By Kristen Koh

It shocks me how little media pundits know about what is really going on when it comes to the mortgage crisis. The PPIP program (Private Public Investment Partnership–buying toxic assets) WILL loosen consumer lending and is NOT stupid.

The banks have TWICE the cash (capital) they had last year, even though they are accused of being insolvent today whereas they were flying high last year this time. The moolah is sitting in their accounts at the Fed earning 0.25 percent.  They are paying 5 percent on TARP money, and earning only 0.25 percent on it.  So are Jamie Dimon and Ken Lewis dumb?  NO.  They are TERRIFIED that bank regulators gone wild will seize their banks for not having enough collateral to back the declining value of their investment portfolios which include these toxic (or maybe not so toxic) assets.

Right now there is no market for these securities. They are absolutely frozen except for a few fire sales from liquidating funds and manipulation tactics from bad hedge funds. On top of this, onerous application of mark to market rules that came into effect in mid 2007 at the market peak are greatly exaggerating balance sheet crises for the banks.

What does this mean?  Let's say that you bought an investment property for $1 million and it generates $50,000 in annual net rental income. You have a mortgage on the property for $700,000.  A comparable property sells under duress for $200,000 in an illiquid market and regulators tell you that your property is now worth $200,000 even though if you ran a Discounted Cash Flow analysis on the rental income stream, you'd get $1 million as an asset value.

You argue that even if rents fell 30 percent, which is a possibility under a Depression scenario, your property is worth at least $700,000.  But the regulator says, no, it's worth $200,000 due to mark to market rules and you are now in violation of rules due to your mortgage ($700k) being higher than your asset value ($200k) so they seize your building since you are unable to come up with the $500,000 difference.

They sell your building for nothing and you are bankrupt.  Does this sound right?  Of course not!  This is why mark to market rules are stupid when the market is hyper-cyclical (artificially inflates values during bull markets and artificially deflates values during bear markets).

That is what is going on with the banks right now.  The market says their asset backed bond portfolios are worth 20 cents on the dollar and the banks are saying they are worth at least 70 cents (albeit on the books at probably 90+ cents), maybe more when held to maturity.  The 50 cent spread was the reason why then Treasury Secretary Hank Paulson (my former boss at Goldman) couldn't make the first TARP effort work.  You can't force the banks to dump their assets below what they are worth and investors are too scared to pay what they are worth.

That is until now since the PPIP program enables incredible leverage with Fed money so that it will be hard NOT to make money on these investments.  You put in $1, the government puts in $7 ($1 equity, $6 debt), and you are allowed to keep 50% of the profits.

So, you say, that the example above would never happen because the comparable building would never sell for $200,000.  Well that's where hedge fund shenanigans come into play.

Let's say I wanted to make some money manipulating the markets.  I would short shares in the big banks.  I would then find some illiquid asset-backed bonds that I know many of the banks owned.  I would find some desperate seller who just got a margin call and buy a tiny piece of his holding ($1000 worth) and print a price on the tape that showed that I bought the bond at 20 cents on the dollar.  Then I would tell everybody how the banks are holding their bond portfolios at 70 cents on the dollar (after 30 percent writedowns) and they are really just worth 20 cents.  I would point to the tape that showed my purchase (a price point I forced on very small volume).  I would go on CNBC and talk about how the banks have negative equity and will be seized by the regulators a la Lehman, Bear, Wachovia, Wamu, etc, and talk about how Ken Lewis is a liar just as was the case with Dick Fuld before Lehman went down in flames. Everyone will panic, and I'll be able to cover my bank shorts 50 percent lower.  This is why Bank of America is trading at $7 instead of $15: hedge funds gone wild.

Regulations are WAY behind the many ways the market can be manipulated.  Don't get me started about naked short selling, the elimination of the uptick rule, and the proliferation of the triple short bear ETFs that skirt existing margin rules.  The only people talking about how these confidence/market shattering conditions don't matter are short sellers upset that they may have to stop taking candy from babies.

This is why it is important that the government is tweaking the application of mark to market rules. Congressman Paul Kanjorski (D-PA and chairman of the House Financial Service Committee) basically told Finanial Accounting Stadards Board (FASB) chairman Robert Herz that if the FASB doesn't figure it out, Congress will legislate mark to market changes making the FASB irrelevant.

This is also why it is important to create incentives for vultures to buy the “toxic” bank assets (PPIP) at closer to 70 cents on the dollar so the banks will actually sell them.  Until those sales happen the banks will hoard capital to avoid what they fear – being seized by regulators.    Until then they will not lend in volume even though they have huge cash reserves being poorly deployed.

