Top Down vs. Bottom Up
In Chapter 17 of “The Either/Or Investor” I talked about the need to look past conventional wisdom when looking at investments. The idea, that the “cream of the crop” might not really be worth as much in the long run, as “the bottom of the barrel”, is a sound one, and is favored by so-called value investors, who are willing to buy seemingly distressed securities if they are compensated for their risk with a decent dividend. But the top versus bottom argument has other applications as well. On Sept. 7th, the U.S. Treasury announced a “top down” takeover of Fannie Mae and Freddie Mac, the two government-sponsored but publicly traded corporations that provide much of the liquidity to the residential mortgage market through their willingness to buy up mortgages from banks and repackage them as securities that can be sold into the institutional markets, thereby allowing the banks to issue additional mortgages while remaining within their own debt covenants. This mortgage shifting has been a sound idea since it began in the depths of the Great Depression, and it has helped to make the housing industry one of the cornerstones not only of American prosperity, but also of a strong home-owning middle class.
So many on Wall Street, waking up on Monday morning, September 8, cheered the Treasury’s takeover of the two troubled lending agencies. Here at last, many argued, was a sign that the Bush Administration was acting in the best interests of the country. Well, yes, but also no. In reality, the takeover was a classic top down solution. The real beneficiaries were not Americans, since Freddie and Fannie shareholders were wiped out in the transaction, and the cost of the takeover and subsequent bailout are going to be borne by American taxpayers, but rather foreign banks and governments – in the form of sovereign wealth funds – who bought enormous amounts of paper from the two agencies. These banks and government funds convinced themselves that Fannie and Freddie were as low a risk as U.S. Treasuries, and that if they ever got in trouble, they had the implicit backing of the U.S. Treasury. In making that backing explicit via a takeover, Treasury Secretary Henry Paulson was violating the moral hazard rule, and rewarding foreign banks and funds for their own greed in sopping up the higher coupon agency paper over Treasuries in order to help keep their returns above average.
It is, of course, possible to argue that Paulson was only doing that he had to. The United States has become a profligate debtor, long dependent upon the kindness of, if not strangers, at least of foreigners. Out Treasury and agencies owe the rest of the world more than $2 trillion, and we show no sign of stemming our borrowing habits. Only by providing Treasury backing for Fannie and Freddie is it possible to avert a future crisis where the old phrase “not worth a Continental” – first applied when the pre-republic Confederation of States came to the verge of losing control of its currency to hyper-inflation – becomes a new term for a more catastrophic currency crisis that would pace the dollar in real peril. So, make no mistake about it: Sec. Paulson’s top down solution was not for American investors – Wall Street gave back all of its gains from the news only a day later – but for the ability of the U.S. to continue as a borrower from the world’s lenders.
But a top down solution should not preclude the possibility of a bottom up one. Having decided that the issue of moral hazard regarding foreign banks was less important than national interest, Paulson, President Bush and the Congress, should now put aside the same moral hazard issue when it comes to homeowners. At the end of the day, it does not matter if some mortgage that ought never to have been issued were sold by banks eager to pump up their bottom line. At the end of the day, it also does not matter if there are hundreds of thousands of people who knowingly bought hoes they could not afford, in the hope of flipping them during an unprecedented real estate boom. Right now, the only thing that matters is that the real estate market, which is the foundation upon which our status as a middle class nation rests, is in serious danger of crumbling. The Hope Now Alliance, a Bush Administration initiative launched in June to help homeowners in danger of default initiate talks with their bankers in hopes of a renegotiated mortgage is less than a Band-aid on a rapidly hemorrhaging wound to society. If Secretary Paulson can act as the godfather to foreign banks and funds, he must now assume the role of Godfather to American banks that issue mortgages. Banks depend upon the Fed and the Treasury to balance their lending and currency needs, going to the Fed’s discount window whenever they are in need of a fix of last resort. Just as Mario Puzo’s Godfather exacted favors for such emergency lending, it is now time for Paulson to do the same: In congress with Ben Bernanke, the Fed’s chairman, he should immediately mandate that every bank offer every mortgage holder in America a 20% lower reset on their mortgage. Forget about Fed interest rates. The onus ought to be on the banks, at least in the short term, because in the long term they will be putting their own houses in better order. First, banks will earn a fee for each new mortgage they initiate, on what had been both good mortgages and bad. Those fees – upwards of $2 trillion if ever mortgage were to reset – would go a long way to restoring the profitability of troubled financial institutions. The banks would also have to tighten up lending standards, so that everyone coming in for a reset would have to meet more normal creditworthiness standards. No more sub-prime loans. No more liar loans. No more balloon mortgages. This reset would apply to plain vanilla loans only.
The new mortgages would not only help the banks, but they would put more money back into communities. A mortgage that was. Say, $1,200 a month would become a $960 a month mortgage, freeing up $240 a month, $2,880 a year, for consumers either to spend, save, or pay spiraling local real estate and school board taxes. Now, not everyone offered a reset would take it. If you are a homeowner with only a couple of years left on a conventional mortgage, there might be little point in taking out a brand-new 10-, 20- or 30-year conventional mortgage on the remainder of your debt, especially if your life situation might be about to change.
Yet another way to approach the mortgage problem in a bottom up manner is to make banks partners with their borrowers. If ideologues are really worried about moral hazard and rewarding irresponsible borrowing, they could take a page from Arab finance and issue sukkuk loans, where the lender gains an equity interest in the future profit from the sale of the property in return for a smaller monthly payment. This equity interest could even be made variable, depending upon the economic health of the borrower, and could be reset periodically.
I do not propose that these are the only solutions, but they are offers of possibility. Looking only at the world from a top down perspective may keep the government of the United States afloat, but in the end, if the people of the United States are not also kept afloat, no top down solution will be able to endure.
