Below the jump, I'll try to excerpt the most important points and add a few of my own at the end.
Fair Use: Hussman includes the following note at the beginning of his piece:
To the extent that this discussion is consistent with your own views, please forward it to others, particularly to your representatives in the House and Senate. There is far too little debate about alternative responses to this crisis.
Therefore, I'll quote from it liberally.
DISCLAIMER: This article appears as a "Market Comment" on the website of Hussman's investment fund. I do not have an account with him.
WHERE ARE WE NOW
Hussman begins with an explanation as to why further capital infusions are not an option at this point:
Capital infusions are certainly a viable option to respond to the immediate threat of insolvency. These infusions were largely responsible for reducing the immediate threat to the U.S. financial system in late 2008. However, in the face of large and increasing losses, capital infusions are not sustainable. The public stands to lose the entire amount of funding if the institution fails, unless the infusions can be provided as a senior claim ahead of bondholders in the event of bankruptcy, and still be counted as “Tier 1 capital” otherwise. There are currently no legal or regulatory provisions to accomplish this.
. . .
Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. As noted below, this can be achieved without customer losses or a disorganized Lehman-style unwinding.
Hussman then takes on the TALF:
. . . the Geithner plan creates a speculative incentive for private investors, by effectively offering them a “put option,” whereby taxpayers would absorb all losses in excess of 3-7% of the purchase amount. This is essentially a recipe for the insolvency of the Federal Deposit Insurance Corporation itself, which would provide the bulk of the “6-to-1 leverage.” To the extent that it is not acceptable for the FDIC to fail, the Geithner plan implies an end-run around Congress, and would ultimately force the provision of funds [by Congress] to cover probable losses.
An equal concern is that there is no link between removing “toxic assets” from bank balance sheets and avoiding large-scale home foreclosures and loan defaults. All the transaction accomplishes is to take the assets out of the bank's hands, to offer half of any speculative gains to private “investors,” and to leave the public at risk for 93-97% of the probable losses. What the plan emphatically does not do is to affect the payment obligations of homeowners in a way that would reduce the likelihood of foreclosure. Moreover, the last thing that a bank would do with the proceeds would be to refinance such mortgages, because that would provide full repayment to the original lenders while taking on the risk of the newly refinanced loans.
THERE IS A BETTER WAY
This is point in the story where the response of many has been, "but what's the alternative?" Hussman provides us with not one, but two alternatives:
From the beginning of the recent crisis, starting with Bear Stearns, I have emphasized that nearly all of the financial institutions at risk of insolvency have enough liabilities to their own bondholders to fully absorb all probable losses without any loss to customers or the American public. The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense.
. . .
The bondholders of distressed financial institutions – not the American public – should bear responsibility for the losses of those institutions. This can be accomplished, without harm to customers or the broader financial system, in one of two ways:
1) The bondholders could voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity (preferred or common), allowing the bank to have a larger cushion of Tier-1 capital, avoiding insolvency, and hopefully allowing the bank to recover by its own bootstraps, preferably assisted by debt restructuring on the borrower side (via property appreciation rights and the like).
Alternatively;
2) The U.S. government could take receivership of the financial institution, defend the customer assets, change the management, wipe out the stockholders and a chunk of the bondholders claims entirely, continue the operation of the institution in receivership, and eventually sell or reissue the company to private ownership, leaving the bondholders with the residual. Indeed, this is how the largest bank failure in history – Washington Mutual – was handled so seamlessly last year that it was almost forgettable. This is not Argentina-style “nationalization,” but receivership – a form of “pre-packaged bankruptcy” that protects the customers and allows the institution to continue to operate, followed by re-privatization. This would fully protect all of the customers and depositors at no probable expense to the public.
THIS IS NOT WHAT HAPPENED WITH LEHMAN BROTHERS
Hussman is not advocating chaos in the financial markets.
What should not be done is what was allowed in the case of Lehman Brothers – a disorderly failure, by which the company was allowed to fail with no conservatorship of the existing business. It was not the failure of Lehman per se, but the disorder resulting from its piecemeal liquidation, that caused distress to the financial markets.
That said, it is true that the bondholders of major banks include pension funds, insurance companies, mutual funds, foreign investors and other holders that would be adversely affected by a writedown in bond values. But this is part of the contract – when one lends money to a financial institution, one also assumes the risk and responsibility of bearing the losses. Congress always has the ability to mitigate the losses of some parties, such as pension funds, if it is agreed that this is in the public interest. But to defend all bondholders of financial institutions at public expense is to commit the future economic output of innocent citizens to cover the losses of mismanaged financial institutions. As a result of the intervention by the Federal Reserve and the U.S. Treasury, even the bondholders of Bear Stearns stand to receive 100% repayment of both interest and principal on their bond investments. This is absurd.
