"Resurrect the Resolution Trust Corporation"

Following up on Tim Duy's statement that "bad assets need to be consolidated and eliminated," and that "Congress needs to be working on ... a new RTC," a group of former financial officials has the same recommendation. They want Congress to create something similar to the Resolution Trust Corporation or the Home Owners Loan Corporation, and use these institutions to remove "toxic paper" from financial markets:

Resurrect the Resolution Trust Corp., by Nicholas F. Brady, Eugene, A, Ludwig, and Paul A. Volcker: We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse.

Neither the markets nor the ordinary diet of regulatory orders, bank examinations, rating downgrades and investigations can do the job. Extraordinary emergency actions by the Federal Reserve and the Treasury to date, while necessary, are also insufficient to resolve the crisis. ...

The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms. This paper, in turn, is unable to support huge quantities of structured financial instruments...

Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy...

There is something we can do to resolve the problem. We should move decisively to create a new, temporary resolution mechanism. There are precedents -- such as the Resolution Trust Corporation of the late 1980s and early 1990s, as well as the Home Owners Loan Corporation of the 1930s. This new governmental body would be able to buy up the troubled paper at fair market values, where possible keeping people in their homes and businesses operating. Like the RTC, this mechanism should have a limited life and be run by nonpartisan professional management. ...

It is certainly the case that the new institution we are proposing will in the short run require serious money. That will involve a risk to the taxpayer; but the institution, administered by professionals, means that ultimate gains to the taxpayer are also possible.

Moreover, a failure to act boldly in the fashion we are suggesting would cost the taxpayer and the country far more. The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link. A deteriorating financial system, diminished economic activity, loss of jobs and loss of revenues to the government is enormously costly. And the cost to our citizens' well-being is incalculable. ... What we need, and in part are proposing, is a road map to financial stability.

Comments

[dd]

No RTC until the multinationals consolidate their derivatives books so taxpayers aren't shoring up phantom assets. It will be difficult enough to stabilize housing and the public debt markets. In any case the attempts to stabilize derivatives have from all indications failed. It's time to stop trying and focus on salvaging "traditional" markets. Once that's done financial innovation can be reconsidered and hopefully the lesson is learned that opaque markets, opaque instruments and opaque financial institutions corrupt transparency and undermine investor confidence.

[bakho]

I thought that an RTC works in part because they can open the books at accurately price assets? Maybe there are jobs for graduating economists? Having Bush organize an RTC could be really bad if he filled it with political hacks like Brownie and Monica Goodling.

[Robinia]

Gee-- lemon socialism? Where are the cries to "starve the beast" of government these days? Times sure are changing.

As ever, the devil is in the details. Agree with dd above that there needs to be assurance that we will not be propping up "assets" that are, essentially, Emperor's New Clothes. In particular, any RTC needs to attack the thorny issue of the large discrepancies across geography in the US. Losses in value have not been uniform-- the run-up in housing values in some locales (Florida, S. California) were the result of mania, and we "keep people in their houses" there at the rates they paid for those houses at the risk of institutionalizing mania, making it a feature of our economic geography and built environment.

Responsible grown-ups with pruning shears are badly needed; non-partisan is good, technical competence is excellent. But, the how should not be engineered by the financial engineers who brought us to this... "hey, why is it so hot in here, and what am I doing in this handbasket?"

[ken melvin]

"At fair market value", I think, is key. Those who purchased homes at many times their actual value didn't steal or get anything. Them that got were those who got the commissions and the proceeds of the bundled loans. There's no reason to pay those loans off. They were and still are worthless. Amen.

[Mike Dillon]

Another RTC? Sure, why not... Just make sure that there isn't another Tom Basmajian around creating another Fairbanks Capital Corp. (n/k/a Select Portfolio Servicing) to finish the screwing that some borrowers have already started getting - I mean, "service" the assets coming out of "RTC2."

[Guessing]

"Moreover, a failure to act boldly in the fashion we are suggesting would cost the taxpayer and the country far more."

He can't really know this. He is just guessing, and sticking us with the monster bill.

[macquecchoux]

I agree with Arnold Kling on this one. To quote:

"With all due respect to the authors, I would subject that proposal to more careful scrutiny before trying it.

The RTC was bounded. It only had to deal with failed depository institutions. The problem today is not limited to any particular type of institution.

The RTC was passive. It received the assets after the S&L's failed. What Brady-Ludwig-Volcker are proposing is an active agency, that would "buy paper." Buy at what price? Using what guidelines?"

[cas127]

"political hacks like Brownie and Monica Goodling"

As opposed to hacks like Franklin Raines (http://en.wikipedia.org/wiki/Franklin_Raines)

...or, as I like to call him, FDR...

[ron]

The only RTC that will be created is to sell off the foreclosure homes that fannie/freddie have on the books. Illusion of wealth is quickly being replaced with reality and no amount of gov't created debt can undo the process.

[Brian in Boise]

Let the values fall to the point at which the vulture capitalists buy. In other words, let the market determine the value of the paper, as opposed to having some government-appointed genius, on behalf of the taxpayers, decide what he or she thinks the value is, thereby obligating the taxpayers ccordingly.

[anne]

Notice the date, and remember that Mark Thoma wrote of this:

http://www.nytimes.com/2008/02/24/business/24view.html?ref=business&pagewanted=print

February 24, 2008

From the New Deal, a Way Out of a Mess
By ALAN S. BLINDER

THE question of the day seems to be this: Are we in, or heading for, a recession? But so much attention is focused on that question that we may be losing sight of an even greater danger: the possibility that powerful headwinds may prevent a strong recovery from any slowdown.

