November 25, 2008
The Key to Recovery
“It’s Home Prices, Stupid”
It has been more than a year since the financial crisis began, and it has now spilled over into the world’s goods and services producing sectors. The U.S. Treasury is in the process of disbursing about half of its $700 billion of TARP funds to alleviate the crisis, and the Fed and other central banks have literally thrown Trillions of dollars into the world’s financial system. (One Trillion Dollars: $1,000,000,000,000 or, in scientific notation, $1012.) In addition, we have promises of bailout money for the U.S. auto makers and a new Congressional stimulus plan that could cost in excess of $500 billion.
Despite all of this, confidence in the economy, and especially the financial system, is all but non-existent. Last week, Citigroup melted. After having raised significant capital this summer and having received $25 billion in the original TARP injection on October 13, the Treasury gave up another $20 billion and agreed to assume 90% of a specific set of Citi’s mortgage assets after Citi takes an initial write-off.
One has to ask, given the huge cash injections that have already occurred or have been promised, why are these issues still occurring? The answer is fairly straightforward. The cash has been thrown at the symptoms, not at the cause. In addition, while one of the major regulatory/accounting issues has been recognized, it has not been treated.
Seized Up Markets
The securitized mortgage market was one of the largest liquid markets in the world. Today, it hardly exists except for those mortgages with government guarantees. Otherwise, the bids for non-guaranteed mortgages are so low as to be a joke. Because of the continuing fall in the prices of homes, at issue is the value of the non-guaranteed securitized mortgage pools. Falling home prices make the value of those non-guaranteed securitized mortgage pools questionable and the value of the institutions holding them suspect, especially given the faulty and rigid FAS 157 “mark to market” rules. Those rules require capital write-downs to “market” prices, which, when markets are seized up, don’t come close to reflecting “fair” value.
“It’s Home Prices, Stupid”
So, as long as the prices of homes continue to fall, the economy will falter and the financial system will continue to be suspect. Confidence can’t return until home prices have stabilized. This is the straightforward reason that the trillions of dollars that have, so far, been thrown at the symptoms, have been somewhat impotent.
Two actions need to be taken by the government:
- Make the concept of “fair value” accounting of FAS 157 actually reflect a value that is “fair”, not one based on a market value from a seized up market.
A bank’s balance sheet contains loans that are not securitized. When a loan becomes a problem, the bank (with regulators looking over their shoulder) does an analysis of what it expects to recover and expenses the difference between the loan amount and the expected recovery amount to its loan loss reserve. With a secured loan, the bank may eventually recover a substantial portion of its loaned principle. If it tried to sell that problem loan to another bank, it would be lucky to get $.15-$.25 on the principle dollar. This cleansing process has been around since modern banking began. And because the bank regulators are there to ensure the analysis is reasonable, it has worked remarkably well. Why securitized loans are treated differently is baffling. The SEC needs to fix FAS 157 such that “fair” value is truly “fair”. Models using present value of cash flows would seem to be the most appropriate way to value if markets are frozen or otherwise malfunctioning.
- Congress must do something to stem falling home prices, as in many markets, the prices have fallen to below replacement cost.
This indicates that the price pendulum has swung past equilibrium. Earlier this month, China instituted direct aid to home purchasers (not aid to those being foreclosed). For over a year, I have advocated such a plan in the U.S.
Only $90 Billion
At current sales rates, there are 10 months of new homes in builder inventory. Some experts say that home prices must fall another 15%. While I believe that prices have already swung past equilibrium, let’s go with the “experts”. What if the government gave home buyers a 15% tax credit (or even cash itself) like the program recently initiated in China. The latest reported median home price is $183,000. Let’s use $200,000 to keep the math simple. If the government gave a 15% credit on each home, the buyer would pay $170,000, and the seller would receive $200,000. Under such conditions, many sellers would be able to pay off their mortgages rather than having them go into foreclosure, be subject to a short-sale, or otherwise become a toxic asset on the lender’s balance sheet. If three million homes were sold as a result, the total cost to the Treasury would “only” be $90 billion. Now, that is a lot of money. But it pales in comparison to what has already been spent or committed! This would turn the housing market and relieve the financial crisis as investors would no longer have to worry about falling mortgage asset values on financial institution balance sheets. In fact, the securitized mortgage markets would eventually return to some semblance of normalcy, and, under FAS 157, the institutions that wrote capital down, would now be able to write it back up as mortgage asset market values rise toward “fair” value.
While the solution looks simple, there appears to be little recognition of the real problem in D.C. The longer they wait to address this issue, the worse the downward spiral will become. Throwing trillions of dollars at the symptoms only increases the budget deficit, burdens future generations, threatens to ultimately result in significant inflation, and significantly undermines the dollar as the world’s reserve currency. Home prices have been, and continue to be, the cause of the crisis, and, until the Congress acts to stabilize them, or until such prices reach their own bottom (which may be much lower from here), don’t expect the financial markets to significantly recover or the financial crisis to disappear.
Robert Barone, Ph.D.
November 24, 2008