Jim’s Random Notes

Congress never ceases to amaze me.  Following the unexpected defeat of the measure on Monday, the Senate decided to take a crack at writing something that could pass.  The Senate’s technique was nothing short of brilliant.  Rather than debating the need for the measure and perhaps rewriting provisions to make it more palatable, they did what any good politician would do:  they added bribes to sweeten the deal for those Representatives who voted against it. 

Because the House is responsible for introducing legislation that deals with budgetary matters, the Senate didn’t introduce this as new legislation. Instead, the Senate greatly amended existing legislation, H.R.1424, which apparently has been bouncing around between the House and the Senate for 18 months. The Senate bill now contains the original enacting clause:

To amend section 712 of the Employee Retirement Income Security Act of 1974, section 2705 of the Public Health Service Act, section 9812 of the Internal Revenue Code of 1986 to require equity in the provision of mental health and substance-related disorder benefits under group health plans, to prohibit discrimination on the basis of genetic information with respect to health insurance and employment, and for other purposes.

And then:

Strike all after the enacting clause and insert the following:

And there follows the 110 pages of the House’s Emergency Economic Stabilization Act of 2008 and 350 more pages of additional legislation.  The bill, now 451 pages long, contains three divisions:

Division A: The Emergency Economic Stabilization Act of 2008.

This is pretty much the same legislation that failed to pass in the House on Monday.  A notable addition is Section 136, which temporarily raises the FDIC and National Credit Union Share Insurance Fund deposit insurance limits from $100,000 per account to $250,000 per account.  The idea behind this move is to reassure businesses and prevent them from moving their deposits from small banks to larger banks that are viewed as more secure.

Division B: Energy Improvement and Extension Act of 2008

Provides tax incentives and credits for renewable energy, investments in cleaner coal technology and biofuels, plug-in electric cars, energy conservation, and many other things.  It’s a scattershot energy bill that’s been working its way through the legislature as H.R.6049 since May of this year. 

DIvision C: Alternative Minimum Tax Relief Act of 2008

This part began life in June 2008 as H.R.6275, to provide relief from the alternative minimum tax for middle- and low-income taxpayers.  The original version was a few dozen pages long.  The new version is almost 200 pages in length and includes all manner of personal and business tax cuts, credits, and deductions.  And then there are the miscellaneous provisions, among them:

• The Paul Wellstone and Pete Domenici Mental Health Parity and Addiction Equity Act of 2008 states that health insurance companies have to provide the same level of coverage for mental health benefits as they do for medical and surgical benefits.
• A reauthorization of the Secure Schools and Community Self-Determination Act of 2000,
• Disaster relief legislation.

If you read the Table of Contents for each of the divisions, it becomes very clear that the Senate in its infinite wisdom targeted certain provisions to individual parties and even individual states in an attempt to win over those who voted against the original bailout plan.  In doing so, they had to be careful not to add something that would cause members who originally voted for the plan to vote against it.  Honestly, though, I don’t think there was much chance of somebody changing his vote from “aye” to “nay.”

Estimates place the cost of new provisions at about $105 billion, a very large part of which would fit under the category of “pork barrel projects.”  Both McCain and Obama voted for the measure, despite recent public statements about the evils of pork barrel spending.

It’s now five minutes to noon in Washington.  Party whips have been making the rounds in the House, trying to get members’ commitments to support the bill.  The House is set to convene at noon, and will be voting on this bill.  I’d like to think that those who voted against it on Monday will stand their ground, but I fear that politics will once again trump good sense.

Since Paulson, Bernanke, and Company aren’t forthcoming with layman’s explanations , I thought I’d take a little closer look at the problem to see if I could understand what’s happening here. What I found is that the problem is very large—potentially catastrophic. I’m also astounded by the hubris that got us into this mess, but that’s a topic for another time.