Most of the potential headwinds stem from the housing slump and related financial crises that began — but, unfortunately, did not end — with the subprime mortgage debacle. Wounded financial markets are supposed to cure themselves: asset prices fall, bargain hunters rush in and markets return to normal. But so far, that doesn't seem to be happening much. Instead, house prices keep dropping, the mortgage-foreclosure problem grows and new strains in the financial system keep popping up like a not-very-funny version of Whack-a-Mole.

While the problems are multifaceted, I have several reasons for focusing on just one aspect of the mess: the potential tsunami of home foreclosures. First, it strikes home, literally. Foreclosures throw families — some of whom were victims of deception — into the streets. They erode home values, damage neighborhoods and reduce the values of other properties, thereby intensifying the decline in housing prices that underlies many of our current problems. And they might even cut into consumer spending, which would really throw us into recession.

A second reason is that reducing the wave of foreclosures would mitigate the closely related financial crises in home mortgages and the alphabet soup of financial creations based on them (M.B.S., S.I.V.'s, C.D.O.'s, etc.). If those markets perked up, other beleaguered credit markets probably would, too.

A third reason for focusing on foreclosures is that we've seen this film before. During the Depression, President Franklin D. Roosevelt and Congress dealt with huge impending foreclosures by creating the Home Owners' Loan Corporation. Now, a small but growing group of academics and public figures, including Senator Christopher J. Dodd, Democrat of Connecticut, is calling for the federal government to bring back something like the HOLC. Count me in.

The HOLC was established in June 1933 to help distressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners could afford. It did so by buying old mortgages from banks — most of which were delighted to trade them in for safe government bonds — and then issuing new loans to homeowners. The HOLC financed itself by borrowing from capital markets and the Treasury.

The scale of the operation was impressive. Within two years, the HOLC received about 1.9 million applications from distressed homeowners and granted just over a million new mortgages. (Adjusting only for population growth, the corresponding mortgage figure today would be almost 2.5 million.) Nearly one of every five mortgages in America became owned by the HOLC. Its total lending over its lifetime amounted to $3.5 billion — a colossal sum equal to 5 percent of a year's gross domestic product at the time. (The corresponding figure today would be about $750 billion.)

As a public corporation chartered for a public purpose, the HOLC was a patient and even lenient lender....

[anne]

http://economistsview.typepad.com/economistsview/2008/03/links-for-20-21.html#c107962884

March 22, 2008

On Financial Market Stress
By Mark Thoma

To summarize my position: I doubted that conventional monetary policy would work from the start and called for fiscal policy very early, earlier than most I think, but when it was evident nothing meaningful would come on the side of the equation - we got what we got - I began to explore non-conventional monetary and fiscal policy. I have worried - from the start as well - that a HOLC * type program could not get through congress quickly enough in an acceptable fashion, and again that was the reason for pushing monetary policy in unconventional directions.

[Still, I think it's useful to continue to push the full array of responses as one never knows how the politics will turn, particularly given the potential for economic and financial market volatility.]

I believe - and I seem to be fairly alone on this - that speed is of the essence and anything involving congress and the president is unlikely to come in time, if at all. Because speed will be of the essence if there are any further signs of deterioration, I began pushing the asset trading/risk reduction strategies (assuming the Fed has the authority to do this). If someone can find a better way to intervene quickly and effectively, then I'm listening.

* Home Owners Loan Corporation

[anne]

http://www.nytimes.com/2008/03/30/business/30hous.html?ref=business&pagewanted=print

March 30, 2008

How to Cast a Mortgage Lifeline?
By ALAN S. BLINDER

THE financial markets are downright scary. And it seems unlikely that we can extricate ourselves from the current series of rolling financial crises without improving the situation in three related markets: those for houses, mortgages and securities based on mortgages.

In a previous column, * I advocated one possible approach: creating a modern version of the Home Owners' Loan Corporation, or HOLC, the Depression-era entity that bought up old mortgages and issued new, more affordable ones in their stead. That idea, which hardly originated with me, stirred huge interest in both financial and political circles. (You should see my in-box.)

But this is one of those cases where the devil truly is in the details. How would it work in practice? Let's concentrate on six major design issues:

STRUCTURE The original HOLC bought mortgages outright. But Representative Barney Frank, the Massachusetts Democrat, and Senator Christopher J. Dodd, Democrat of Connecticut, the chairmen of the two banking committees of Congress, are now cooperating on a different way to skin the same cat.

Their approach would use a beefed-up Federal Housing Administration to guarantee new mortgages — issued, say, by banks — instead of buying up old ones. The effects would be much the same: old, unaffordable mortgages would be replaced by new, affordable ones; and the government would then assume the risk of default. But in the Frank-Dodd proposal, the federal government would be a big insurer rather than a big bank. Because the approach actually has a chance of becoming law, let's adopt its structure.

BAILOUTS The Frank-Dodd plan for a Super F.H.A. is intended to make a bad situation better. But it must not be too generous in shielding people and businesses from the consequences of their own bad decisions — both for economic reasons (to minimize moral hazard) and for political reasons (to gain voter support).

So, what to do? ...

[anne]

Mark Thoma thought a fiscal-legislative policy approach was needed before this year, but when the idea was brought up in the Democratic campaign by Hillary Clinton a year ago the idea to my surprise was largely ignored. Of course, the idea was brought up significantly earlier by community advocates who were watching the problems created in African American neighborhoods in the wake of stress caused by high cost mortgages which were so often sold to African Americans.

Jesse Jackson directly appealed to leading Democrats to respond to the problem, but again was strikingly ignored save for Clinton. I have not understood why the issue was not better responded to from the household perspective early on.