CONGRESS MUST ACT
There is a need for Congressional action. Hussman suggests certain specific legislative measures that would need to be passed in order to make the foregoing a reality:
It is essential for regulators to have the ability to take distressed institutions into receivership, so that customers and counterparties of insolvent financial companies can be fully protected. Ideally, this determination should be made not by the Treasury, but by the FDIC, which has a clearer regulatory role. The objective of receivership provisions would be to allow the failing institution to be partitioned into an operating entity (including whatever questionable loans are on the books), while cutting away the obligations to the stockholders and bondholders of that institution. Upon the sale, liquidation, or re-privatization of the institution, the bondholders would receive the portion of the proceeds that are not required as regulatory capital.
SOLVING THE ACTUAL PROBLEM AT THE ROOT OF THE CRISIS: FORECLOSURES
This crisis began with foreclosures and it is unlikely to end as long as the flood of them continues. Hussman introduces a novel government program that could radically reduce foreclosures without unjustly enriching homeowners, at zero cost to the taxpayer:
Although trillions of dollars have been promised or committed in hope of resolving the current financial crisis, the simple fact is that virtually nothing has been done to reduce the incidence of foreclosures. Even if the plan to remove toxic assets from bank balance sheets is successful (however “success” might be defined), the rate of foreclosure will be unaffected, because no change in the payment obligations of homeowners will result.
As with financial institutions, insolvent mortgages would best be addressed by a) voluntarily swapping debt for equity, or failing that; b) technical default and restructuring of the debt obligation.
From the standpoint of homeowners, a debt-equity swap is equivalent to writing down the mortgage principal, while at the same time giving the lender an equal and offsetting claim on the future appreciation of the home. The most useful feature of government in resolving the foreclosure crisis is not its ability to squander taxpayer money, but its ability to provide coordinated action . . . the best approach to foreclosure abatement would be for the Treasury to set up a special “conduit” fund to administer “property appreciation rights” or what I've called PARs.
“Suppose a $300,000 mortgage is in foreclosure (or the homeowner and lender can agree to the following arrangement outside of foreclosure court). A reasonable mortgage restructuring might be to cut the principal of the mortgage to $200,000, and to create a $100,000 property appreciation right. The homeowner would agree to pay off the PAR to the Treasury (and administered through the IRS) out of future price appreciation on the existing home or subsequent property. The homeowner would be excluded from taking on any home equity loans or executing any “cash out” refinancings until the PAR was satisfied. The maximum PAR obligation accepted by the Treasury would be based on the value of the home and the income of the homeowner.
“The lender would receive not a direct claim on that homeowner, but a participation in the Treasury's “PAR fund” which would pay out proportionately from all PAR proceeds received by the Treasury (technically, new shares in the PAR fund would be assigned based on a ratio reflecting the extent to which existing shareholders have already been paid off, so earlier shareholders don't receive more than they have coming to them).
“Importantly, the Treasury would not guarantee repayment, but would simply serve as a conduit. There would be no “free lunch” at taxpayer expense. If the homeowner was to eventually sell the home and not purchase another, the obligation would become a low-interest loan obligation and would eventually be a claim on the estate of the homeowner, but with an initial exclusion at low income and a progressive recovery rate based on the size of the estate. The PARs would be tradeable, since they would be based on a single pool of cash flows, though they would almost certainly trade at a discount to face value. Assuming that the PAR obligations are fixed and don't increase at some rate of interest, then even if home prices were expected to take about 15 years to recover, the PARs would still trade at more than 50% of face. Given that recovery rates in foreclosure are running at only about 50% of the entire loan, it is clear that this sort of approach would be preferable to foreclosure in most cases. If this sort of mechanism were available, lenders might agree to outright principal reductions as well in preference [to] a costly foreclosure process.
“This sort of approach would reduce foreclosures without relying on free money from the government, or violating contract law. The PARs would provide a legally enforceable, diversified stream of cash flows at far lower cost than individual lenders would have to spend to collect from individual homeowners. Since home sales are taxable events, the IRS would be in an ideal position to enforce these obligations.”
THE 'FIERCE URGENCY OF NOW'
According to Hussman, we have a short window of opportunity between now and later this year to implement this plan because of the impending flood of adjustable rate mortgages written at the height of the housing bubble due to reset later this year and in 2010 and 2011:
This reset profile is of great concern, because the majority of resets are still ahead. Moreover, the mortgages to which these resets will apply are primarily those originated late in the housing bubble, at the highest prices, and therefore having the largest probable loss. Though many of these mortgages are tied to LIBOR, and therefore benefit from low LIBOR rates, the interest rates on the mortgages are typically reset to a significant spread above LIBOR, and this spread remains constant as interest rates change. Undoubtedly, some Alt-A and option-ARM foreclosures have already occurred, but the likelihood is that major additional foreclosures and mortgage losses lie ahead. If we fail to address foreclosure abatement during the current window of opportunity (early to mid-2009), there may not be time for legislative efforts to contain the resulting fallout.
