FDIC insurance funds are technically not directly from the taxpayer, they are indirectly, as banks raise their fees to pay for regulatory expenses.)  This action by JPM appears laudable.  After all, the shareholders of JPM appear to have gained from FDIC assistance.  So, some give back appears appropriate.  However, let’s not so quickly attribute this to JPM’s generosity.  JPM “purchased” WaMu’s assets at a huge discount to face value.  While I do not know the exact terms, let’s, for the sake of this example, assume 60% of face.  So, JPM was holding my client’s mortgage on its books at a $562,000 value.  Under accounting rules, JPM could only recognize a “profit” after my client had first paid down the $562,000 carrying value.  That would be 12 years away at the current payment.  JPM knows this homeowner is underwater, and, while they probably wouldn’t lose money if a foreclosure occurred, they would have foreclosure expenses and market wait time.  But, by forgiving $250,000 of the $937,000 balance (or 27%) but doubling the interest rate, JPM immediately recognizes more interest income on its financial statement (i.e., 2.5% of $937,000 = $23,425 while 5.0% of $687,000 = $34,350).  In addition, my client can now sell that home at market (about $800,000).  If the home does sell, the client ends up with some equity, and JPM recognizes an additional $125,000 in income ($687,000 principal balance less $562,000 carrying value).  No foreclosure.  No downward pressure on the neighborhood’s home prices.  Everybody wins!

The way the bailouts were done, it takes this kind of circumstance to actually get an appropriate outcome.  Had the $2 trillion in bailout funds been used to benefit the underwater homeowners to begin with, I doubt the housing market would be in its current funk.  As a nation now committed to bailouts, the operative rule ought to be, “any use of taxpayer money must directly benefit taxpayers”.

Robert Barone, Ph.D.

July 6, 2010