[Ken Houghton]

"We are in the midst of the worst financial turmoil since the Great Depression...."

QUICK. Someone tell Donald Luskin that those rampant commiesNick Brady, Paul Volcker, and the Wall Street Journalare engaging in spurious speculation that is clearly designed to hurt the current Administration's brilliant policies.

Just like Dow 10,500.

[flow5]

"Between 1933 and 1935, the RFC purchased more than $1.7 billion in preferred stock in individual banks. To gauge the significant size of this agency's activity, in 1935 the total book value of equity capital (including the RFC investment) for all commercial banks was $3.6 billion"

New RFC bank investment effectively ended by late 1935, and banks gradually repurchased the government's stock out of their earnings when the banks subsequently returned to profitability.

RFC was given the power to purchase preferred stock or capital notes of banks and trust companies in order to provide them with long-term investment funds. The Act authorized national banks to issue preferred stock with limited liability for purchase by the RFC

RFC required that the bank make semi-annual dividend payments on the preferred stock. The dividend rate initially was set at 5 percent and subsequently reduced to 3.5 percent. Eventually, the banks were to repurchase the RFC's preferred stock out of their future earnings after they had achieved a capital to deposit ratio of at least ten percent.

[flow5]

During the life of the preferred stock program, the RFC authorized investment in 6,104 banks totalling $1.7 billion; but almost without realization by the public. The RFC investment ended in 1935.

[flow5]

most of the above commentary are quotes, but I no longer know the references

[Macquechoux]

Oh my God, Anne:

Foreclosures throw families — some of whom were victims of deception — into the streets.

Foreclosures rarely ever, "Throw families in the street." Around where the sheriff moves people who refuse to move, from foreclosed homes. Foreclosure is not an overnight happening; it is a rather long drawn out process as is the eviction process which is separate from foreclosure that gives the occupants plenty of time to find another place to live. It rarely ever happens that people end up in the street. Where I live it is renters that usually end up in the street. Foreclosure usually turns former home owners into renters, not homeless people. Or they move back in with their families. Check with your local sheriff or court on that please.

Your next point pretty much says the same thing several different ways, foreclosure erodes property values. However, at some point the price of the home reaches it realistic market value and homes become more affordable to people who where priced out of the market or were just patient. The quicker prices fall to whatever the market will bear the sooner the recovery.

Finally, all real estate is local. What is happening in LA and Phoenix has little to do with real estate in Houston and Baton Rouge. I recently read and article that broke down real estate values in LA by Zip Code. In some Zip Codes the price of housing was still declining while in others the value had risen by three plus per cent over the past 12 months. The same was true in the Phoenix area, too.

Finally, I am not to sure we need another federal program for more affordable housing. Isn't this pretty much how we got where we are in the first place? Besides, whatever happen to the FHA?

[anne]

http://economistsview.typepad.com/economistsview/2008/03/links-for-20-21.html#c107962884

March 22, 2008

On Financial Market Stress
By Mark Thoma

To summarize my position: I doubted that conventional monetary policy would work from the start and called for fiscal policy very early, earlier than most I think, but when it was evident nothing meaningful would come on the side of the equation - we got what we got - I began to explore non-conventional monetary and fiscal policy. I have worried - from the start as well - that a HOLC * type program could not get through congress quickly enough in an acceptable fashion, and again that was the reason for pushing monetary policy in unconventional directions....

I believe - and I seem to be fairly alone on this - that speed is of the essence and anything involving congress and the president is unlikely to come in time, if at all. Because speed will be of the essence if there are any further signs of deterioration, I began pushing the asset trading/risk reduction strategies (assuming the Fed has the authority to do this). If someone can find a better way to intervene quickly and effectively, then I'm listening.

* Home Owners Loan Corporation

[I got it then, I get it now.]

[anne]

http://campaigningforhistory.blogs.nytimes.com/2007/05/21/when-government-was-the-solution/

May 21, 2007

When Government Was the Solution
By Jean Edward Smith

Roosevelt had no master plan for recovery but responded pragmatically. Some initiatives, such as the Civilian Conservation Corps, which employed young men to reclaim the nation's natural resources, were pure F.D.R. Others, such as the National Industrial Recovery Act, were Congressionally inspired. But for the first time in American history, government became an active participant in the country's economic life.

After saving the banks, Roosevelt turned to agriculture. In Iowa, a bushel of corn was selling for less than a package of chewing gum. Crops rotted unharvested in the fields, and 46 percent of the nation's farms faced foreclosure.

The New Deal responded with acreage allotments, price supports and the Farm Credit Administration. Farm mortgages were refinanced and production credit provided at low interest rates. A network of county agents, established under the Agricultural Adjustment Act, brought soil testing and the latest scientific advances to every county in the country.

The urban housing market was in equal disarray. Almost half of the nation's homeowners could not make their mortgage payments, and new home construction was at a standstill. Roosevelt responded with the Home Owners' Loan Corporation. Mortgages were refinanced. Distressed home owners were provided money for taxes and repairs. And new loan criteria, longer amortization periods and low interest rates made home ownership more widely affordable, also for the first time in American history....

[anne]

http://www.feri.org/common/news/details.cfm?QID=2056&clientid=11005

April 7, 1932

The Forgotten Man
By Governor Franklin Roosevelt

Albany, N. Y.

Although I understand that I am talking under the auspices of the Democratic National Committee, I do not want to limit myself to politics. I do not want to feel that I am addressing an audience of Democrats or that I speak merely as a Democrat myself. The present condition of our national affairs is too serious to be viewed through partisan eyes for partisan purposes.

