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Generational Dynamics Web Log for 1-Dec-07
Dept. of Treasury proposes national mortgage bailout as losses become more widespread

Web Log - December, 2007

Dept. of Treasury proposes national mortgage bailout as losses become more widespread

Florida state and local governments are in financial crisis this weekend, after Gov. Charlie Crist halted further withdrawals from the state-run muncipal investment pool.

Local governments had made panicked withdrawals of $13.5 billion in the past two weeks, leaving only $15 billion remaining. The panic was triggered by recent news that some of the fund's investments were tainted by the subprime mortgage crisis, and were being downgraded by the ratings agencies.

School districts, counties and cities across the state are scrambling this weekend to take out short-term loans to cover payroll for teachers and other employees. "The unthinkable and the unimaginable have just happened here in Florida," said the CFO of one school district.

The largest investor in the frozen fund is Citizens Property Insurance Corp., with $2 billion. Citizens was set up in 2002 to provide property insurance to Florida citizens after several insurance companies had pulled out of Florida in the wake of several hurricanes.

Gov. Crist is seeking the services of outside financial advisors over the weekend, hoping to resolve the situation and permit emergency withdrawals by Tuesday.

Florida is not unique in having these investment pools. Like many individual investors, muncipal governments do not have the expertise to make the best investments. They rely on investment pools set up by the state or region to manage all investments in the state or region. There are thousands of local districts across the country investing in these pools.

In fact, a similar situation is brewing in Montana, where panicky towns and school districts have withdrawn of the state's Short Term Investment Pool funds.

These pools are supposed to invest in only the highest rated AAA securities. However, as more and more financial firms are discovering, an AAA rating doesn't necessarily have much value when the securities are risk-laden mortgage-based CDOs that have been created by financial geniuses who found ways to transform high risk mortgage loans into "zero risk" CDO securities.

As the "subprime crisis" continues to spread, politicians and other officials are searching for ways to delay, delay, delay the inevitable.

Last month the big idea, promulgated by the Dept. of Treasury and Citibank, was the mind-boggling Master-Liquidity Enhancement Conduit (M-LEC). Its purpose was to commit fraud by allowing banks to sell worthless CDOs to one another at inflated prices, in order to establish phony "market prices."

Citibank's fraudulent M-LEC idea didn't take off, forcing the bank to take $16.4 billion in writeoffs of worthless CDOs after all. Citibank might have failed completely except that it was saved by an investment by the Abu Dhabi Investment Authority.

Public opinion is changing very rapidly these days. A few months ago, the idea that Arab oil sheiks might own a piece of Citibank would have been met with enormous outrage. But today, Americans are getting so desperate for money from somewhere, anywhere, that there's no outrage to be had.

That's why everybody's looking hopefully toward a brand new boondogle, much, much huger than the M-LEC boondoggle. The M-LEC plan was worked out between the Treasury Dept. and the banks, especially Citibank. (Massive fraud is OK, but only if Treasury says it's OK.)

The new boondoggle is being worked out between the Treasury Dept. and mortgage lending firms. Next week, Treasury Secretary Henry Paulson is expected to announce a plan to "save struggling homeowners" from foreclosure, as adjustable rate mortgages reset. According to leaks, the plan will keep low teaser rates low for an additional period of time.

This is going to be quite a mess if it's tried. First off, a lot of the "struggling homeowners" facing foreclosure don't have adjustable rate mortgages (ARMs). They have regular Prime or Alt-A mortgages, but they lied about their income to get them. In many cases, they planned to "flip" the house, but falling real estate prices have ended that idea.

Second, many of the mortgages were for 100% of the purchase price, and with falling real estate prices, the mortgage loans now exceed the value of the house, sometimes substantially. As CNBC's financial pundit Jim Cramer ranted in July, if your home is worth less than your mortgage loan, and you're struggling to make payments, then you might as well walk away from it.

Third, there's a big complication that comes from the financial engineering that the geniuses set up. Remember that the company that made the mortgage loan no longer holds the mortgage. The mortgage debt was sliced and diced into collateralized debt obligations (CDOs). So your Aunt Mabel's mortgage loan is really being held by other investors. If mortgage rates don't reset to higher rates, then mortgage payments will be lower than the financial geniuses predicted, and the investors will have the right to take legal action.

By coincidence, the BBC's Business Daily radio show just had a commentary on another bailout -- the bailout of African countries that couldn't pay their debts.

Long time readers of this web site will recall that in 2005, the "wealthy nations" made a decision at the G-8 meeting to cancel Africa's debts. The politicians were very self-congratulatory at this "historic" gesture, even though the whole thing was a joke.

Well now comes this commentary by the BBC's regular Kenyan commentator, Wycliffe Muga (MP3/Podcast file), saying that the Kenyans aren't very happy with the situation that's unfolded:

"A few weeks ago, I spoke about the grassland ecosystem that ranges from the Serengeti National Park in Tanzania to the Masai Mara game preserve in Kenya, which is famous for the annual wildebeest migrations, and I explained how the superior infrastructure on the Kenyan side of the border insured that Kenya, which is already better off than Tanzania, earned far more [[from tourists]] from this jointly owned resource than Tanzania.

But there are situations in which a poor country will benefit in a way that a slightly better off neighbor cannot. Take for example, the Highly Indebted Poor Countries Initiative of the World Bank and the IMF. Under this arrangement, the debts of 38 poorest countries in the world, most of them in sub-Saharan Africa, were substantially written off by the lending institutions. There were conditions attached to this, but it was a massive debt writeoff, all the same.

In East Africa, Tanzania and Uganda qualified for the debt relief, but Kenya did not.

Now, you would think that Kenyans would regard this as a compliment. After all, it cannot be a matter of national pride that your country is identified as highly indebted and poor.

But that is not how many Kenyans saw it. Both political leaders, and ordinary people, were prompt in expressing their outrage at the fact that Kenya had been left out of this beneficial program.

The argument raised was that Kenya was being punished for having been diligent in paying its debts, and for struggling to live within its means, while neighboring countries, which had recklessly piled up loans beyond their capacity to repay, were now being rewarded for their folly.

The more enterprising commentators took it a step farther, and presented convincing approximations on how many classrooms or clinics, how many kilometers of paved roads, and how many additional schoolteachers and nurses the government of Kenya would be able to employ if it could convert the money currently used on annual debt repayment to providing services to its people.

And this line of argument invariably concluded with a demand that Kenya should immediately be placed on that list of poorest nations, so that it too could benefit from the Debt Cancellation Program.

So whereas in tourism it pays to have some money if you are to create the infrastructure needed for exploiting a game park, when it comes to the global programs, run by the World Bank and the IMF, it's being poor and heavily indebted that will really get you a slice of the cake."

And so, Kenyans are unhappy because they're not being bailed out like the Tanzanians and the Ugandans were.

That's probably going to be the fatal flaw in this new program to bail out "struggling homeowners" facing foreclosure.

Someone who responsibly made all his mortgage payments and even planned ahead for the ARM interest reset is going to get no help at all, while his next door neighbor, who lied about his income and doesn't even care whether he's foreclosed or not is going to get huge amounts of help.

That's the "moral hazard" argument that applies to all of these situations. People are high and mighty when they say, "You made your bed, now lie in it." Or, as the Kenyans say, "Why are those other countries being rewarded for the recklessness?"

But when Americans become sufficiently desperate, then this concern about moral hazard, rewarding people for being reckless, goes out the window, just like the outrage over Arab ownership of Citibank has gone out the window. (1-Dec-07) Permanent Link
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