When a Door Closes a Window Opens

As the financial system of the last century winds itself down to an end through the loss of the the large independent investment banking model, the fall of major institutions including Bear Stearns, Lehman Brothers, Merrill Lynch, Indy Mac Bank, and now Washington Mutual, the largest bailout in American history, and the subsequent regulation that will forever scar the landscape, there is hope for how we rebuild.

Today the Republicans via Rep. Eric Cantor proposed, at the last minute, and an intriguing solution that would leave investors (mostly institutions and whats left of Wall Street) with the proverbial “bag’.  In Cantor’s proposal was the concept of creating a mortgage-backed security insurance fund that would force owners of the toxic assets Henry Paulson wants to buy–with your money–instead to purchase insurance that would guarantee them some protection on their principal.  While the details of the plan have at this moment not been made public, in theory this could make a ton of sense.

Part of the reason we are in this “conundrum” (I love to hate that word), is because the companies whose job it was to insure these “toxic” assets mis-priced the insurance.  Theoretically, had the insurers who slapped AAA ratings on a ton of these securities actually “modeled” (another word I love to hate) the risks correctly, they [the insurers] would have a) not become insolvent, and b) been able to guarantee security holders from loss.  Don’t get me wrong there are a lot of people to blame for this mess, I pick on insurers only because it’s relevant to the point, and because it’s easy.

Thus the idea of a federally imposed and managed insurance system might be more than novel–the “federally imposed” part is always scary, but we’re gonna have to settle on the idea that the Fed is going to be involved in some manner.  If you consider what this really means, you can see how this might make sense.

Let’s use a really simple and well laid out example from a wonderful independent analyst I recently was introduced to: John P. Hussman, Ph.D.  In his most recent post, Dr. Hussman uses the following outline of how an investment bank can, and has, run into trouble.  The math that he has laid out could easily be used to describe the basic mechanics of a run of the mill mortgage-backed security.  Let’s consider (I’ve taken this out of context to illustrate more simply):

Consider a simplified balance sheet of a typical investment bank:

Good assets: $95

Assets gone bad: $5


Now, as these bad assets get written off, shareholder equity is also reduced. What has happened in recent months is that this equity has become insufficient, so that the company technically becomes insolvent provided that the bondholders have to be paid off:

Good assets: $95

Assets gone bad (written off): $0


These institutions are not failing because 95% of the assets have gone bad. They are failing because 5% of the assets have gone bad…

No consider changing the words company, institution and investment bank to CMO, CDO, MBS or any other three letter acronym that has gone from invoking “easy money” to something more akin to the “Black Plague”.  If you consider that historical default rates on investment grade debt is acutely small, then when you consider a rapid increase in default rates you must consider not just the relative increase in bad debt (i.e. default rates are up 50-100%), but also the absolute value of that same bad debt in dollar terms.

For example, lets assume that before all this began someone smart kid from Wharton “modeled” the expected default rate on a single security to be 0.10%, or 10 cents on $100.  Say he made this assumption, at least in part on historical data, which is generally how it goes.  (Funny how all investment performance materials say in bold letters that past performance is not indicative of future results and somehow none of the Ph.D.’s and Nobel Laureates who did all that modeling seem to know that) Now assume we take some of the worst headlines of expected increases in defaults over the next couple of years and multiply them.

Now say that instead of a default rate of 0.10%, we find out that the future default rate will be 1.0%.  If the default rate shoots up to 1% then that means that 99% of the principal is still going to be returned to the holder.  If that historical rate of 0.10% shoots up another 10 times, or 100 times the original 0.10% assumption, then we would face defaults of 10%.  But still, 90% of the security would be repaid.  At this moment in time, the market is pricing these assets much closer to 0 than to 100.  Sure, if you tack on leverage, the impact of default rates are amplified, but then you are still gonna end up with a lot more principal than the market is pricing in today.

At the end of the day, unless this spiral continues, we are most likely not going to see 20% of all homeowners kicked out of their homes.  Think of 1:5 people in your building or in your development foreclosing, assuming they own their place.  According to the White House the number of homeowners in the US in 2003 reached 73.4 million or 69.2% of the US population.  20% of that would be 14.7 million American homeowners.  That is slightly larger than the population of the entire state of Illinois as of 2000.  If you account for the fact that roughly 69.2% of the folks in Illinois own their home, then you’d have to consider a larger state to make this point.  If the national foreclosure rate reached 20%, approximately every homeowner in Texas would lose their house.  Texas is the second most populated state after California.  And just to drive this point home, to reach 14.7 million foreclosures, more than every existing home sale recorded in 2005 and 2006 would have to go into default.

