just gave Hank Paulson a vote of no confidence. Unfortunately, it's the rest of us who will pay the price. As Paulson made
clear this past week, he is stalling, subverting the express intent of Congress when it passed the bailout bill, by his refusal
to take action on foreclosure relief for distressed homeowners. Paulson's inaction has triggered a chain reaction that goes
something like this:
says it won't take steps to prevent home foreclosures, so that
Second: Prices of mortgage securities collapse, so that
Bank equity gets wiped out, so that
Fourth: Banks, with shrunken equity capital, are forced to cut back on all types of
credit, so that
Fifth: Financing for anything, especially residential mortgage loans, dries up, so that
values of homes decline further, so that
Seventh: Mortgage securities decline further, and the downward spiral becomes
is best illustrated by the numbers.
fall in mortgage securities.
The free fall in market prices
for mortgage securities implies that the eventual recovery on distressed mortgage loans will be a lot worse than anyone expected
on the eve of Obama's election. We see that from the Markit ABX Indices, which are something like a Dow Jones Average for subprime
November 3: 55 November 20: 34.25
ABX-HE-PENAAA 06-2, November 3: 82 November 19: 58.32
When ABX-HE-PENAAA 06-2 traded at 82, or 82 cents on the dollar, the implied recovery rate on
the entire mortgage pool is was something like 66%. When the same security trades at 58.32, the implied total recovery is
about 47%. Here's why. The way these securities are structured, different classes of creditors, or different tranches, all
hold ownership interests in the same pool of mortgages. But the tranches with the lower ratings - BBB, A, AA - take the first
credit losses; they are supposed to get wiped out before the AAA bondholders lose anything. Typically, AAA bondholders represent
about 75-80% of the entire mortgage pool. (Market Price@ 82 X approx. 80% of total pool = 66% total recovery). (ABX-HE-AA 06-2
currently sells at about 12; ABX-HE-A 06-2 sells under 6. At those prices, a buyer is betting that the eventual recovery
will far exceed the market's expectations.)
securities and bank stocks fall in tandem.
From the price
graphs of the ABX benchmarks, accessible via hyperlink, you can see how the downward slopes closely match those for bank stocks
since election day.
ABX-HE-PENAAA 07-1, November
3: 55 November 20: 34.25
ABX-HE-PENAAA 06-2, November
3: 82 November 20: 58.32
Citicorp, November 3: 13.99 November
Bank of America, November 3: 23.61 November
JPMorgan Chase, November 3: 40.73 November
S&P 500, November 3: 966 November 20: 752
3, Citicorp, Bank of America, and JPMorganChase have lost in excess of $240 billion in market value. Most of the other global
banks, such as UBS, Barclays, BNP, have suffered similar declines.
The link between
ABX indices and bank equity requires
some further explanation.
Declines in mortgage
securities wipe out bank capital and confidence in our global financial system.
About 18 months
ago, banks lost control of their balance sheets. Losses on securities receive different accounting treatment than losses for
loans. Comparatively speaking, loan losses are more predictable and more manageable. Before they report their quarterly results,
banks review their problem loans and calculate the associated loss provisions. Banks don't expected to be whipsawed by market
events on the last day of a fiscal quarter.
Things changed around July
2007, when AAA mortgage securities started trading at prices materially below par, or below100. Up until then, many banks
had bulked up mortgage securities that were rated AAA at the time of issue. Why? Because they believed that AAA bonds could
always traded at prices close to par, and consequently the bonds' value would have a very small impact on the earnings and
equity capital. The mystique about AAA ratings dated back more than 80 years. From 1920 onward, the default experience on AAA rated bonds, even during the Great Depression, was nominal. Similarly,
during the Great Depression national average home prices held their value far better than they have in the past two years.
of a highly liquid trading market and gradual price declines, proved to be way off the mark. Beginning in the last half of
2007, the price declines of AAA bonds was steep, and the trading market suddenly became very illiquid. Under standard accounting
rules, those securities must be marked to market every fiscal quarter, and the banks' equity capital shrank beyond anyone's
worst expectations. Hundreds of billions of dollars have been lost. The losses in mortgage securities, and from financial
institutions like Lehman that were undone by mortgage securities, dwarf everything else.
Before the end
of each fiscal quarter, bank managements must also budget for losses associated with mortgage securities. But since they cannot
control market prices at a future date, they compensate by adjusting what they can control, which is all discretionary extensions
of credit. Banks cannot legally lend beyond a certain multiple of their capital.
This uncertainty about banks
in general, and the ripple effect of reduced credit, creates a crisis in confidence throughout the financial system and the
Why Treasury's intervention was
needed to forestall a bigger glut of foreclosures.
Why did mortgage
securities and bank stocks fall so much more sharply in the last few weeks? The market was expecting that Hank Paulson would
act in a manner consistent with Congressional intent when it passed the bailout. As time passed, anxiety about treasury's
inaction increased. Then on November 12, Paulson announced that he would do nothing
soon to provide foreclosure relief to homeowners.
As we've seen
above, stabilizing home prices is key to stabilizing the broader economy. And the key to stabilizing home prices is to limit
the spate of foreclosures that would flood the market. If homeowners are able to remain in their homes and make partial payments
on their mortgages, lenders may attain a better recovery than from a series of fire sale liquidations.
The problem is
concentrated among private-label securitizations. Though they represent only 20 percent of all mortgages, they represent 60
percent of all defaults, according to The Financial Times. Unlike most mortgage securities that follow the standardized underwriting guidelines of Fannie
Mae and Freddie Mac, private-label securities make it almost impossible for the lender
to negotiate modifications with the homeowner. Congress passed the bailout package
on the condition that a large chunk of the $700 billion to assume control of these assets so that the government could renegotiate
terms with distressed homeowners.
Paulson ignored Congressional intent, and went off into an entirely different direction, allocating funds to
bolster securitization of credit card receivables. Barney Frank, with great specificity, called him on his bad faith bait-and-switch tactics. But that exchange didn't
get nearly as much coverage amid Paulson's platitudinous soundbites and talk about bailing out GM.
purpose of the bill was to protect our financial system from collapse," Paulson told the House Financial Services Committee.
And the markets signaled what they think of Paulson's job performance.