Fifteen years ago my public duty called me to an active part in a great national emergency, the World War. Success then was due to a leadership whose vision carried beyond the timorous and futile gesture of sending a tiny army of 150,000 trained soldiers and the regular navy to the aid of our allies. The generalship of that moment conceived of a whole Nation mobilized for war, economic, industrial, social and military resources gathered into a vast unit capable of and actually in the process of throwing into the scales ten million men equipped with physical needs and sustained by the realization that behind them were the united efforts of 110,000,000 human beings. It was a great plan because it was built from bottom to top and not from top to bottom.

In my calm judgment, the Nation faces today a more grave emergency than in 1917.

It is said that Napoleon lost the battle of Waterloo because he forgot his infantry—he staked too much upon the more spectacular but less substantial cavalry. The present administration in Washington provides a close parallel. It has either forgotten or it does not want to remember the infantry of our economic army.

These unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power, for plans like those of 1917 that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.

Obviously, these few minutes tonight permit no opportunity to lay down the ten or a dozen closely related objectives of a plan to meet our present emergency, but I can draw a few essentials, a beginning in fact, of a planned program.

It is the habit of the unthinking to turn in times like this to the illusions of economic magic. People suggest that a huge expenditure of public funds by the Federal Government and by State and local governments will completely solve the unemployment problem. But it is clear that even if we could raise many billions of dollars and find definitely useful public works to spend these billions on, even all that money would not give employment to the seven million or ten million people who are out of work. Let us admit frankly that it would be only a stopgap. A real economic cure must go to the killing of the bacteria in the system rather than to the treatment of external symptoms.

How much do the shallow thinkers realize, for example, that approximately one-half of our whole population, fifty or sixty million people, earn their living by farming or in small towns whose existence immediately depends on farms. They have today lost their purchasing power. Why? They are receiving for farm products less than the cost to them of growing these farm products. The result of this loss of purchasing power is that many other millions of people engaged in industry in the cities cannot sell industrial products to the farming half of the Nation. This brings home to every city worker that his own employment is directly tied up with the farmer's dollar. No Nation can long endure half bankrupt. Main Street, Broadway, the mills, the mines will close if half the buyers are broke.

I cannot escape the conclusion that one of the essential parts of a national program of restoration must be to restore purchasing power to the farming half of the country. Without this the wheels of railroads and of factories will not turn.

Closely associated with this first objective is the problem of keeping the home-owner and the farm-owner where he is, without being dispossessed through the foreclosure of his mortgage. His relationship to the great banks of Chicago and New York is pretty remote. The two billion dollar fund which President Hoover and the Congress have put at the disposal of the big banks, the railroads and the corporations of the Nation is not for him.

His is a relationship to his little local bank or local loan company. It is a sad fact that even though the local lender in many cases does not want to evict the farmer or home-owner by foreclosure proceedings, he is forced to do so in order to keep his bank or company solvent. Here should be an objective of Government itself, to provide at least as much assistance to the little fellow as it is now giving to the large banks and corporations. That is another example of building from the bottom up....

[RR]

Bloomberg:

"Senate Banking Committee Chairman Christopher Dodd said the Federal Reserve has the authority to act as an ``effective Resolution Trust Fund'' to buy up and dispose of bad debt stemming from the subprime mortgage crisis."

The Fed taking on this risk? Holy crap!

[Women On Welfare]

International Finance Agreement

Article: The fact is that the financial system needs basic, long-term reform, but right now the system is clogged with enormous amounts of toxic real-estate paper that will not repay according to its terms.

Given the breadth of this crisis, I suggest that a "fix" which is uniquely American will not suffice.

After all, the Bretton Woods agreement was necessary after the collapse of the pre-War dysfunction of international exchange rates. The agreement set up the first international system of fixed exchange rates (based upon a gold standard).

Given (1) the great many degrees of freedom that international finance now possesses and (2) the breadth and depth current mess, it seems obvious that another international agreement -- perhaps using the Basel 2 accords but most certainly treaty based seems necessary.

The agreements will likely focus on increased, verifiable reserve requirements as a percentage of any international bank's total high-risk portfolio. Avoiding a repetition of the patently gross negligence of the Rating Agencies will also have to become part of the agreement. An auditing regulatory mechanism should also be considered as "trust" has proven woefully insufficient.

Given their key complicity in this mess, the Credit Rating agencies perhaps should be internationalized, i.e., taken from the private domain and made to report to an international body. Or at least given a regulatory charter of conduct that can be repealed if negligence is uncovered.

It would not surprise me, once this crisis is passed, and it WILL pass, that such an agreement will be forced upon the US. There is likely no escaping the agreement. The US has far too much debt in the world and for it bootstrap its way out of the current mess, it will need even more indebtedness.

Such measures won't assure the US the necessary funds without more stringent controls based upon an international agreement that applies to all countries that partake in the international financial system. That leaves out damn few.

The US, as a result of this crisis, has lost a great deal of goodwill as well as credibility in international relations. Repairing it will take a while, which is why it will be a first priority of the incoming PotUS.

[gordon]

Since we're rehashing old ideas, here's an old idea of mine. This is a comment I made on the old post (Mar.29) based on Alan Blinder's NYTimes article How To Cast a Mortgage Lifeline?"

Alan Blinder: "But in the Frank-Dodd proposal, the federal government would be a big insurer rather than a big bank".

Precisely. That is why Alan Blinder's original HOLC proposal was better, because it really was a proposal for a big bank.

