Are the Housing GSEs and TBTF Banks Blocking the Economic Recovery?

John Mauldin | August 29, 2011

This week your Outside the Box offers two views, one from the US and one from Europe, both dealing with banks and financing. First, back in July, my friend Chris Whalen at Institutional Risk Analytics wrote an important comment about how the situation in the housing market is blocking efforts by the Fed to stabilize the US economy. IRA is a rating agency that follows every US bank and consults for a number of large commercial and governmental institutions on bank performance and risk. (You can see the IRA reports of all the failed banks since 2008 on their website. The folks at IRA have a retail website (www.irabankratings.com) that allows you to follow your banks performance for just $50 per year or subscribe to see all US banks for $1,000 per year. Many large corporations, investment advisors, insurers, and banks use the retail IRA bank ratings for counterparty risk management and other bank credit tasks. It is a great value for people who want to sleep soundly at night with reliable knowledge about their banks.) One of the things that Chris has been writing about for the past several years is how the policies followed by the top four banks Citigroup, JPMorgan Chase, Wells Fargo, and Bank of America plus Fannie Mae and Freddie Mac, are preventing millions of American homeowners from refinancing their homes. While banks and corporate issuers of debt have benefited greatly from the Feds low-rate policies, consumers have been locked out. At long last, we now see President Obama and other politicians talking about the need to refinance American homeowners. Chris and his colleagues in the mortgage market, like Alan Boyce, are largely responsible for educating policy makers on this issue. Hopefully they are not too late to make a difference. The second and shorter part of todays OTB is two articles from Ambrose EvansPritchard of the Telegraph, on the current crisis in Europe. You need a scorecard to keep up with the latest developments, and he certainly provides one. Things could get very volatile, if he is even close to correct. Have a great week, and my sympathies to all my friends who have issues, as in no power, etc., in the Northeast. Makes 100+ degrees seem like nothing. Your waiting for cooler weather in Texas analyst, John Mauldin, Editor Outside the Box __________________ The Institutional Risk Analyst

Are the Housing GSEs and TBTF Banks Blocking the Economic Recovery?

Yesterday our colleague Chuck Gabriel at Capital Alpha Partners in Washington put out a research note indicating that the Obama Administration has decided to support a two-year extension in the conforming loan limit for Fannie and Freddie. As we have noted in past comments, the limit on loans that can be guaranteed by the GSEs is set to fall back to pre-crisis levels at the end of September. Loan markets around the US have already begun to seize up in anticipation of the change. But while this eleventh hour fix is good news of sorts, it does not change the fact that the Obama Administration and most of the federal regulatory community have badly botched the government's response to the mortgage crisis. Part of the issue is a lack of understanding of the problem, but mostly it is the big banks and GSE continuing to exercise their cartel pricing power to deny American homeowners their legal right to refinance. Let's review the history so we can all get on the same page. In 2002, when the Fed dropped interest rates dramatically after the banking industry and markets went into a stall, the mortgage markets saw a wave of home refinancings. This is precisely what the Federal Open Market Committee wanted to see happen: liquefy households and boost consumer demand. In response, the GSEs started to accelerate their purchases of private label securities (PLS), buying the AAA-rated pieces of PLS to help to maintain the yield on their retained portfolios. Remember that a decade ago we were still pretending that the GSEs were private corporations, and their officers were busy enhancing earnings to build their bonus pools. Paul Krugman, Bob Kutner, and Frank Portnoy, among others, are right when they say that Wall Street's greed drove the mortgage debacle. But they forget that Fannie Mae and Freddie Mac were considered part of Wall Street until the collapse of Lehman Brothers and Bear Stearns in 2008. You cannot separate the private- and public-sector contributions to the crisis; it was a true partnership, but one that starts with the government intervention in the housing sector with the New Deal. While the GSEs were buying all of that AAA-rated PLS paper from the Wall Street dealers for the retained portfolio, the inferior tranches went to fuel the CDO machine, paper that was eventually bought by EU investors. While liberal commentators still argue that Wall Street and not their beloved New Deal agencies caused the crisis, the fact is that those CDO deals built on "A" through "BB" tranches would never have been done without the GSEs providing a ready market for the AAA-rated tranches. The surge in prepayments in 2002 drove the banks and GSEs to loosen their criteria in order to generate new, high spread at time of origination or SATO loans to replace the RMBS in portfolio that were seeing very high prepayment speeds. This decrease in credit quality at banks and by the GSEs had the same motivation, namely greed. But again, it is impossible to separate the role of the government and the private banks in creating this mess. The two constituencies were locked in a loving embrace that went on for years and with the full connivance of both political parties in Washington.

