Wednesday, September 24, 2008

This is NOT a Bailout!!

From the Desk of Joe Rollins

I’m absolutely stunned at Congress’ naïveté concerning the proposed financial plan that they’re currently negotiating. I know I’ve expressed my frustrations with Congress before, but this current situation is really over the top! It just goes to show that basic intellect must not be a prerequisite for being elected to our country’s Congress.

There’s absolutely nothing about this proposed plan to indicate that it is a bailout. Essentially, it just frees-up the liquidity in the United States banking system so the banks can begin loaning money again. Why the media is defining this as a “bailout” belies even the most basic of common sense.

Since there doesn’t seem to be a good understanding of what is going to take place under the proposed plan, I thought I’d bore you with the details. Basically, the government will create a pool of money to purchase – in reverse-auction method – these troubled assets and securities. In $50 billion increments, the government will put out a request to financial institutions around the world that would like to sell their particular securities to the U.S. government.

Instead of a being a typical auction where the highest bidder wins, in reverse-auction cases (Dutch auction), the lowest “bidder” wins. The institution quoting the lowest acceptable amount will receive cash from the government in return for their securities. You may rest assured that each and every seller of these securities will lose money based on the price for which they were initially purchased. Therefore, if this plan were a true bailout, then the price would at least equal the amount for which they originally purchased the security. However, under this method every seller of these securities will be guaranteed to lose money.

After the assets are purchased by the government, the government will immediately attempt to resell them in the open market. There are a stunning amount of purchasers out there that have already expressed an interest in purchasing these securities from the government. In fact, private equity pension funds and solvent wealth funds around the world have lined up to purchase them. There is no question that the government will have no trouble selling these securities. In fact, every knowledgeable commentator on the subject indicates that the government will probably be able to make a small profit on the sold securities.

For that reason, to characterize this plan as a $700 billion hit to the Treasury is not only inaccurate, but it also reflects a complete misunderstanding of the facts. In a time where understanding the ramifications of our financial circumstances is paramount, I’m beginning to question whether this lack of understanding is due to a deficiency of intelligence or if it’s a signification of malice.

As the government buys securities from the institutions, they’ll turn around and resell them in the open market, which will subsequently allow them to purchase more securities to resell. The $700 billion discussed is a minimum amount, not a maximum amount. It’s entirely possible that there could be trillions of dollars in assets purchased under this plan that are then resold in the open market, and there’s absolutely nothing negative about this transaction (even if Congress and the unknowledgeable media seem to be characterizing it as a bad deal and a bail-out of the greedy Wall Streeters).

The good thing from an investment standpoint is that, even though the financial institutions will lose money on the transactions, it’s actually still a positive scenario for them. First, as I have written extensively on this blog, the banks have already written down these securities to a level much lower than they’ll ultimately sell them to the government. From the standpoint of a business transaction, if the government purchases them for more than they are now recorded in their books, then the banks will almost assuredly make a profit in spite of losing a significant amount of money from the amount they were first purchased at due to the write-downs.

Additionally, the cash that will be infused into the banking system will allow the banks to once again start to make loans and free-up their available capital that our banking system needs. This would be an extraordinarily positive move and is an absolute stroke of genius by the architects of the plan, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.

Some have commented that this plan will benefit Wall Street, which I find quite baffling. First and foremost, what exactly is “Wall Street” today? There aren’t anymore brokerage companies – the last true brokerage houses, Goldman Sachs and Morgan Stanley, have now converted to National bank status, and as such, they’ll be under the same scrutiny and supervision that local banks must endure. Simply put, there’s no longer a “Wall Street”– they’re all just National banks subject to the same rules, regulations and significant financial supervision. Most of the banks that will sell these securities are in North Carolina, not New York.

Something else that bothers me is that some people seem to be saying that the securities most in question are worthless, which simply isn’t true. If you recall the final years of the Clinton Administration, you might better understand the magnitude of the problem. It was the Clinton Administration and Congress at that time that wanted to make homeownership available to everyone. They allowed and mandated that Freddie Mac and Fannie Mae make mortgages available to virtually every American, regardless of their financial circumstances. You may question the wisdom of that action now given the current circumstances, but no one should question that the concept had great merit.

By virtue of this program to our credit, literally thousands of Americans were able to gain homeownership at a very low entry cost and the availability of loans created industry in this country that was a boon to all Americans. By far, the vast majority of these mortgages are still in existence and are still being serviced. While there’s definitely a fringe component of mortgagees who have defaulted on their loans, it’s a relatively small percentage of the loans that were extended.

