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A lesson on Banking & housing prices

No Aid to Homeowners

 

Paulson fails to follow the Bailout bill passed by Congress which had clauses requiring such aid.  This failure is predicable since neoliberals provided aid only to the top 1%. 

 

The Simple Arithmetic of Hank Paulson’s Financial Disaster

 

David Fiderer, November 20,2008 Huffington Post

Financial markets 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:

First: Treasury says it won't take steps to prevent home foreclosures, so that
Second: Prices of mortgage securities collapse, so that
Third: 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
Sixth: Market values of homes decline further, so that
Seventh: Mortgage securities decline further, and the downward spiral becomes self perpetuating.

This phenomenon is best illustrated by the numbers.

The free 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 mortgage securities.

Market Price
ABX-HE-PENAAA 07-1, 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.)

Mortgage 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.

Market Price
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 20: 4.71
Bank of America,
November 3: 23.61 November 20: 11.20
JPMorgan Chase,
November 3: 40.73 November 20: 17.35
S&P 500, November 3: 966 November 20: 752

Since November 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.

Those assumptions, 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 broader economy.

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.

"The primary 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.

 

 

 

 

 

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Must watch:

Parts of Europe (such ask Netherlands and Denmark) use small local electricity generation plants, which permits the use of the byproduct heat for heating.  In one example they use all he CO2 generated to supply 4,000 hectares of green houses.   The combined heating and energy production (CHP) is a proven technology that lowers the energy consumption for electricty and heating by over 50%.   British (BBC) documentary on this http://www.youtube.com/watch?v=klooRS-Jjyo&mode=related&search

 

Teddy Roosevelt's advice that, "We must drive the special interests out of politics. The citizens of the United States must effectively control the mighty commercial forces which they have themselves called into being. There can be no effective control of corporations while their political activity remains."

 

For the best account of the Federal Reserve  (http://www.freedocumentaries.org/film.php?id=214).  One cannot understand U.S. politics, U.S. foreign policy, or the world-wide economic crisis unless one understands the role of the Federal Reserve Bank and its role in the financialization phenomena.  The same sort of national-banking relationships as in our country also exists in Japan and most of Europe.