In 2008, when the Fed again dropped interest rates to liquefy households and boost consumer demand, the GSEs responded by raising the barrier to home refinancing, by changing the loanlevel pricing adjustment, or LLPA. This move defeated the Fed's LSAP program to purchase mortgage securities and thereby drive a significant increase in home refinancing. Rich people got refinancings, but the vast majority of Americans who now had the legal right to refinance in 2008 and 2009 were locked out by the banks and GSEs, who did not want to see the highcoupon, high-SATO loans produced between 2002 and 2007 prepay. Again, the reason was greed, both on the part of banks and the GSEs. Remember that the biggest holders of these RMBS are the GSEs themselves and the Fed, followed by banks and private investors. But because of the actions of the GSEs to prevent Americans from exercising their legal right to refinance, the holders of the high-coupon securities have been overpaid for years. Hundreds and hundreds of billions of dollars worth of Fannie and Freddie securities should have prepaid years ago, but instead the GSEs and other holders of these securities have been receiving above-market yields on their investments. This is not only unfair to American homeowners, but it also means that the US economy is not going to recover until the government forces the GSEs to change their LLPAs and aggressively start to refinance these high-SATO loans. Senator Barbara Boxer (D-CA) has introduced a proposal to force the GSEs to refinance the loans in their portfolios, as well as in pass-through securities. The Obama Administration has finally put forward a proposal to force trustees of private RMBS to allow principal reductions on mortgages, to help keep up to one million people in their homes. Both of these initiatives are important and necessary for the US economy to recover. But both proposals also represent a deliberate government-mandated default on these debt instruments. So much for the arguments about raising the federal debt ceiling that rely on the need to avoid default. In the event, this new wave of refinancings will mean a massive prepayment to the GSEs and to private investors, who have been free riding at the expense of homeowners and the American economy. A broad program of refinancing will make the losses at Fannie and Freddie soar and will reduce the cash flow going to banks and other investors in GSE paper. It is likely that several large financial institutions will be forced into a Dodd-Frank restructuring when the government rips away half of their net interest margin as a result of prepayments on vintage RMBS. These two proposals will be very bad for the future participation of bond owners of PLS in the mortgage market, but senior bond holders will likely do much better. The Boxer and Obama proposals are probably good for loan servicers, too, as they are first in line to get repaid servicing advances when the loans are sold. This is a "servicer safe harbor" issue, but the larger economics are always better for all investors on a short sale or modification than a long, drawn-out foreclosure process. But shed no tears for holders of private RMBS. The excess spread that these investors have been receiving because of the GSE efforts to block home mortgage refinancings for the past three years more than compensates for the lower yields they will receive when the proceeds of

prepayments are reinvested at today's market rates. Strange as it may seem, we support the Boxer proposal. Indeed, we suspect that Senator Boxer may have been reading the work of our friend Alan Boyce, head of the Absalon Project. For the past three years and more, Boyce and other member of our Berlin-Los Angeles axis of understanding have been trying to educate members of Congress and other inhabitants of Washington as to the reality of the GSE-bank mortgage-market cartel. In particular, Boyce has focused on how the GSEs and the largest banks are actively seeking to prevent Americans from refinancing their mortgages and at the same time thwarting the Fed's efforts to stabilize the economy through QE. Click here to see the latest version of Alan's presentation. Note particularly page 13, which shows that high-income homeowners who could qualify for the tighter LLPAs put in place by the GSEs in 2008 were twice as likely to refinance as lower-income borrowers. The bottom and lower-middle-income households with high-SATO loans are precisely the mortgages that the GSEs and banks own in their portfolios. Now that it's the one-year anniversary of Dodd-Frank, there have been lots of discussion on what should be done in the future, Boyce notes, but no discussion of what is happening on a daily basis. Bottom line: If the Obama Administration wants to see the US economy recover, then we must start the real process of restructuring that Washington and Wall Street have been avoiding since 2007. President Barack Obama may not be able to turn things around before the 2012 election, but he will be remembered more kindly in the history books if he has the courage to do the right thing. As always, we are available to help in this process, if and when somebody in the White House or Treasury wants to pick up the telephone. ____________________ And from the Telegraph:

Euro bail-out in doubt as "hysteria" sweeps Germany

German Chancellor Angela Merkel no longer has enough coalition votes in the Bundestag to secure backing for Europe's revamped rescue machinery, threatening a constitutional crisis in Germany and a fresh eruption of the euro debt saga.