If the fundamental danger inherent in the current crisis is, as so many have said, collateral damage to the "real economy", then a big Govt. bank is a good response; not only could it be used to refinance mortgages, it could assist other parts of the real economy by offering finance to the creditworthy across the board. This is, of course, my previous proposal of a "Commonwealth Bank of the United States". That proposal can be understood as an extension of the HOLC proposal - no longer called HOLC, and undertaking a wide range of refinancing functions including roll-over of loans to existing creditworthy businesses and new finance for creditworthy start-ups. These are banking functions which it is feared existing banks may underperform in a credit-squeeze environment. And, of course, refinancing mortgages.

Such a response is, I think, in line with New Deal thinking, which relied on creation of new Govt. agencies just as much as it did on regulation.

[flow5]

Try this:

The mortgage crisis which occured in 1966 also brought forth massive infusions of government credit, and other emergency measures:

The Federal Home Loan Banks (FHLB's) relaxed the conditions for making advances to member savings and loan associations, and in the mid-1966 Congress appropriated $billion to the Federal National Mortgage Association (FNMA) for purchases of certain private housing loans.

The Federal Home Loan Bank Board (FHLBB) and the FDIC were given temporary emergency powers to fix divident & interest rate ceilings for savings and loans and mutual savings banks.

Then on July 1st 1966 the Board of Governors of the Federal Reserve System took the unprecedented action of authorizing the Federal Reserve Banks to make their credit facilities available, through the member banks, to the mutual savings banks, and the savings and loan associations (i.e., the thrifts were allowed access to the FED's discount window).

[gordon]

From the Wikipedia article on the Reconstruction Finance Corporation (RFC):

"The RFC also had a division that gave the states loans for emergency relief needs. In a case study of Mississippi, Vogt (1985) examined two areas of RFC funding: aid to banking, which helped many Mississippi banks survive the economic crisis, and work relief, which Roosevelt used to pump money into the state's relief program by extending loans to businesses and local government projects".

Flow5, what's the difference between the RFC and a big Govt.-owned bank? What could the RFC do that a big Govt.-owned bank couldn't do? Why wouldn't it be better to use a big Govt.-owned bank to provide credit directly to the creditworthy rather than to funnel money into existing banks which might not channel it directly into the real economy?

[BJ Feng]

Let's make this clear, the vast majority of this crisis is about the financial institutions making bad loans, subjecting them to huge losses. Individual homeowners are not the ones in trouble because they didn't have to put very much money in, if any, to buy a house. Yes there are foreclosures, but if someone gives you 500,000 to buy a house and you end up not paying the mortgage, guess what, you've lost very little, it wasn't your money! This is not really a main street crisis, it is a Wall Street crisis. Look at the type of mortgages that make up the problem securities. They are option ARM, Alt-A, and subprime mortgages. These are the type of mortgages speculators used to obtain a home and then flip it. They are not prime mortgages, very few actual traditional homeowners have lost their homes. And if they did, the loan terms given to them mean that they've lost 10% at most plus interest paid, while the financial institution lost 90%.

Any sort of recovery fund would be for the benefit of the financial institutions. Therefore my proposal (and I hear Paulson is already working on something similar) is for the fund to be financed completely by stronger private sector financial institutions. Sound institutions would effectively contribute capital to this fund which would be used to either loan money, or swap money for assets from troubled institutions so that they could be sold later in an orderly process. Contributors would make money off of the loan interest, there would still be substantial risk to the fund, but at least risk would not be transferred from one institution to another (like Merrill to BOA) but would be swallowed by the fund. Losses to the fund would not destroy the contributors like losses from buying an AIG would doom the buyer today.

[Lafayette]

The consumer is king

BJF: And if they did, the loan terms given to them mean that they've lost 10% at most plus interest paid, while the financial institution lost 90%.

I beg to differ.

The original financial institution that committed fraud to "sell" to provide a loan lost nothing. The loans were consolidated and resold forward, so the commercial bank or credit agency lost nothing -- they recuperated their money almost immediately. Which permitted them to borrow more and start the vicious cycle once again. (Some may have been caught, at the very end, before they could do a final consolidation with some outstanding subprime loans.)

The ultimate holder of the SIV is the loser in the sense that they hold a debt on a house that has no revenue whilst, at the same time, they probably ALSO borrowed money to purchase that debt. Let us remember, the debt was sold as "high-return, realty backed instruments". So, the holders were fools not to purchase -- with cheaply borrowed money on money markets -- the supposedly "high-return" instruments.

Too good to be true, wasn't it? Well, yes. Absolutely. So, the investors holding the SIVs have only a residual value (of real estate) that produces no income, whilst they have the burden of paying the money rent of the funds they obtained to buy it.

Is this holding worth nothing? Of course not. It is probably not worth the price at which it was purchased, but it does have residual value -- and the realty market in the US will determine at which point the premises have a value that is stable, from which the market will recover and start selling off the houses to willing customers.

Which is why the Central Banks have increased liquidity -- that is, for the investors holding his toxic-waste to pay the outstanding debt on their holdings. Is this bail-out? Yes and no. The Central Banks still own the money they are lending to the holders of this dysfunctional debt.

What we are all waiting for is customers to finally come back to the counter to buy houses. At some moment, that will happen. We just don't know when, because the high unemployment has all customers worried, therefore restraining their expenditures from discretionary income. For which, they are not about to incur any further debt buying new housing at present.

The consumer is king, once again. The Finance System is waiting for Mr. & Mrs. America to reignite its propensity to consume. When will that happen? Who knows, but it WILL happen. It always has in any post-war economic cycle. (And to say this is a repeat of the Crash of '29 is pure hogwash. History repeats itself, but most often in different ways.)

What lesson should we obtain from this sad story. That we took the "hard way" at learning that something that is "too good to be true", probably isn't. As I've ranted before, the "dumbing down of America", propelled by personal greed and transported by cheap money, knew no bounds -- until it hit a wall. This is the story of a classic financial bubble, based as are all bubbles on individual cupidity.