With the exception of Goldman Sachs and Morgan Stanley, the banks are holding their “toxic assets” at probably 90 cents on the dollar saying that they plan to hold these assets to maturity.  FASB rules allow assets in hold-to-maturity investment accounts to be valued differently than those in trading portfolios which have to be marked to market daily.   This makes sense,  yes, but banks have to mark down their portfolios at sale which is keeping them from selling at today's irrationally depressed prices.  .

Now here is the important part.  The write-down from 90 cents to 70 cents can probably be absorbed by the operating profits of the banks given time.  It's a good business to borrow at 0 percent and lend at 10 percent A write-down to 50 cents or less probably makes the banks truly insolvent which is keeping them from trying to sell these assets.  This uncertainty is what motivates banks to hoard cash.  There is $831 billion in cash on the balance sheets of these banks (held with the Fed earning 0.25 percent). So all the TARP money is right back where it came from, just under the ownership of the banks rather than the Fed.

That money is sitting there doing nothing while businesses are starving from the lack of credit.

Remember it's not the quantity of money but the velocity of money that will get us going.

So what is the risk to the PPIP program?  The banks may refuse to dump assets at the prices these hedge funds are willing to pay.  This would give us a standoff where the velocity of money stays at very low levels.  That's what happened in Japan where the market fell for ten years and real estate prices have been going down for 20.

We don't want to be Japan.

Kristen Koh is chief financial officer of Home-Account. She personally owns bank ETFs and call options on those ETFs.

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When is a hedge not a hedge? When it is hedging an Alt-A or Sub-prime mortgage, according to Democrats who are proposing that lenders not be allowed to substantially shift repayment risk from such exotic loans.

The legislation proposed this week in the U.S. House of Representatives would prohibit lenders from “directly or indirectly” hedging or transferring a minimum retained credit risk on most nontraditional mortgages, including some loans that have adjustable interest rates or require little documentation of a borrower’s income. The bill, introduced yesterday, is being sponsored by Representatives Barney Frank of Massachusetts, and Melvin Watt and Brad Miller of North Carolina.

The bill is designed to curb “predatory” lending and encourage the use of traditional 30-year, fixed-rate loans. “The growth of exotic, non-traditional mortgages was a major factor in the current housing and foreclosure crisis,” Frank, Watt and Miller said in a statement.

Alt-A loans were primarily sold to borrowers who wanted atypical terms such as proof-of-income waivers, investment- property collateral or delayed principal repayment, without enough positive compensating attributes. Subprime loans were made to people with poor or limited credit histories.

About 20 percent of Alt-A mortgages securitized with bonds not backed by Fannie Mae, Freddie Mac or the federal government are at least 60 days past due, in foreclosure or already seized. The Alt-A market expanded to $400 billion in 2006 from $55 billion in 2001, according to newsletter Inside Mortgage Finance.
The legislation would make permanent rules that prohibit lending to borrowers who don’t have a “reasonable ability” to repay. It also restricts so-called yield spread premiums, which are upfront commissions paid to mortgage brokers when a loan is closed. The legislation builds on a measure Frank said lacked political support last year to pass.

“We don’t know whether this would work for individual mortgage lenders” that rely on warehouse lines of credit — a form of interim financing — to fund the loans they originate, said Francis Creighton, the chief lobbyist for the Mortgage Bankers Association in Washington. For smaller independent mortgage firms, it may be difficult to repay those credit lines if they cannot sell off 100 percent of the loan, Creighton said.

“The political climate has changed,” Miller said in the statement. “The foreclosure crisis has wreaked havoc on middle- class families and our economy as a whole.”

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Mortgage rates have hit all-time lows according to Bankrate.com, which announced this week that it's latest survey pegs the average 30-year fixed mortgage rate at 5.19 percent with an average of 0.42 discount and origination points.

The average 15-year fixed rate mortgage retreated to 4.80 percent and the average jumbo 30-year fixed rate fell to 6.66 percent. Adjustable rate mortgages were lower also, with the average 1-year ARM pulling back to 5.30 percent and the 5/1 ARM slipping to 5.21 percent.

Mortgage rates fell lower than ever recorded in the 24 years of Bankrate's survey, eclipsing the previous low of 5.28 percent seen this January and in June 2003. The last time mortgage rates were recorded lower than this was December 1956, according to the National Bureau of Economic Research. Jumbo mortgage rates benefited as well, with rates now at the lowest level since May 2007, prior to the onset of the credit crunch. The catalyst for the decline in rates was the Federal Reserve's March 18 announcement of stepped up mortgage debt purchases and an initiative to buy Treasury securities.

Mortgage rates have dropped substantially over the past five months. The average 30-year fixed mortgage rate in late October was 6.77 percent, meaning a $200,000 loan would have carried a monthly payment of $1,299.86. With the average rate now at 5.19 percent, the monthly payment for the same size loan would be $1,096.99, a savings of more than $200 per month for a homeowner refinancing now.

Bankrate's national weekly mortgage survey is conducted each Wednesday from data provided by the top 10 banks and thrifts in the top 10 markets.