While in some communities the foreclosure rates may be abnormally high, at the national level its not going to be that bad.  Please don’t confuse this explanation with a lack of concern or empathy for the millions of Americans who are being displaced by this crisis.  At the individual level, the impact is devastating. However, as it pertains to finding an intelligent and affordable solution, that protects tax payers, and puts the cost of risk back onto the very people who took these risks, Rep. Cantor may be on to something.

The idea of an insurance fund would simply mean that instead of the Fed having to buy $700 billion of potentially “toxic” assets, they would only need to help orchestrate a fund that can account for the 3% of defaults, or $21 billion, or worse yet, 10% and $70 billion instead of the much larger number.  This would allow anyone who owns these assets to pay just a little to protect their principal, and in turn increase the current market value of all of these assets that no one currently wants to own.  It’s kinda like passing the hat for the greater good.  But instead of charging each and every American $2,300 to buy all of the assets, they’ll be charging mostly institutions a palatable number to insure their losses.

At the same time, the Democrats have announced a stimulus package of approximately $56 billion to be used to support everything from unemployment to launching new infrastructure projects.  The real tell here is that a window is opening to catalyze much needed investment in America’s infrastructure.   From preventing future massive blackouts by building a less “brittle” energy network using sustainable energy sources like wind and solar, to Army Corps type projects to protect flood plains and shorelines, to repairing many of our roadways, bridges and tunnels we are at one of those moments where instead of sending petrol dollars off-shore, we will undoubtedly reinvigorate an admittedly protectionist, but important “Invest in America” campaign.  Back are the days of “Buy American”.  However, instead of buying American gas guzzling cars, we will be able to buy American energy and infrastructure solutions, and in time, the proposed bailout of Detroit will also allow us to once again “Buy American” fuel-efficient cars. A weak dollar ought to help that along!

In addition to these intriguing solutions it is obvious and mostly wishful thinking that both sides of the political aisle could–if they really, really, really try–work together to build a comprehensive set of plans that might get us out of this mess.  Contrary to a previous post, this is a time for politics, but not the  politics of the 20th century.  This is a time for American politics to pull itself from an arcane and broken system of bifurcation.  This is a time for politicians to be politicians outside of their party.  It’s time that they represent America before their political affiliation.

The future for America is bright.  It is the entrepreneurial spirit that built this country, and we remain a country of entrepreneurs.  Entrepreneurs are problem solvers, risk-takes, and at times thick enough in the skull to do just about what ever it takes to succeed.  In its best form, this spirit can drive us back on track to once again be a country of solutions rather than problems, and to be a country of opportunity rather than crises.

Anyone who has met one of them knows that entrepreneurs are emboldened by chaos, because they see it as massive opportunity.   The greater the chaos, the larger the disparity there will be between “winners” and “losers”.  However, the spirit that drives these folks to solve our larger problems, in the end, makes us all better off.

Lastly, and somewhat tangentially, I feel as though the green movement has galvanized the concept of sustainability.  Not only do we need to find sustainable infrastructure solutions, but we will need to reinvigorate our markets through sustainable economic development. We now, at this moment know, that expecting home prices to rise exponentially was not sustainable.  Neither was massive and increasing amounts of leverage.  The unsustainable systems of the last century are crumbling, but in their rubble can rise new, and more intelligently designed models for success, like the Phoenix from the ashes.

An Open Letter to the U.S. Congress Regarding the Current Financial Crisis
John P. Hussman, Ph.D., September 22, 2008

Expanding Home Ownership
whitehouse.gov, December 16, 2003

Ranking Tables for States: 1990 and 2000
U.S. Census Bureau, April 2, 2001

Existing-Home Sales Overview Chart for Printing (PDF:17KB)
National Association of Realtors®, August 25, 2008

Senate Democrats Propose $56 Billion Economic Stimulus Plan
Brian Faler, Bloomberg, September 25, 2008

Rescue Plan Talks Set Back by Republican Alternative
Jim Rowley and Alison Vekshin, Bloomberg, September 25, 2008

Phoenix (mythology)
Wikipedia, 09:54, 5 October 2008


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