The fundamental problem today is that there is a lack of confidence in the financial system. Not so much by you and me, but by banks that lend money and large institutions that buy the banks’ debt for investment purposes. Investors demand more documentation and higher interest rates, which causes the banks in turn to charge higher interest rates and to be more careful in selecting borrowers. Ultimately, fewer individuals and companies will qualify for loans, and those who do will end up paying higher interest rates. Credit hasn’t dried up, but it’s a lot less available than it was previously. Creditors and investors got burned (in large part by their own greed), and now they’re being very (perhaps overly) cautious.

A key factor in the lack of confidence is that financial institutions’ portfolios have large numbers of assets that are difficult or impossible to value. A simple example would be mortgage backed securities. A mortgage backed security is, in essence, a bundle of loans that a lender has packaged up and sold as a single investment instrument. The price the bank asks for the package is based on the quality of the mortgages that make it up: their face value, the interest rates they pay, their maturities, the quality of the collateral backing them, and the credit worthiness of the borrowers. Industry rating agencies such as Moodys and Standard & Poor’s assign ratings that give some indication as to the risk level of such securities. Investors demand higher interest rates (or, sometimes, lower prices) for more risk.

But there’s a problem. It’s exceedingly difficult to know the real value of even one mortgage. Imagine the difficulty involved in computing the real value of a box that contains 100 mortgages. If you buy the box directly from the originating bank then you can have some confidence in the box’s value. Assuming, of course, that you trust the bank and the rating agency. But if you as an investor want to sell that box on the open market, you’re subject to the whim of the market. When things are going well, that’s a good thing. People are willing to spend $1,000,000 on that box of low-risk loans that pay an average of 5% interest because they have confidence that they’ll get their payments and that they can re-sell the box if they need the cash.

But the market can go sour. If a bank starts reporting higher levels of loan defaults, then every box of loans that the bank sold becomes less valuable because the probability of the box actually paying the stated interest or being sold at face value is lower. You could find that the market value (the price people are willing to pay for) your million-dollar box of loans is only $900,000.

Because of the difficulty in valuing mortgage backed securities (and many other investment vehicles), a very commonly used method of determining their value is mark to market. The box’s value is what people are willing to pay for it. Generally accepted accounting principles state that financial institutions use mark to market in determining their assets’ values. And transparency laws on the books insist that banks and other regulated financial institutions calculate the value of their assets on a daily basis.

Now, imagine that you’re a small bank. You take deposits from customers and lend money to individuals and local companies. You also buy high-quality (i.e. low-risk) mortgage backed securities to invest the depositor’s money. You’re very conservative with your investments, always get good documentation from your borrowers, and everything’s going great. Whenever you need a little cash to meet depositors’ demands, you sell one of those securities on the open market. This is how the financial system works when people have confidence in it.

But if the bank from whom you bought those mortgage backed securities starts seeing a higher than usual number of loan defaults, the value of the security you’re holding in your vault declines. As that bank’s troubles deepen, so do yours because it becomes increasingly difficult to sell those securities–not only at face value, but at all. If the originating bank defaults, you could very well end up unable to find a buyer for your box of loans. At any price.

You know that if you could open the box and show the individual loans to potential buyers, you could at least salvage some value from your investment, but that’s not the way it works. Your investment is essentially worthless. And since you have to report your financial condition on a daily basis, it doesn’t take long for the public (your depositors) to find out and begin demanding their money. You’re wiped out, and you didn’t do anything wrong.

I’m not just spinning a fantasy here, by the way. Such things do happen, and they have a cascade effect. As more securities become worthless, investors become less inclined to buy any securities. Institutions who hold those securities are unable to sell them in order to meet other obligations, and the financial system grinds to a halt.

That’s it in a nutshell. I’m sure there are economists who will say that the problem is more complex than that. In some ways, that’s true. I haven’t mentioned the more creative investment vehicles (like tranches) and the mania that helped get us where we are. I’ve tried to concentrate on what the problem is, rather than what caused it.