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New economic numbers released by the government yesterday suggest that if the recession isn't getting better at least it isn't getting worse, either. Retail sales have held steady recently. And there are signs that the housing market is stabilizing.

The number of newly issued residential building permits, which offers a glimpse of construction activity in coming months, ticked up 3 percent in February from January. Existing-home sales were up 5.1 percent, according to industry data released this week. And yesterday, government data showed that sales of new single-family homes increased 4.7 percent, the first increase in that market in seven months. Median sale prices of those homes, however, were down 18 percent over a year ago.

The positive signs in the housing market are particularly encouraging. It was the housing bust that led the nation into recession, and for months analysts have said that a recovery in the market will be key to leading the nation out of recession.

Analysts said buyers are being enticed back into the market by plummeting home prices, along with historically low mortgage rates and an $8,000 tax credit for first-time home buyers in the stimulus package.

“There are some pieces of information that reconfirm that we are very near the bottom. . . . I want to see a couple more before I am confident that this truly the bottom,” said David Crowe, chief economist for the National Association of Home Builders.

Forecasters, for their part, stress that even after the worst is over, the economy will be fragile for some time. Recovery is expected to be weak, especially in the housing market, because there's so much excess inventory. Consumers are still deeply in debt, unemployment is still on the rise, and countries around the world remain mired in recession, crippling demand for U.S. goods.

“Businesses have a ways to catch up to weak demand over last six months, so business spending will be extremely weak. . . . Exports will fall further as the global economy falls,” said Scott Anderson, an economist with Wells Fargo. “But this increases the odds the economy will start growing at the end of this year.”

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March 26, 2009 — At a hearing before the House of Representatives' Financial Services Committee, U. S Treasury Secretary Timothy Geithner is asked Congress to grant the Treasury Department sweeping authority over a range of financial institutions previously beyond the reach of bank regulators, including insurance companies and hedge funds, and possibly even the finance divisions of major U.S. corporations.

Geithner outlined parts of the administration’s ideas for regulatory reform during several public appearances this week, including testimony before the same House panel Tuesday.

Broadly speaking, the administration is looking for powers similar to those held by the Federal Deposit Insurance Corp. in its handling of bank failures. This would allow the government to take over non-bank financial institutions, sell their assets and renegotiate contracts with employees and counterparties.

The government wants to create a regulatory structure that will prevent the failure of some large firms from exposing the entire financial system to too much risk. Officials have said that if such regulation were in place, the government would not have needed to continue funneling money into American International Group, which has soaked up $170 billion in taxpayer money as the government props it up.

“Destabilizing dangers can come from financial institutions besides banks,” Geithner warned in a speech at the Council of Foreign Relations Wednesday. “Our plan will give the government the tools to limit the risk taking at firms that could set off cascading damage.”

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U.S. Treasury Secretary Timothy Geithner this week revealed details of his plan to get toxic assets — primarily Collateralized Mortgage Obligations — off the books of American banks, freeing up capital so the banks can resume lending. The stock market reacted positively to the news.

Under the plan, private investors will put up as little as 6% in capital to purchase equity, a number which suprised some observers as quite low. But Geithner, discussing the plan on Monday morning , dismissed those worries by stressing that private investors would be on the hook before taxpayers. “Their entire capital will be at risk, that's the important thing,” he said.

If there are gains, however, the government will benefit as well, Geithner said. “If there's a return over time, which we expect there will be, taxpayers will share in that return.”

The Geithner plan has broadened somewhat since he first announced in early February that the Treasury intended to join with hedge funds, private equity firms, and other investors in public-private partnerships to buy up the bad assets weighing down banks. Following that speech, investors and others on Wall Street heavily criticized Geithner for providing only vague details as to how the partnerships would work. The stock market immediately tanked, with the Dow Jones industrial average finishing down 4.6% that day.

Wary of a repeat of that performance, Geithner and other officials issued a flurry of detail on Monday. Officials said the plan would rely on three principles: maximizing the impact of each taxpayer dollar, shared risks and profits with private-sector participants, and private sector price discovery for the “legacy” assets.

“This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly,” Treasury said in a briefing paper. “Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases—along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets.”

The program will leverage funds using a maximum six to one debt to equity ratio. Officials said by using $75 to $100 billion in capital from the Troubled Asset Relief Program (TARP) and capital from private investors, the plan will generate $500 billion in purchasing power to buy the troubled assets. The program could be expanded to purchase up to $1 trillion in troubled assets.

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This is the week U.S. Treasury Secretary Timothy Geithner attempted to put to rest the problem of toxic Collateralized Mortgage Obligations, creating a system to take them off the books of U.S. banks by selling them to public-private partnerships. The plan is too complex to explain here but its underlying goals are clear, to save the banks and arrest the fall of U.S. housing prices.

