Bailout FAQ

I apologize if it seems false advertising, but there are really only three frequently asked questions so far:

1) Who is to blame for this mess?

2) What should be done to keep from blowing the taxpayers' huge investment?

3) What legislation should be passed right now?

I omit Question Zero: "Can't we just say 'no'"? I start from the premise that inaction (meaning, from the current session of Congress) is unacceptable . Those who argue otherwise simply don't perceive the scale of the current danger, or are totally unfeeling. Implications range from a total collapse of the dollar to rampant inflation to decimation of all savings, retirements, and current investments.

This is a true Black Swan (as coined by Nassim Nicholas Taleb for the title of his book)--an unexpected outcome which throws off all of our mundane calculations. This is not to say that no one saw this coming--I'm sure Taleb did, for example, that's probably why he wrote it--or even warned the world or tried to take action. It's just that the risk of this event did not filter down into the activities of our many marketplaces.

The current symptom of our Institutional Disease--the inability of our marketplace to value with confidence the masses of Collateralized Debt Obligations and derivatives thereof on the books of all the major financial institutions--can be remedied with Paulson's Bailout Elixir, but taking it straight would risk the "successful operation, but the patient died" outcome. Only more radical procedures can bring back some health to the patient, who, by the way, is completely willing and able to make major "co-payment".

1) Who is to blame for this mess?

The underlying problem for the mortgage-backed securities business that has emerged fully in these dire days is that the risk management was insufficiently robust. Mortgage risk models did not protect sufficiently from credit losses, because the mindset under which they were created was not one that considered the possibility of a widespread drop in domestic property values. Blame for this problem goes pretty wide.

Remember that in the classic mortgage--the one where the bank keeps the loan on its books--credit losses only result when both the borrower can't pay and the underlying asset value (the collateral) is insufficient. The provisions for these CDO's and their ilk were/are based on historical default rates and historical appreciation rates for property values, i.e., they were too low. This was basic greed on the part of the "originators" (institutions offering the mortgages), but one that was legitimized by the system that developed.

Originators had to follow a formulaic approach to packaging mortgages; if they checked all the boxes, they'd get Triple-A from the credit rating agencies (which was an absolute requirement for the buyers of the loans). For the most part, originators became just that, neither holding any of their loans nor, often, even servicing the ones they originated. They took their cut (front-end fees helped), pushed the product, and washed their hands. Instead of keeping low-return assets on their books, they got them off forthwith and pocketed their fees, allowing them to churn out vast quantities.

The rating agencies deserve a huge amount of the blame, because they failed to make the distinctions of risk within the mortgage packages. They all came out with the same rating, and not much background. For example: where were the audits of underwriting procedures reviewed critically for those downstream? How about some documentation going with the loans, showing their locations, the degree of equity present, especially when considering various appraisal methods (replacement value, market valuation sensitivity)? Rating agencies will now need to be instruments of government financial policy, or be abolished and replaced directly by a government agency. They'll probably choose the former if they can.

Originators ran their loans through impressively-complicated "legal vehicles"--money-laundering entities. The standard was a "conduit" to a Cayman Islands-incorporated Potemkin-village financial institution. The purpose was to put a stone wall between the originators and any dissatisfied buyers.

What came out the other side was a Triple-A rated debt instrument, suitable for purchase by the investment houses. They sliced and diced up the original loan packages--mixing institutions, loan vintages (time since booked), areas of origination, underwriting standards, etc.--in the interest of providing "diversification", but all oriented toward the goal of providing high yield at low risk (so, inherently, it was a cheat). The investment shops didn't give anything along the lines of direct guarantees on quality of cash flow or underlying credit in their offerings--they could, with some cynical justification, point to the rating. They also didn't reserve capital against this off-balance-sheet business, which also allowed them to churn out vast quantities. They didn't really want to know about the loans, and they made it as hard as possible for anyone further downstream to know, either.

Which brings us to the consumers of these instruments, which will be where most of us feel the pain. Our agents out there purchased these "bonds" in (cynical) good faith, and put them in the investment portfolios that all Americans have been encouraged to buy into, one way or the other. Even those who only save in FDIC-insured bank accounts (you losers!): when the banks can't churn vast quantities of mortgages anymore, they'll pay squat for your savings and live off service fees. Plenty of local banks already do that for you.

And all you folks chasing that extra 20 basis points (0.20%) of return should be able to share in the credit for the collapse of the investment principal you're currently experiencing ("my loss was only 24.8% while the S&P lost 25%!")

2) What should be done to keep from blowing the taxpayers' huge investment?

Let's work backward from the consumers and taxpayers. What we can and should expect from this exercise is that there will be a functioning market for this stuff, that it will be priced properly for its risk and that the risk will be better understood. We can expect that the most egregious actions will be punished, and that our initiatives will make a recurrence impossible and that the Bile Bubble will not simply be pushed onto the next weak spot in the financial industry. We can not expect the government to protect our investments in these dogs (and I've heard virtually no one argue otherwise).

We start by dumping the Triple-A ratings for all this stuff; this is really just recognizing the obvious--in the end, those ratings by themselves didn't protect anyone. An intense process to evaluate this industry and develop better risk ratings is the second step: the rating agency personnel, who know something about where the skeletons are buried (in spite of the seeming blindness of their agencies' ultimate rating values) would be drafted to work alongside the sharpest analytical minds the government can recruit, for high-pay, high-security jobs (these people will be needed for as long as they are willing to stay on). A three-part testing process--of knowledge, of ability to learn both quickly and thoroughly, and of ethics--should be required of all new hires. We're not going to be running any moles, here.