The problem, then, is that financial institutions are holding securities that nobody wants to buy. The securities’ values, based on mark to market, are essentially zero because there is no market for them. The truth is that some of those securities are very valuable and some really are worthless. But right now there’s no way for buyers to know which is which. The point behind the bailout is to create a market—to buy securities and by doing so restore some investor confidence so that they, too, will begin buying.

So that’s the problem and the rationale behind the proposed solution. Whether the proposed solution is right or even necessary is still a matter of some debate among economists, and also in my own mind.

I was pleasantly surprised yesterday when the House failed to pass the Emergency Economic Stabilization Act of 2008.  (Be patient.  That site is getting hit pretty hard right now.  You might be better off visiting your favorite news site for the full text.)  From news reports over the weekend and yesterday, I was pretty sure that it was going to pass.  It’s interesting to note that approximately 40% of Democrats and about two-thirds of Republicans voted against the bill.

What would be much more interesting to me is why the bill didn’t pass.  News reports contain nothing but a bunch of partisan sniping.  Some say that Speaker Pelosi’s comments before the vote angered Republicans.  If true, that doesn’t say much for those representatives whose feelings were hurt, or for Rep. Roy Blunt, who was dumb enough to put forward the suggestion.

I wonder how many voted against the bill because it was unnecessary, or because it was bad legislation.  I also wonder how many members’ votes were cast in response to constituents’ support or opposition.  According to an Associated Press analysis, 13 of the 19 most vulnerable (in the upcoming election) Republicans and Democrats voted against the bill.

And that brings me to the real point I’ve been struggling with:  where should a Congressman’s loyalty lie?  Should he be more concerned with the good of the country, or should he be more concerned with satisfying the whim of his constituents so he can get re-elected?  On the same note, do we elect our Congressmen because we trust them to do what’s best for the country while keeping our interests in mind, or do we elect them to bring home the bacon?

I need to think more about that one.

In all the hype surrounding this mess, I’ve heard a lot of alarmism, but very little hard fact.  Paulson and Bernanke warn us of “dire consequences” if we don’t provide some assistance.  I’d like to trust them, but I trusted President Bush and his advisers when they told us that we needed to invade Iraq.  I trusted that they had credible evidence of nuclear or biological weapons development and that they actually had a plan to transition Iraq into a stable, functioning democracy.  It turns out that they had no credible evidence and their “plan” amounted to “kill the bad guys and everybody else will join hands singing Kumbaya.”

So excuse me if I’m skeptical when the administration all of sudden decides that the economy is in grave danger and the only way out is to spend 700 billion dollars.  This is the same administration (and largely the same Congress) that has been ignoring the problem for the last few years, insisting that there is no cause for concern.  Bernanke and Paulson may very well be smart guys.  But their association with the current administration makes them suspect in my eyes.  They’ll have to provide me with a whole lot more evidence than their vague warnings of “dire consequences” before I’ll believe what they have to say.

Have you read the text of the Bush Administration’s proposed 700 billion dollar bailout of financial institutions?  If you don’t want to wade through the three-page proposal (although it is written in reasonably clear English), this summary will tell you all you need to know.  (Thanks to David Stafford for the link.)

When that proposal was presented, Congress was given the opportunity to exercise its most important obligation under the Constitution:  to serve as a check on the Executive branch.  Were Congress seriously interested in doing what’s best for the economy, for the taxpayers, and for the country, they would have just said, “No.”  Instead, they view the proposal as a starting position and are taking this opportunity to ingratiate themselves with their constituents and extend government’s control over private lending.  You doubt that?  Consider:

