Tuesday, February 17, 2009

John Hussman on "How To Climb Out of the Global Financial Hole"

From Dr. Hussman's market commentary today, "How To Climb Out of the Global Financial Hole":

•  Financials that are insolvent and are likely to survive only with large and sustained infusions of taxpayer funds should be allowed to fail in pre-packaged bankruptcies that wipe out both the shareholders and the bondholders of those institutions. Customers and depositors will not be hurt, and it won't cost taxpayers a penny. As Stiglitz notes, “you should not chase good money after bad.”

•  The government should continue to provide capital directly to large, diversified financial institutions which remain solvent but have some impairment to capital. Preferred stock is a reasonable form, though a high (possibly deferred) yield to the government is preferable to a low one (Bagehot's Rule[1]). Tight restrictions against using taxpayer capital for compensation and bonuses are certainly appropriate. These institutions include major banks like Citigroup, Bank of America, Wells Fargo, J.P. Morgan, and others, which appear to be experiencing pressure not because of insolvency, but because of uncertainty about potential future loan losses, and the ongoing availability of publicly provided capital.

•  Troubled assets should only be purchased if all of the pieces of a given issuance can be collected. The ability to aggregate all of the pieces is necessary because that's the only way the underlying mortgages can be restructured. If, for example, all of the pieces could be purchased at an average of 40 cents on the dollar (which is well above where many of these securities are marked), the underlying mortgages could be reduced by as much as 60%, making them solvent and likely to be repaid. The restructured loans might eventually even be re-sold into the market through the GSEs at no taxpayer expense.

•  The most direct method of intervening is at the point of foreclosure through the courts. One way of doing this would be to give judges the ability to write down principal, and to assign the balance as a deferred “property appreciation right” (PAR) to the lender. This would reduce foreclosure rates, preserve the value of the existing mortgage securities, and avoid concerns about fairness. A more ambitious government-sponsored program would be to make the PARs an obligation of homeowners to the Treasury administered through the IRS, asserting a claim on the price appreciation of the home or subsequent property owned by the homeowner. The foreclosure court would reduce principal, assign an offsetting PAR obligation to the homeowner, and assign the lender that same share in the Treasury's PAR Fund (basically a national pool of those PAR obligations). The PARs would then be marketable. Though they would undoubtedly sell at a discount to the face amount since not all the PARs will be repaid, they would be backed by a pool of real assets that are likely regain their value in the long-term, if not the near term. The Treasury could aggregate these claims and pay them out proportionately to the lenders, but would not even have to guarantee full payment – just enforce the claims by collecting and paying out.

The emphasis above is Hussman's. Hussman reiterates here a point he's made previously (e.g., "You Can't Rescue the Financial System If You Can't Read a Balance Sheet"), that forcing bondholders to take a haircut, or swap some of their debt for equity, would obviate the need for bailout funds from taxpayers in some cases. His advocacy of allowing bankruptcy judges to modify loans while awarding "property appreciation rights" (PARs) to lenders (his fourth bullet point above) raises a question though: if PARs existed now, would it be necessary for judges to intervene, i.e., wouldn't lenders have an incentive to write-down mortgages in return for PARs, particularly if such rights would be marketable, as Hussman envisions? Perhaps before allowing judges to re-write mortgages, the government ought to create a market for PARs and see if this helps expedite more voluntary restructuring of mortgage debt.

Another question Hussman's commentary raises relates to his point (in the third bullet point above) about the benefit of owning all the pieces of a securitized mortgage issue, i.e., that it would let the owner re-structure the underlying mortgages, making more of them viable and thus marketable. Why aren't more deep-pocketed institutional fixed income investors doing this already?

1"Lend freely at the penalty rate".


JK said...

The problem is that through securitization, leverage, and credit default sweeps, the liabilities became far more than the sum of their parts. Not only that, but honestly no one is sure where, exactly, all the parts actually ended up. A lot went overseas, a lot went to now-bankrupt companies, AIG remains a black hole for forensic accountants, etc.

People levered up not just on the mortgages, but essentially, the underlying risk models (via "insurance" in layman's terms), which, as always, are flawed. The problem isn't primarily the mortgages, but the liabilities on top of the mortgages (debt on top of debt on top of debt on top of an asset declining in value). This is where the really big losses have been occurring, but it's hard to explain complicated financial instruments to a regular economist, much less the general public, so the story is "things are bad because people are defaulting on their mortgages", or in the case of financial reporters, "...because people are defaulting and some bonds went south". Reality is not that simple, and you're not going to have a thorough end-all be-all solution without an army of mathematicians and independent financial contract lawyers to act as arbitrators, because no one wants to take the hit (that's why the Bear Stearn's counterparties orchestrated a strike, BS was giving everyone the shaft). Of course the government doesn't want to do that either, so they tell everyone "we don't want to figure this shit out, you each handle it on your own the best way you can and we'll foot the bill until everything fizzles out in a few years."

DaveinHackensack said...

Part of what you bring up is the coordination problem Hussman mentions, that could be ameliorated by one entity (in his example, the government) owning all the pieces of a mortgage-derived security issue (e.g., all of a particular CDO). Absent the instance of one entity holding all the pieces, I'm still not clear on what authority a servicer or trustee would have, acting in the best interests of the investors, to modify underlying mortgages. Perhaps that's something that could be cleared up by legislation or a judicial decision.

The salient point that Hussman makes though is that, at bottom, a lot of debt needs to be restructured if we're going to get past this. My guess is that Obama's economic team is aware of this, but has no intention of attempting any sort of big-bang solution this year, out of fear that the price tag -- when added to the rest of the deficit this year -- would spook the bond market. They may hope that things "fizzle out", as you suggest, or at least that we can muddle through until next year.

Another part of what you bring up, unwinding derivatives more removed from mortgages, could be ameliorated by nationalization of some insolvent institutions. If the government owns both counter-parties to a CDS, for example, then it can just cancel it out.