In Chapter 17 of “The Either/Or Investor” I talked about the need to look past conventional wisdom when looking at investments. The idea, that the “cream of the crop” might not really be worth as much in the long run, as “the bottom of the barrel”, is a sound one, and is favored by so-called value investors, who are willing to buy seemingly distressed securities if they are compensated for their risk with a decent dividend. But the top versus bottom argument has other applications as well. On Sept. 7th, the U.S. Treasury announced a “top down” takeover of Fannie Mae and Freddie Mac, the two government-sponsored but publicly traded corporations that provide much of the liquidity to the residential mortgage market through their willingness to buy up mortgages from banks and repackage them as securities that can be sold into the institutional markets, thereby allowing the banks to issue additional mortgages while remaining within their own debt covenants. This mortgage shifting has been a sound idea since it began in the depths of the Great Depression, and it has helped to make the housing industry one of the cornerstones not only of American prosperity, but also of a strong home-owning middle class.
So many on Wall Street, waking up on Monday morning, September 8, cheered the Treasury’s takeover of the two troubled lending agencies. Here at last, many argued, was a sign that the Bush Administration was acting in the best interests of the country. Well, yes, but also no. In reality, the takeover was a classic top down solution. The real beneficiaries were not Americans, since Freddie and Fannie shareholders were wiped out in the transaction, and the cost of the takeover and subsequent bailout are going to be borne by American taxpayers, but rather foreign banks and governments – in the form of sovereign wealth funds – who bought enormous amounts of paper from the two agencies. These banks and government funds convinced themselves that Fannie and Freddie were as low a risk as U.S. Treasuries, and that if they ever got in trouble, they had the implicit backing of the U.S. Treasury. In making that backing explicit via a takeover, Treasury Secretary Henry Paulson was violating the moral hazard rule, and rewarding foreign banks and funds for their own greed in sopping up the higher coupon agency paper over Treasuries in order to help keep their returns above average.
It is, of course, possible to argue that Paulson was only doing that he had to. The United States has become a profligate debtor, long dependent upon the kindness of, if not strangers, at least of foreigners. Out Treasury and agencies owe the rest of the world more than $2 trillion, and we show no sign of stemming our borrowing habits. Only by providing Treasury backing for Fannie and Freddie is it possible to avert a future crisis where the old phrase “not worth a Continental” – first applied when the pre-republic Confederation of States came to the verge of losing control of its currency to hyper-inflation – becomes a new term for a more catastrophic currency crisis that would pace the dollar in real peril. So, make no mistake about it: Sec. Paulson’s top down solution was not for American investors – Wall Street gave back all of its gains from the news only a day later – but for the ability of the U.S. to continue as a borrower from the world’s lenders.
But a top down solution should not preclude the possibility of a bottom up one. Having decided that the issue of moral hazard regarding foreign banks was less important than national interest, Paulson, President Bush and the Congress, should now put aside the same moral hazard issue when it comes to homeowners. At the end of the day, it does not matter if some mortgage that ought never to have been issued were sold by banks eager to pump up their bottom line. At the end of the day, it also does not matter if there are hundreds of thousands of people who knowingly bought hoes they could not afford, in the hope of flipping them during an unprecedented real estate boom. Right now, the only thing that matters is that the real estate market, which is the foundation upon which our status as a middle class nation rests, is in serious danger of crumbling. The Hope Now Alliance, a Bush Administration initiative launched in June to help homeowners in danger of default initiate talks with their bankers in hopes of a renegotiated mortgage is less than a Band-aid on a rapidly hemorrhaging wound to society. If Secretary Paulson can act as the godfather to foreign banks and funds, he must now assume the role of Godfather to American banks that issue mortgages. Banks depend upon the Fed and the Treasury to balance their lending and currency needs, going to the Fed’s discount window whenever they are in need of a fix of last resort. Just as Mario Puzo’s Godfather exacted favors for such emergency lending, it is now time for Paulson to do the same: In congress with Ben Bernanke, the Fed’s chairman, he should immediately mandate that every bank offer every mortgage holder in America a 20% lower reset on their mortgage. Forget about Fed interest rates. The onus ought to be on the banks, at least in the short term, because in the long term they will be putting their own houses in better order. First, banks will earn a fee for each new mortgage they initiate, on what had been both good mortgages and bad. Those fees – upwards of $2 trillion if ever mortgage were to reset – would go a long way to restoring the profitability of troubled financial institutions. The banks would also have to tighten up lending standards, so that everyone coming in for a reset would have to meet more normal creditworthiness standards. No more sub-prime loans. No more liar loans. No more balloon mortgages. This reset would apply to plain vanilla loans only.
The new mortgages would not only help the banks, but they would put more money back into communities. A mortgage that was. Say, $1,200 a month would become a $960 a month mortgage, freeing up $240 a month, $2,880 a year, for consumers either to spend, save, or pay spiraling local real estate and school board taxes. Now, not everyone offered a reset would take it. If you are a homeowner with only a couple of years left on a conventional mortgage, there might be little point in taking out a brand-new 10-, 20- or 30-year conventional mortgage on the remainder of your debt, especially if your life situation might be about to change.
Yet another way to approach the mortgage problem in a bottom up manner is to make banks partners with their borrowers. If ideologues are really worried about moral hazard and rewarding irresponsible borrowing, they could take a page from Arab finance and issue sukkuk loans, where the lender gains an equity interest in the future profit from the sale of the property in return for a smaller monthly payment. This equity interest could even be made variable, depending upon the economic health of the borrower, and could be reset periodically.
I do not propose that these are the only solutions, but they are offers of possibility. Looking only at the world from a top down perspective may keep the government of the United States afloat, but in the end, if the people of the United States are not also kept afloat, no top down solution will be able to endure.