Rather than overpaying for these debt instruments, thus re-capitalizing the fallen industry giants, the emphasis will be on the government's buying low and selling high. The financial industry's capital will be enhanced by the fact that their stock valuations have been protected from becoming worthless through the government intervention, and that should be enough.

In terms of using their stake, the government agency should start with the most homogeneous, transparent CDO's--ones where they can actually figure out where the loans are from, how they were made, and how they are performing--paying the minimum amount possible for them, and then work down from there. The idea is to have a robust market for various types of securitized debt, and the financial houses will figure out the game very quickly (the ones that want to survive, anyway), doing their own research and analysis. We can offer them some bounty if they can expose upstream fraudulence.

Longer term policy considerations: In a market where opacity is punished, the recourse to legal vehicles will be more carefully considered, and it may ultimately wither and die. Originators must be held accountable--a start would be a requirement to increase the credit enhancement put into every one of these loan warehouses. This is something that even those other industrialized nations which don't want to fund this exercise can do. Similarly, healthy (i.e., painful) reserve requirements for these off-balance sheet businesses can be established internationally.

Finally, we get back to the originators. The initial response--of all the banks--to the housing/mortgage crisis which started 18 months ago was to make more precise cookies with our cookie-cutter approach. Documents multiplied, processes slowed, asses were attempted to be covered. Alas, we were still being mooned!

The mortgage industry's risk management needs to be thoroughly upgraded. For example, riddle me this: how important is the famous 38% ratio (mortgage payment to income) when job stability is so low? How does one weigh that against self-employment income (more dynamic, less secure), against credit bureau score, and against unpledged assets that borrowers have? How are we going to give seniors, young independents, and small businesses long-term credit in the new world that is emerging?

The biggest revolution in the industry's risk management will come from improved methods of property valuation. There are already a couple of values that come out of today's appraisals: the bank takes the lowest one (as they would the lowest credit bureau score from the three bureaus), uses that, and calls it "conservative". I don't see any evidence of real market sensitivity being considered: what is the property's potential for losing its value over the time horizon of the loan (and the upside, too, for that matter, when it comes to more marginal credit)?

If we make originators who pass on loans responsible for the credit quality, they might have to get more involved with how the property is maintained over time. That may sound too intrusive, but consider the fact that you don't really "own" your home until it's free and clear. At the end of the day, better (more robust) credit models are long overdue for the mortgage industry, and they must be forced to emerge from both the origination process and the loan servicing business.

The government has the opportunity, and the need, to stick its nose into all these tents--as long as originators don't intend to hold onto all their mortgages for their duration. If they want to do that, they would indeed be subject to less regulation.

3) What legislation should be passed right now?

I've heard a lot of talk about "$700 billion" but not about where that number came from, and what it will pay for. Let's proceed for argument's sake on the assumption--which should be studied closely for its merit--that it's a good figure for the total amount the government can and should be allowed either to spend, or to have at risk, at any one time.

Right now, Congress should allocate much less: enough to get the operation started. Hire the new people (credit agencies will have to provide assistance at their expense, or die), develop the initial models, create a facility to trade the stuff, and buy, at bargain-basement prices, some of the best stuff they can identify. Make sure it is clear they will stop buying if they don't have demand-side participation from the banks who provide the stuff in.

Congress should only authorize a portion of the funds for the period from now until Jan. 20, 2009. The appropriation should be: $100 billion (say) for setting up the agency and for its direct expenses for a year, and a $200 billion line as the initial stake. When the agency shows success in its initial tasks (establish initial risk categories, success with first, well-documented purchases, functioning market for the higher-quality CDO's), then it can get access to another $100 billion of the $600 billion credit line ultimately planned with Treasury (but not sooner than next year). The line will need to increase because, as they move down the pyramid from the peaks in quality toward the swamp, it gets wider and broader.

After a year or so, the program needs to pay for its own operations from its proceeds. Perhaps, if it needs to be expanded, it can be funded off the proceeds from the AIG steal (a great deal for the government, which bought a hugely-profitable business enterprise for the cost of a bridge loan).

The real bottom line, and we simply have to get partisan here: we can't let the Bushites have access to the whole pile, or they will simply bail out their buddies, they'll all walk away scot-free, and they'll consider it a done deal, regardless of whether the markets are preserved (the Reagan-Bush I escapade). By the time the tax increases come through, they'll be long gone with their ill-gotten gains. The short-term expectations for the CEO's (yes, control their packages!) and shareholders should be only loss of income.



Background and disclaimer: I worked on the "production" side for securitized receivables at the end of the last decade and beginning of this one--for mortgages peddled on through a Fannie Mae-like organization in Hong Kong (HKMA), and for credit card receivables produced and securitized domestically. In this sense, I came to the borders of the main event (already in progress), had to learn the rules and business framework quickly to survive, and was totally appalled at and admiring of the processes' leveraging powers. Then I left. I've been watching this Bushite Recovery (2003-2007) from the sidelines, never truly believing in the solidity of the growth which has allegedly been attained.

As a side note, the credit card securitizations I worked on should be better protected from variations in credit performance, because they considered credit losses to be a major part of the economic model, so the credit reserves (called "credit enhancements") were significant and, more importantly, dynamic. Only a generalized depression should bring them down.