So, who is ultimately responsible? We have met the enemy and he is us. (Pogo by Walt Kelly)

[yamada]

"Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions."

Here is the one:

Why we think central bank should not be insolvent, by providing original fund to the banks for write-offs, to save financial systems?
We must remember the way how bubble was made, and build up the system to cope with the bubble, accordingly.

Bubble is caused by peoples’ expectation that the price of asset(real estate) will soar in future, with pouring high-powered money to the asset side of economic units’ balance-sheet. So, to solve this problem, such asset bubble on economic units’ balance-sheet must get ridden of in order, by the new system as below. Though it may be seen contradictory, high-powered money enables to work this new system. Please remember, no one has ever invented the solution in history, which fact that entraps economic dispute into confusion nowadays.

1. Every economic unit’s(including banks) assets that caused the bubble(real estate or CDO et al) on balance sheet should be evaluated on mark to market basis by the authorization of a third party(maybe auditor), which brings about some insolvent(i.e. debt section surpasses asset section on balance sheet) economic units.
2. FRB decide to write off a certain amount of the loans to the banks, which amount distributed to each bank according to the amount of each banks’ insolvency, calculated on 1.
3. Every bank that gets profit from written off should next enforced to, by using the profit from written off as original fund, write off its loans to its each debtor, according to the amount of insolvency of each debtor. If the bank is unable to use all the written off profit it earned, the remainder is taxed all.
4. Other economic unit that gets profit from the written off by the bank should next enforced to, by using the profit from the written off as original fund, write off it’s loan(or trade claim) to its each debtor, according to the amount of insolvency of each debtor. If the economic unit is unable to use all profit it earned, the remainder is taxed all. These processes are to be repeated operationally.
5. In consequence, the bubble portion of the targeted asset is extracted from the economy, and is transformed to tax.
6. It’s up to the Government how they dispose of their above tax claims, considering the situation of economy, of each bank and of each economic unit. Talking about the latter two, as a option the Government should examine the possibility of the bank’s and economic units’ turnaround, together with the other creditors, remaining desirable debt to the bank’s and economic unit(empirically it's ten to fifteen times annual earnings before interest, taxes, depreciation and amortization, known as EBITDA, of the economic unit), writing off the rest debt, with taking into account the value of disposable collateral(that do not accrue earnings), of guarantor and of consolidated basis.
7. Every write off must be supervised and tracable by centralized function of the system. So every write off must be executed through this function. Every write off may be done through this function, which exist on internet for access.
8. For cross-border. For each non-residential economic unit, the amount of write off should also be calculated in the same way as 4. , on the only cause from specific asset depreciation in the resident country. Economic unit that will be written off should next write off in the same booked currency. In case profit of the written off exists on the non-residential economic units, it's taxed and absorbed by the foreign(=non-residential) government and handed over to the sovereign(=residential) government of the currency, based on treaty.
9. In case inflation expectation exists, the system enables FRB to on one hand raise benchmark rate to cope with inflation expectation, on the other hand restructuring the balance sheets of economic units.
10. FRB should carefully watch the rate of the number of insolvent economic units to the number of all economic units in the US, when deciding the amount of the loans(trade claim) written off on 2.
11. As a result, FRB may bankrupt because FRB paid for asset depreciation to save financial system, the new second FRB shall be established which take over the first FRB.

For further details, please see the blog as below:

http://reversewealtheffect.blogspot.com/

[AStepahead]

I think were seeing the pieces already coming into view:

September 17, 2008
HP-1144

Treasury Announces Supplementary Financing Program

Washington- The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week. To manage the balance sheet impact of these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

Announcements of and participation in auctions conducted under the Supplementary Financing Program will be governed by existing Treasury auction rules. Treasury will provide as much advance notification as possible regarding the timing, size, and maturity of any bills auctioned for Supplementary Financing Program purposes.

-30-

[BJ Feng]

I'm not sure I'm reading you correctly, but it sounds like when you say "write off" you mean you want to cancel or make disappear the liabilities of the banks to make them solvent? So if a bank magically eliminates its debt to another entity, it can book that as a profit, which would then be used to forgive money it loaned to others? If that's the case, someone will still have to get screwed and take a huge loss, in the end, that's the individual investor who loaned money to bank #1 by buying a bond. Now that bond is canceled, his investment is gone, the bank books a profit and transfers that down the line, that's nice for everyone but those who lent the bank money in the first place. And those loans to the banks are ultimately financed with investor money in mutual funds and the like. What are you going to say to those people? That money represents their savings, they never borrowed to buy that bank bond so they have no debt to cancel, they just lose their savings, bad idea. Who the hell would want to invest and buy bank debt or any type of debt after that? The whole system would immediately collapse and no company would be able to raise money without paying an incredible interest rate.

If you mean "write off" in the traditional sense of recognizing losses, "writing off" something doesn't create a profit, it creates a loss for the bank. The bank who made a bad mortgage loan admits that the loan is no longer worth $500,000 let's say. They can only hope to, maybe, recover $300,000 so they "write off" $200,000 and book it as a loss. And because the bank used $500,000 of deposits or borrowed that $500,000 to make the loan in the first place, they still owe $500,000, yet they now only have $300,000 in assets left. They are insolvent, this is the problem.

When we get down to it, you can't "reverse" the bubble because you can't reverse all the transactions that were made in the bubble. You can't reverse the home buyer paying $500,000 (financed by a mortgage from a bank) for a home now worth $300,000. You would have to reverse all those purchases, meaning that sellers who received $500,000 would be told to return the $500,000 (if it is still there, a big if) and now they have their old home back. This is an incredibly bad idea.