• Democrats are pushing for legislation that allows bankruptcy judges to rewrite mortgages to “ease the burden” on homeowners who are facing foreclosure.  This contentious issue probably will be dropped in favor of getting a bill passed.
• Democrats want any proceeds of the bailout to go into a fund designed to pay for housing for poor families.  This is the old shell game.  On one hand, they’re telling us that we’ll “get back” much of that $700 billion when the assets are sold.  The reality is that any proceeds will go into the general fund, which Congress can squander at their whim.
• Lawmakers on both sides have agreed in principal to limit pay packages for executives whose companies benefit.  This is largely a symbolic move, as executive pay is a drop in the bucket compared to the amount of money we’re discussing.  But it looks good to the voters.  “I voted to limit executive pay!”
• Absent the “No” that they should give, Congress is right in insisting that it be given more control over the bailout than what the proposal allows.  But I doubt that they’ll exercise restraint.  I fear that they’ll make a serious power grab.  For example, Representative Barney Frank has said: “we’re now the biggest mortgate holder in town, and we can do serious foreclosure avoidance.”  That frightens me, as I think it should frighten anybody.

I’m not convinced that this bailout is at all required.  Were Congress to do the right thing—nothing—markets would take an immediate tumble, rebound a bit, and then financial institutions and others affected would get back to business.  Sure, it’d be a struggle.  But the relatively short-term pain involved will be much less than the long-term pain that this bailout legislation will undoubtedly cause.

Needed or not, I’m certain that it doesn’t have to happen within the next week, as Secretary Paulson and Federal Reserve Chariman Bernanke insist.  I’m always nervous when Congress acts at all, and I get very, very scared whenever Congress rushes through legislation to “address a serious problem.”  Eight years of an administration and a Congress that have both lost all concept of the term “fiscal restraint” has taught me that much.

Join me in a little thought experiment.

Seal a 100 dollar bill in an envelope, affix a price tag to the envelope, and write $110 on it.  Then put it up for sale, telling potential buyers that if they spend $110 on this envelope, they can turn around and sell it for more.  Don’t worry about what’s in it.

Somebody buys it, affixes a new price tag that says $125, and sells it to somebody else who also increases the price and turns it over.

This goes on for some time, with each new buyer swapping out the price tag.  Somewhere along the way, somebody gets the bright idea of putting 10 envelopes into a larger, fancier-looking envelope.  Why not make 10 times the profit in a single transaction, right?

And the party goes on.  The fancy envelopes beget pretty printed shoeboxes and the prices go up again.  Nevermind the party poopers screaming, “But what’s in the box?”  Nobody cares what’s in the boxes.  They must be valuable, right?  People keep paying more for them.

One day, the holder of a refrigerator-sized package wrapped in gold paper and sporting all manner of ribbons and bows tries to sell it for $100,000,000, and fails.  The lender who floated him the loan to buy the thing takes it back and decides to sell it at a loss just to get it off the books.

But the lender finds out that he can’t sell it at any price.  A lot of people have been having trouble selling their pretty boxes and envelopes.  Not only that, but lenders have a lot of money tied up in those pretty boxes, meaning they don’t have any money to lend for other purposes.

Desperate, the lenders start trying to sell their assets at ever-lower prices, trying to get something out of them.  But nobody’s buying.  Nobody wants a pretty box that he can’t resell at a higher price.

Finally, the lender finds a buyer who says that he’ll be happy to buy the box, provided he can open it beforehand to see what’s inside.  The lender reluctantly agrees and looks on as the potential buyer opens the box and pulls out 100 pretty shoeboxes.  Inside each shoebox there are 10 fancy envelopes, each of which contains 10 plain white envelopes holding a single hundred dollar bill each.  The lender’s $100,000,000 “asset” is worth $1,000,000.

My dad used that little parable (also known as the last sucker theory or, more commonly, the greater fool theory) to explain the events leading up to the savings and loan crisis in the late 1980s.  It’s equally apt in explaining much of the current financial meltdown, what with the mortgage backed securities that were “backed” by worthless mortgages, investment firms that were leveraging their investments 35-to-1, and all the while knowing that they were just riding the wave—hoping they weren’t the ones holding the box when somebody demanded that it be opened.