This follows last week’s dramatic move by the Fed to drive down interest rates by directly purchasing mortgage securities.

Alas, while market will probably greet both plans with a roar it seems doubtful to Home-Account that they will have significant success over the long term.

But wait, there’s more! Geithner also needs a way for banks to improve the book value of assets they can’t sell or choose to retain. To accomplish this we see coming modification of the mark-to-market rule that helped spark this credit crisis last summer.

We expect the Treasury, Fed, and the Financial Accounting Standards Board will come up with some kind of “don’t ask-don’t tell” system for valuing these assets that will give lip service to mark-to-market while practically returning asset valuations to the same murky place they’ve mainly lived in since 1937. Again, the market will soar, buoyed by a dubious system of accounting with two sets of books – the essence of non-transparency.

While these efforts will hopefully create at least a bottom for the housing market, they seem intended far more to help banks than to help home owners, which is not the way it should be. Talking to lenders it is clear that the Treasury’s plans for modifying mortgages are moving forward only slowly and are months from being implemented on a scale broad enough to even show that the plan will work. By that time millions more homes may be lost to foreclosure. Not good.

Homeowners and their mortgages are at least as important as banks and it is time for the Obama Administration to prove they understand that.

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For all the talk of declining interest rates and mortgage modifications, it is difficult for us to find much evidence of either happening yet in real terms or great volumes. Yes, published mortgage rates are being pushed down by aggressive actions on the part of the Federal Reserve, but much of this good news for homeowners is mitigated by increasing mortgage fees from Fannie, Freddie, and FHA. Lenders, too, are pushing fees higher to deal with a crush of refinance business that isn’t making them much money because of low approval rates. The market IS somewhat better for homeowners or prospective homebuyers who are extremely well qualified, but millions of underwater homeowners have no relief in sight and may not find any. It could get very ugly for them.

The Obama Administration seems to be taking its time about implementing the housing programs it has announced. First they announce, then they detail, and eventually they roll it out, or at least that’s the plan, because we see little evidence yet of such roll-outs. Few if any mortgages are being modified, for example, along the recent Treasury guidelines.

We at Home-Account are optimistic but realistic. The Obama Administration has good intentions but those intentions are tempered by multiple agendas. The Administration seems more focused right now on using the mortgage crisis to set a long-term spending agenda than with jump-starting the economy. We’d like them to hurry up.

We worry, too, that in their final versions these government programs won’t even be as useful as they have been described. We were told, for example, that the mortgage modification process would use interest rate reduction, longer term, and principal reduction. Yet the new web site http://makinghomeaffordable.gov seems to offer none of these options. Maybe they didn’t get the memo.

But this too shall pass. Lenders seem to be gearing-up for higher refi volumes. Some of this is an attempt to outrun delinquency and loss rate with new loan production, (the old finance company way to drive loss rate down — lend your way to lower delinquency, more volume). But government programs to save the homeowner do not seem to be a top priority this week with either lenders or government.

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Wells Fargo & Co. Chairman Richard Kovacevich criticized the Federal Government for retroactively adding rules to the Troubled Asset Relief Program (TARP), which he said forced the bank to cut its dividend, and called the administration’s plan for stress-testing banks “asinine.”

When the U.S. Treasury made the nation’s nine largest banks accept capital investments in October, it signaled the industry was weak, Kovacevich, 65, said in a March 13 speech at Stanford University in California. Even though Wells Fargo didn’t want the money, it had to comply with the same rules that the government placed on banks that did need it, he said.

Kovacevich joins a growing list of bankers who are chafing at restrictions imposed by the TARP program, which affect lending, foreclosures, pay and perks. Those lenders including Bank of America Corp., U.S. Bancorp and Goldman Sachs Group Inc. have said they want to give back the money. More than 500 banks, insurers and credit card companies applied for TARP capital, and the government has distributed almost $300 billion.

Wells Fargo slashed its dividend by 85 percent on March 6 to 5 cents a share, citing savings of $5 billion and the need to build a capital cushion in case the market deteriorates further. Last month the San Francisco-based bank made a quarterly payment of $371.5 million to the Treasury for interest on the $25 billion TARP investment.

Kovacevich said the government is still making mistakes as it tries to save the industry. The “stress test,” designed to determine which of the 19 largest U.S. banks need more capital, provides opportunities for short-sellers to drive down bank stocks and can hurt confidence in the system even more, he said.

The Obama administration announced the test last month and said it will help determine which banks are healthy enough to withstand surging unemployment and tumbling home prices. Results are due by late April, according to the Treasury.

“We do stress tests all the time on all of our portfolios,” Kovacevich said. “We share those stress tests with our regulators. It is absolutely asinine that somebody would announce we’re going to do stress tests for banks and we’ll give you the answer in 12 weeks.”

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