We can't make losses disappear by magic, well we can but someone has to get screwed then. The losses are REAL, they're not some accounting gimmick that you propose. Someone has to lose their money. Now the FED can "create" money and loan it or give it to the banks, but that's called a bailout. I'm being very simplistic, but ultimately, the expansion of money supply, new money from the FED going to the banks, will dilute the value of the dollar, thus taxing us all. That is why (among others) it is a taxpayer funded bailout. Bottom line is that your proposal won't work at all.

[Lafayette]

A walk down Memory Lane

Here are excerpts from an article written (in 2001) about Japan’s situation during its real estate crisis that laid low the country for a decade. (Read the article, here.)

The truth is that the banks themselves do not know the scale of their bad debt problems. Japanese banks do not have accurate credit risk assessment capabilities, and internal information is of poor quality.

Prime Minister Koizumi started his leadership with a promise to clean up the bad loans, but little has happened in the months since he took office. The reason for delay is simple to understand politically: closing bad loans means shutting down businesses. Among these, the worst cases are Japan's big construction companies, which are the biggest employers in the nation, accounting for about 10 percent of all jobs. Unemployment would rise sharply if bad loans were closed out. Closing down bad loans would also necessitate government takeover of some banks, or new injections of public money into the banks. If the government fails to act, some big banks will eventually collapse, bringing collapse of additional companies and even higher unemployment.

But even if banks were willing to lend, bank loans are unsuitable for new startups, or for restructuring existing businesses. What is needed is equity capital and new sources of financing with instruments of lengthy maturity, to get businesses going, or get them past the current problems and into new modes of operation.

Seem familiar …. ?

And the article’s author’s conclusion:

Among the most important lessons, I responded, was that restructuring the American economy was not done with bank loans. It was done with innovations in the financial market that channelled non-bank funds into the revitalization of America. In the 1980's we had the rapid emergence of private equity and venture capital, high-yield bonds, securitization of debt, derivatives, and myriad other new financial instruments, which enabled companies to take bold steps without the continuing pressure of debt service obligations. This opened the way for dramatic changes in M&A activity, buyouts, mezzanine financing, incubation of startups, bundling of distressed assets, and many other essential steps on the path to restoring the competitive strengths of the U.S. economy.

Many in Japan took the US crisis of 1980 as the “benchmark experience” towards which a solution could be found. So, the Japanese swept the bad debt under the rug by funnelling into a government organization and getting rid of it in dribs and drabs. Some of it, the Japanese state just swallowed – tantamount to the taxpayer paying for the sins of inept risk management.

But, who is going to lend to America in order to prime it out of the economic quagmire it finds itself. And, at what money price? Wouldn’t it be like throwing good money after bad?

All questions that the next PotUS is going to have to consider. And, they expect a “sprightly McBush” to have the mental wherewithal to meet this enormous challenge in righting America? I’d rather ask Father Christmas.

2008 is not 2001. The chronic deficit of the US plus this present debacle has changed subtly but permanently attitudes. Those holding American debt will no longer be walked over and any silly nonsense such as “I owe the bank $10,000, I’ve got a problem; but if I owe the bank a million dollars, the bank has a problem” is America’s proverbial way of sticking its head in the sand.

[yamada]

To Ms or Mr BJ Feng,

You are near to the point.

"If that's the case, someone will still have to get screwed and take a huge loss, in the end, that's the individual investor who loaned money to bank #1 by buying a bond."

That’s not the individual investor, but that’s FRB.

"You can't reverse the home buyer paying $500,000(financed by a mortgage from a bank) for a home now worth $300,000. You would have to reverse all those purchases, meaning that sellers who received $500,000 would be told to return the $500,000 (if it is still there, a big if) and now they have their old home back."

Please see the post on my blog dated August 14, 2007 and December 17, 2007.
When we talk about the entity at the end of diffusion, I could say that because the creditor of the loan's bubble portion(=the dissaｐpeared worth) of home has changed from private company to tax agency, there is a room for the debtor to loosen the repayment pitch to some extent(which on the other hand relatively promote the repayment pitch to private company). This is possible because the aim(=to stabilize social and financial system) of FRB(=tax agency) is different from that(abide by contract) of private company.

"Now the FED can "create" money and loan it or give it to the banks, but that's called a bailout. I'm being very simplistic, but ultimately, the expansion of money supply, new money from the FED going to the banks, will dilute the value of the dollar, thus taxing us all."

If banks’ liquid(=cash) position is under strain, they borrow from FRB. The more insolvent the bank is, the more it borrows from FRB. Perhaps the borrowed amount is called "bailout" in your meaning. As a character of the system, FRB write-off the loan according to the insolvency of each bank, and the amount of the write-offs(=fund) comes back to FRB in the end as claims to corporate or individual debtors. Because the fund is specifically characterized, it should not be regarded as money supply. Though the fund inflicts the balance sheet of FRB, it has nothing to do with dilution of dollar value.

"The losses are REAL"

The losses which are recognized(booked) at each bank will be set off with the profit brought to the bank by written-off by FRB, for the debt which each bank owes.
Please see the post on my blog dated August 14, 2007 and December 17, 2007 again.
The system enables to
1. diffuse written-offs to economic units that are insolvent(if one is written-off, the one must next write-off same amount to another economic unit as a rule. In this point, the system is not rescuing only banks).
2. remove the bubble portion(=the dissappeared worth) of economic units and change them into tax claim, which may finally assigned to FRB. In other words, though FRB must at first provide the fund (for write-off) which FRB recognize it as a loss, they are finally absorbed as tax and come back to FRB. Some may be repaid by rescheduling, but some may not be repaid if the debtor bankrupted.
3. get rid economic units of the bad loans, in turn, like domino (=multiplier effect), which minimize the cost of FRB.
If it is not for 1., 2. and 3., FRB must pay for the full amount of wealth lost(=bubble portion) for all economic units in the economy, which it seems heading now.