The real problem concerns Congress’ mandating that the quasi-governmental agencies, Fannie Mae and Freddie Mac, were to go out into the public arena and purchase mortgages from banks. Accordingly, the banks would make the loans to the public and turn around and sell them to Fannie Mae and Freddie Mac for a fee. Rather than hold the loans as they’d done in prior years, these governmental agencies would group them together and sell them as a collateralized mortgage security back into the public market. By doing so, the governmental agencies were able to free-up cash so they could buy more loans and create more bonds. The cycle caused no entity to be responsible for the mortgage; the banks would sell loans to the governmental agencies and then the governmental agencies would package the loans and resell them to the public.

None of these transactions were done maliciously, but in many cases there were abuses. Some banks – knowing that they wouldn’t have to service the loans – reduced their credit standards and made loans they never should’ve made. Due to governmental intervention, the governmental agencies purchased loans they shouldn’t have purchased and then turned around and sold them in the open market. While the intent was positive, the execution created excesses and abuses.

We need to take a good look at what’s really going on – these collateralized mortgage obligations are not all bad. The foreclosure rate in America today is less than 7% of outstanding mortgages. While this percentage is high in historical terms, it’s still not a ridiculous percentage. Assuming that the mortgages represented by collateralized debt suffer a 7% foreclosure rate, then this reduces the face value of these securities. However, the houses still need to be recovered and resold, so none of the loans will be a complete loss.

Let’s assume that the gross face amount of these loans is potentially unrecoverable at the rate of 20%, then there’s a great deal of incentive for a potential buyer to want them. If the average rate on these mortgages is 6.5% and a potential buyer pays 80% of the face amount, then the average yield to maturity is 8.125% (assuming that they don’t even collect one dime of the 20% of the gross amount). Obviously, if they collect significantly more, then the yield increases exponentially. Now do you understand why potential buyers are lining up to purchase these securities? With a 10-year Treasury today paying 3.6% and these securities paying potentially 8% or more, many buyers are willing to take the collection risks.

Even more interesting is that many of these banks have now written down the securities by 50%. They have the potential for selling them at 75%, even though they’re recorded on the books at 50%. This looks like a clear win-win for the banks, the government, the homeowners and the investors. Bailout? No way! And anyone who tells you otherwise is showing their ineptitude on the subject.

On an unrelated matter, on Tuesday morning I noted the new electric cars being rolled out by Chrysler. They indicated that in late 2009, they’ll offer a mass-produced, fully electric automobile. The high price of gasoline is finally having its impact on the automobile industry. Based on my limited research, it appears that there will be 10 different models of electric cars in the marketplace by 2010. What is stunning is that in only 18 months, there’s potentially a partial solution to the problems concerning fossil fuels.

Once again, our Congress has done nothing whatsoever to resolve the oil drilling issue. Notwithstanding the positive effect that hybrid automobiles will have on the energy crisis, we still need to drill for oil. Cars running on electricity and natural gas will be readily available in a few years, but we’ll still need fossil fuels for at least the next 10 years. While Congress continues arguing about minutia, the U.S. continues to suffer from a lack of a complete energy package.

Our Congress has wasted billions of dollars on the unworkable ethanol program. We make ethanol in this country not for reducing oil consumption but to help the corn farmers in the Midwest. It’s hard to believe that we have such an incredibly misguided energy policy!

The key to less energy reliance on the Middle East is cars that are powered by electricity and natural gas, both of which could be readily available to consumers relatively soon. If the government would pass an energy income tax credit to neutralize the cost of electric and natural gas cars to standard fossil fuel cars, the public would immediately buy them. It’s been proven that the public is unwilling to pay a premium for hybrid automobiles, but with the government’s help, they’ll be more willing to purchase them.

Much has been said about Congress reducing the Federal tax credits to the oil industry. You may rest assured that the oil industry isn’t concerned with $18 billion in Federal tax credits over the next decade. I’m sure they’d readily give up those credits for reasonable offshore drilling rights. With the combination of more drilling and a Federal tax credit to neutralize the cost of hybrid automobiles, the solution to our energy problems will be in place. Unfortunately, Congress cannot even seem to agree on where to go for lunch, and like Nero, only seems to be fiddling while Rome burns.


Allen Davidson said...

I know this has to be an economic 101 question but since the government runs on a deficit who do they borrow the 700 billion from and pay the interest to, Warren Buffet?

Rollins Financial Advisors, LLC said...


Thanks for the questions.

The U.S. will sell new government bonds, and use the money to buy the bonds from the banks.

The interest is paid to the holders of the bonds, usually the general public or central governments from around the world.

The bonds from the U.S. Government are the most stable in the world, and they have never defaulted. For this reason, individuals and foreign nations want to invest in U.S. bonds.

Thanks again.