Debra called while I was on my way to lunch this afternoon. Somebody purporting to be the Capital One fraud department had left a message on the home answering machine saying that it was imperative that I contact them. They left a toll-free callback number. That got me to thinking, though. How could I trust the number? Anybody could call and say that they’re Capital One.

So I called the customer service number on the back of my card. After wading through several levels of menus and going around the loop twice, I finally started hitting ‘0′ until I got a real person on the line. After verifying my identity, the woman confirmed that the fraud department had called, and she transferred me to them.

Ten minutes on hold later, I got to verify my identity once more and the representative asked me about some possibly fraudulent charges: one for over $1,000 at the Boeing Store, and one for a two-year subscription to Experts Exchange–neither of which I had authorized. The card is of course being canceled and I’ll receive a replacement in the mail soon. But it got me to wondering about several things.

• Why were the charges refused? Perhaps the Web sites asked for the 3-digit security code and when the number entered wasn’t correct, they reported possible fraud? Or maybe the shipping address was different from my home address. I’m curious how Capital One decided that those charges were possibly fraudulent. It’s not inconceivable that I would have made those purchases.
• How the heck did somebody get hold of my credit card number? I guess that in itself isn’t terribly difficult, but you’d think that somebody who was buying a two-year subscription to Experts Exchange would be smart enough to know that he couldn’t make the purchase without the card security code and a confirmed home address.
• How many people would call a number left on an answering machine from somebody purporting to be the fraud department? I think it’s terribly irresponsible for Capital One to leave a callback number. I honestly thought the answering machine message was a scam. It would be more reasonable to say something like, “Please call the customer service number printed on the back of your card and ask to speak with the fraud department.”

Regardless, I’m happy to see that they were able to identify those unauthorized charges and prevent somebody from having fun at my expense. I hope they can track down the miscreant before he does real damage to somebody’s credit.

Almost two years ago in The Housing Bubble, I warned that the then-current home building boom was unsustainable and that soon we would begin to see record numbers of defaults and foreclosures. I said then that I hoped I was wrong. I wasn’t.

Last Tuesday, the Mortgage Bankers Association released their Latest MBA National Delinquency Survey (for the end of 2006) and issued a press release that summarizes the report. According to the report:

• The delinquency rate for all home mortage loans was 4.59 percent. This represents an increase in deliquencies for all loan types, but particularly for subprime and FHA loans.
• The percentage of loans in the foreclosure process was 1.19 percent of all loans outstanding. This, too, is a significant increase over the 2005 numbers.
• The foreclosure rate for subprime loans was 4.53 percent, up from 3.86 percent a year before.

Things are getting bad. Mississippi has an overall delinquency rate of 10.64 percent. Louisiana 9.1 percent, and Michigan 7.87 percent. Foreclosures in Ohio are at 3.83 percent. In Illinois, 6.22 percent of all subprime loans were in foreclosure at the end of 2006 (source). It’s almost certain that the numbers are much worse now, almost three months later.

The not surprising part of this whole mess is, now that the things many analysts had predicted and warned about two and three years ago are coming to pass, people are starting to look for somebody to blame. It couldn’t be their own dang fault for taking on the risk of getting a subprime loan. Of course not. It’s predatory lending practices or the government’s fault:

The Administration and Congress helped create the sub-prime crisis by ignoring warning signs and, as a result, they bear some responsibility for assisting the families facing payment shock and foreclosure…

This Administration and the previous Congress allowed the horse not only to gallop out of the barn but jump over the cliff as well…

We call on this Administration and this Congress to take the reins back by immediately allowing FHA to play a role in helping borrowers and passing legislation to protect not only borrowers but also the nation’s overall economy.

The denial is almost over, and the anger has begun. It’s time to find a scapegoat. I said two years ago that this was going to be worse than the fallout from the late 1980s S&L crisis. It’s going to be much worse than I ever imagined.

(Note 2007/04/18: I closed comments on this entry because it has attracted a large amount of comment spam.)