So, you can not deny the function of this system.

[Todd Kneeland]

If I recall correctly the RTC lost hundreds of billions of dollars in its clean up of the S & L crisis that also was most egregious in TEXAS of all places??? Hum...?

Does anyone actually know what the final (-loss) was to the US Govt and its taxpayers.---I think $500,000,000 is the final loss number I heard years ago.

Todd
PS: Incidentally this latest iteration of a solution does not really address the underlying problem of the Collatrialized Debt Swaps does it---which is a FAR BIGGER PROBLEM in fact by a factor of 10X!!!
Thanks

[BJ Feng]

I'm not sure Todd, but this new RTC would not pay face value, if they paid a low enough price, the government can make money, we need more details to make an assessment. And what do you mean about Collaterialized Debt Swaps? The RTC would also purchase derivatives such as CDOs, and CMOs, and could also purchase Credit Default Swaps from what I understand.

Yamada, thank you for clearing up the point that you want the FED to write off the loans they make to the banks. Yes, that would fit my definition of a bailout. You indicate that it would be balanced out by a tax claim on future profits, or just a tax claim on the "profit" made from having their bad loan written off? In the second case, the tax rate is only 30% and can be offset by other losses. Now if you want to place a permanent tax lien on the banks for the amount that was "forgiven" by the FED, that would have to be entered into the bank's balance sheet as a liability. It would go under unpaid or deferred taxes payable. So it wouldn't make an insolvent bank solvent because whatever amount that was forgiven by the FED would just be replaced by a new tax liability. I don't see how they could even book a profit unless you change accounting rules and such.

Basically, what you're proposing is a loan from the FED to the bank that has to be paid backed through future taxes? A loan will not make an insolvent institution solvent. Only a new equity stake, capital infusion, cash gift, or forgiven debt can make an insolvent bank solvent. But because you are replacing the forgiven debt (let's look at it this way) with a new claim or new debt represented by future taxes owed, this still makes the bank insolvent.

Insolvent institutions can still be profitable however. And perhaps what you are saying is that the FED would not force the bank into bankruptcy, but rules will have to be changed because banks must maintain positive equity. Other creditors could also demand payment, especially when they see that the bank is insolvent, forcing the bank into bankruptcy that way.

Solvent institutions like AIG would be helped out, your proposal is sorta like the AIG "bailout" in that it is a loan that AIG has to pay back in the future. In anycase, if I understand your proposal now, there are much simpler and easier proposals that would do the same thing your proposal ends up doing.

Again, you cannot avoid losses which are real. If you want to transform those losses into claims on future profits, well that's pretty much the same thing as a direct investment in the form of stock. Stocks give the holder the right to future profits. The FED could just buy new shares (or warrants like in AIG) and recoup their investment through future profits. There is no need for the complex system you proposed.

[Lafayette]

BJF: A loan will not make an insolvent institution solvent. Only a new equity stake, capital infusion, cash gift, or forgiven debt can make an insolvent bank solvent. But because you are replacing the forgiven debt (let's look at it this way) with a new claim or new debt represented by future taxes owed

Yes, it does, punctually. And, in the future, that debt will be maintained until quietly forgiven by the state (read, FRS).

This is the way the Japanese handled the problem and though it took a decade, Treasury Secretaries come and go. Few people maintain a collective memory of that debt, because it represents great discomfort.

Besides, who are we kidding? There is no alternative. Because the state is, always has been and always will be the Ultimate Recourse - which is it's raison d'être*.

Now and forever, amen.

* Aside from pocket wars on foreign soil so a PotUS can show the world that he has a set of cojones. ;^)

[yamada]

To Ms or Mr BJ Feng,

“You indicate that it would be balanced out by a tax claim on future profits, or just a tax claim on the "profit" made from having their bad loan written off?”

I’m talking about neither tax claim on ”future profits” nor tax claim on “the profit made from having their bad loan written off”.
I know it’s hard to understand, because this idea has never existed before.
I would like to remind you of the basic idea of high-powered money by central bank in macro-economics, which bring about multiplier-effect on money supply. I also would like to say in this chance that this high-powered money helped pouring money into real estate and into its financial products.
My basic idea is simple: a bank written-off first by FRB, next the bank write-off certain entity which bring loss to the bank but off-set by the written-off profit(Don’t think of tax at this phase, it’s exempt if off-set. And don’t be haunted by formulated tax system nowadays), and then the certain entity write-off another entity which bring loss to the entity but off-set by the written-off profit, and so on.
There is a multiplier effect, because the original write-off amount by FRB has been doubled or tripled or quadrupled...which lightens the burden of FRB.
I’m not denying capital infusion or loan to financial institutions by FRB or by Government, or public expenditure or tax cut.
Essential thing is: find the way how to minimize the cost of public sector.

[flow5]

gordon says...
"Flow5, what's the difference between the RFC and a big Govt.-owned bank? What could the RFC do that a big Govt.-owned bank couldn't do? Why wouldn't it be better to use a big Govt.-owned bank to provide credit directly to the creditworthy rather than to funnel money into existing banks which might not channel it directly into the real economy?"

I assume that a "big Govt. owned bank" would finance the rescue with new money...i.e., every time a CB makes a loan to or buys securities from the non-bank public it enlarges the money supply.

The RFC presumably would be funded thru the sale of GOV't securities. But I need more detail to give an appropriate answer.