Seething discontent in Germany over Europe's debt crisis has spread to all the key institutions. Photo: AP

By Ambrose Evans-Pritchard 28 Aug 2011 Mrs Merkel has cancelled a high-profile trip to Russia on September 7, the crucial day when the package goes to the Bundestag and the country's constitutional court rules on the legality of the EU's bail-out machinery. If the court rules that the 440bn rescue fund (EFSF) breaches Treaty law or undermines German fiscal sovereignty, it risks setting off an instant brushfire across monetary union. The seething discontent in Germany over Europe's debt crisis has spread to all the key institutions of the state. "Hysteria is sweeping Germany" said Klaus Regling, the EFSF's director. German media reported that the latest tally of votes in the Bundestag shows that 23 members from Mrs Merkel's own coalition plan to vote against the package, including twelve of the 44 members of Bavaria's Social Christians (CSU). This may force the Chancellor to rely on opposition votes, risking a government collapse. Christian Wulff, Germany's president, stunned the country last week by accusing the European Central Bank of going "far beyond its mandate" with mass purchases of Spanish and Italian debt, and warning that the Europe's headlong rush towards fiscal union strikes at the "very core" of democracy. "Decisions have to be made in parliament in a liberal democracy. That is where legitimacy lies," he said.

A day earlier the Bundesbank had fired its own volley, condemning the ECB's bond purchases and warning the EU is drifting towards debt union without "democratic legitimacy" or treaty backing. Joahannes Singhammer, leader of the CSU's Bundestag group, accused the ECB of acting "dangerously" by jumping the gun before parliaments had voted. The ECB is implicitly acting on behalf of the rescue fund until it is ratified. A CSU document to be released on Monday flatly rebuts the latest accord between Chancellor Merkel and French president Nicholas Sarkozy, saying plans for an "economic government for Eurozone states" are unacceptable. It demands treaty changes to let EMU states go bankrupt, and to eject them from the euro altogether for serial abuses. "An unlimited transfer union and pooling of debts for any length of time would imply a shared financial government and decisively change the character of a European confederation of states," said the draft, obtained by Der Spiegel. Mrs Merkel faces mutiny even within her own Christian Democrat (CDU) family. Wolfgang Bossbach, the spokesman for internal affairs, said he would oppose the package. "I can't vote against my own conviction," he said. The Bundestag is expected to decide late next month on the package, which empowers the EFSF to buy bonds pre-emptively and recapitalize banks. While the bill is likely to pass, the furious debate leaves no doubt that Germany will resist moves to boost the EFSF's firepower yet further. Most City banks say the fund needs 2 trillion to stop the crisis engulfing Spain and Italy. Mrs Merkel's aides say she is facing "war on every front". The next month will decide her future, Germany's destiny, and the fate of monetary union. _________________

European banks set cash test by IMF chief

European banks face ordeal by fire this week after the International Monetary Fund called for urgent action to shore up their defences, if necessary with state money and under legal compulsion.

Recovery is in danger if we dont shore up defenses, says Christine Lagarde. Photo: AP

By Ambrose Evans-Pritchard 9:27PM BST 28 Aug 2011 Christine Lagarde, the IMFs new chief, set off tremors at the Jackson Hole summit over the weekend with warnings that the global financial system is on very thin ice and vulnerable to the slightest shock. We are in a dangerous new phase. The stakes are clear: we risk seeing the fragile recovery derailed, so we must act now, she said. Banks need urgent recapitalisation. If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalisation, she said. Europes lenders are already reeling from a share price collapse since the debt crisis spread to Italy and Spain, threatening to overwhelm Europes bail-out fund and leave banks exposed to sovereign defaults. Shares of Intesa SanPaulo, Credit Agricole and Commerzbank are all below the extremes seen during the panic in March 2009.

Europes inter-bank market is effectively frozen and EMU banks have lost access to Americas $7trillion (4.3trillion) money markets. Lenders have parked 126bn (112bn) at the European Central Bank for safety rather than risk exposure to peers. The IMF exhorted Europes banks over the last two years to beef up their capital base while the rally lasted. Many failed to do so and will now face harsher terms. Some may fall under state control, wiping out shareholders. The eurozone economy ground to a halt in the second quarter, tightening the noose on EMUs weaker states and their banks. Julian Callow from Barclays Capital said Europe is already in industrial recession and risks tipping into outright economic slump. The recent slide is eerily reminiscent of the pattern during the third quarter of 2008, he said. Mrs Lagarde issued a thinly-veiled attack on the ECBs rate rises and Europes fiscal austerity drive. Monetary policy should remain highly accommodative, as the risk of recession outweighs the risk of inflation. Fiscal policy must navigate between the twin perils of losing credibility and undercutting recovery, she said. Tim Congdon from International Monetary Research said it is folly to force Europes banks to raise money too quickly or crystallize losses abruptly. This will cause a monetary implosion and a repeat of the 2008 disaster. He said the ECBs restrictive policies over the last 18 months and the lack of EMU fiscal union have doomed the euro. to certain break-up. It cannot be saved. Banks will suffer large losses, he said.