THE CONSEQUENCE OF FAILURE
Finally, Hussman argues that failure to properly allocate the losses from the collapse of the housing bubble could impair our economic development for years to come:
The misguided policy of defending bondholders against losses with public funds has increased uncertainty, crowded out private investment, harmed consumer confidence, and prompted defensive saving against possible adversity. We observe this as a plunge in gross domestic investment that is much broader than just construction and real estate, and a corresponding but misleading “improvement” in the current account deficit as domestic investment plunges.
Aside from a few Nobel economists such as Joseph Stiglitz (who characterized the Treasury policy last week as “robbery of the American people”) and Paul Krugman (who called it "a plan to rearrange the deck chairs and hope that that keeps us from hitting the iceberg"), the recognition that this problem can be addressed without a massive waste of public funds (and that it is both dangerous and wrong to do so) is not even on the radar.
In short, attempting to avoid the need for debt restructuring by wasting trillions in public funds increases the likelihood that the current economic downturn will be prolonged, places a massive claim on our future production in order to transfer our nation's wealth to the bondholders of mismanaged financial companies, and raises the likelihood that any nascent recovery will be cut short by inflation pressures. We are nowhere near the completion of this deleveraging cycle.
A FINAL PERSONAL NOTE ON THE THREAT OF FINANCIAL 'ARMAGEDDON'
In a previous discussion about the bailouts, I encountered the following response to my suggestion that "zombie banks" be allowed to fail:
Unemployment would be 25% overnight. Whatever savings you have would not be there tomorrow. Your checking account wouldn't exist. All credit cards would be called in immediately. Entire neighborhoods would be abandoned.
We had two significant bank failures last fall, Wachovia and Washington Mutual, at the time, the nation's fourth and sixth largest banks, respectively.
As of June 30, 2008, Washington Mutual Bank had total assets of US$ 307 billion. It was servicing for itself and other banks loans totaling $689.7 billion.
http://en.wikipedia.org/wiki/Washing...
On September 25, 2008, the United States Office of Thrift Supervision (OTS) seized Washington Mutual Bank from Washington Mutual, Inc. and placed it into the receivership of the Federal Deposit Insurance Corporation (FDIC) . . . The FDIC sold the banking subsidiaries (minus unsecured debt or equity claims) to JPMorgan Chase for $1.9 billion, which re-opened the bank the next day. The holding company, Washington Mutual, Inc. was left with $33 billion assets, and $8 billion debt, after being stripped of its banking subsidiary by the FDIC. The next day, September 26, Washington Mutual, Inc. filed for Chapter 11 voluntary bankruptcy in Delaware, where it is incorporated.
As an accountholder myself, for a moment last fall when WaMu was in its death throes, for the first time in my life I considered the possibility that I might lose the money in my bank account. Ultimately, however, I trusted that the FDIC would make good on its guarantees. This turned out to be a wise choice. I never experienced a single moment of inconvenience as a result of the failure -- not to my savings account, my checking account, my ATM card, WaMu credit card, nothing. No effect. Everything worked seamlessly. I can and may decide to change banks for other reasons, but that will be entirely up to me. Only suckers pulled their money out and thereby inconvenienced themselves.
Let's look at Wachovia, previously the nation's fourth-largest bank:
On the morning of September 29, the FDIC board, acting under a 1991 law empowering it to deal with large bank failures on short notice, voted to order Wachovia to sell itself to Citigroup. The FDIC's open bank assistance procedures normally require the FDIC to find the cheapest way to rescue a failing bank. However, the FDIC bypassed this requirement after determining that a potential failure of Wachovia posed a "systemic risk" to the health of the economy. Steel had little choice but to agree, and the decision was announced roughly 45 minutes before the markets opened.
Wachovia's takeover was so smooth that a bidding war soon broke out:
However, on October 3, 2008, Wells Fargo and Wachovia announced they had agreed to merge in an all-stock transaction requiring no FDIC involvement, apparently nullifying the Citigroup deal. Wells Fargo announced it had agreed to acquire Wachovia for $15.1 billion in stock.
. . .
The Federal Reserve approved the merger with Wells Fargo on October 12, 2008.
Again, not a single person lost access to their savings, checking, or credit card accounts for a single moment as a result of Wachovia's failure.
We can also go back to the 80's S&L crisis where 8000 banks failed and again there were no losses to depositors and no collapse of the financial system. In fact, since the establishment of the FDIC in 1933, no depositor has ever lost a penny of insured deposits.
Would it be a challenge for the federal government to orchestrate a takeover of a Citigroup or BofA? Of course. But I do believe that if the FDIC can close the nation's fourth and sixth largest banks within days of each other, not to mention 8000 banks during the S&L crisis, with zero inconvenience or loss to the general public, it's unlikely that closing number two and three would be the Armageddon that everyone fears.
