The Sunshine Report

Tag Archive: Bond Insurance

1. TARP 1.0 Didn’t Get Lending Going and TARP 2.0 Won’t Be Much Better" rel="bookmark">TARP 1.0 Didn’t Get Lending Going and TARP 2.0 Won’t Be Much Better

   February 12, 2009 11:35 pm 7 Comments

   TARP 1.0 didn’t get lend­ing going and TARP 2.0 won’t be much bet­ter. The prob­lem is that TARP 2.0 con­tin­ues to focus on banks as the pri­mary lend­ing insti­tu­tions despite the fact that banks aren’t the pri­mary source of non-real estate credit for con­sumers or busi­nesses. Most non-real estate lend­ing takes place through the “shadow bank­ing” sys­tem which was bypassed by TARP 1.0; and, it doesn’t look like TARP 2.0 is going to help non-bank insti­tu­tions either. Until Gei­th­ner addresses the liq­uid­ity issues of non-bank lenders and investors, nor­mal lend­ing won’t restart.

   TARP 1.0 didn’t restore the nor­mal func­tion of the con­sumer and com­mer­cial credit mar­kets because it used flawed logic. Paul­son incor­rectly believed in a “cause and effect rela­tion­ship” that didn’t exist. He thought that increas­ing bank equity would result in increased lend­ing. Unfor­tu­nately, he was wrong because most non-real estate lend­ing takes place out­side of the bank­ing sys­tem and lenders and investors out­side the bank­ing sys­tem didn’t get helped by TARP 1.0. So, while banks ben­e­fited from TARP 1.0, it didn’t help the com­pa­nies that lend the most to con­sumers and businesses.

   Also, TARP 1.0 didn’t work because it was “back­ward lean­ing”, i.e., it didn’t pro­vide cap­i­tal for new loans but tried to fill in cap­i­tal holes cre­ated by old loans turned bad. To stim­u­late new lend­ing, TARP 2.0 needs to be “for­ward lean­ing pol­icy” and focus on new loans while hav­ing other pro­grams fix past prob­lems. Replac­ing lost cap­i­tal and a melt­down are great pol­icy objec­tives but they are dif­fer­ent from mak­ing new loans.

   While one sec­tion of TARP 2.0 is for­ward lean­ing, it doesn’t work because it almost entirely misses non-bank insti­tu­tions. Instead of look­ing for ways to restart non-conventional lenders and investors, Gei­th­ner reverted to what he is famil­iar with and focused on using the ulti­mate bank­ing insti­tu­tion, the Fed­eral Reserve, to restart lend­ing. But, non-bank lenders and investors don’t nor­mally inter­face with the Fed­eral Reserve, and, the AAA rat­ings require­ments to qual­ify for Fed­eral Reserve stim­u­lus puts even more dis­tance between non-bank lenders and Treasury’s pro­grams. Gei­th­ner made the rookie mis­take of retreat­ing into his “com­fort zone” to solve the prob­lem with­out exam­in­ing alter­na­tives. He is com­fort­able in the ster­ile world of Fed tech­nocrats and not expe­ri­enced in the down and dirty world of decen­tral­ized non-bank institutions.

   But, Gei­th­ner is a quick learner so there is hope that he will ditch pol­icy ini­tia­tives that don’t work.

   Set forth are four sug­ges­tions for ini­tia­tives that will get the non-bank sys­tem work­ing again.

   • Form new gov­ern­ment spon­sored finan­cial guar­anty and bond insur­ance com­pa­nies. The fail­ure of the finan­cial guar­anty and bond insur­ance indus­try led the U.S. into the finan­cial cri­sis and the restart­ing of this indus­try will help lead Amer­ica out. These insur­ance com­pa­nies work because they cre­ate oper­at­ing effi­ciency for investors and back up their work by assum­ing risk. The bond insur­ers serve a func­tion sim­i­lar to rat­ing agen­cies but unlike rat­ing agen­cies, the bond insur­ers align their inter­ests with investors by putting “skin” in the game. Bond insur­ers were essen­tial to the cap­i­tal mar­kets for decades. Newly formed and well cap­i­tal­ized bond insur­ance com­pa­nies can be started by Trea­sury in a mat­ter of weeks and, if formed, will help restart­ing lend­ing.
     

      

   • Amend the mutual fund and tax laws to pro­mote the for­ma­tion of tax effi­cient pools of invest­ment money for lend­ing. The inter­play of the laws gov­ern­ing mutual funds and taxes make it dif­fi­cult, if not impos­si­ble, for investors to form tax effi­cient invest­ment pools that orig­i­nate and own high qual­ity com­mer­cial and con­sumer loans. The laws are anti­quated, restrict cap­i­tal for­ma­tion, inad­ver­tently encour­age risky behav­ior and make lit­tle com­mon sense. A pas­sive invest­ment in a non-mutual fund direct lend­ing pool can have dis­as­trous tax con­se­quences for for­eign­ers, not for prof­its, pen­sion funds and indi­vid­u­als (because of state tax­a­tion issues in the case of indi­vid­u­als). And, the laws reg­u­lat­ing mutual funds have the unin­tended side effect of encour­ag­ing risky behav­ior instead of pru­dent lend­ing. Gei­th­ner can fix these laws and encour­age the for­ma­tion of invest­ment cap­i­tal to restart lend­ing. And, there will be no impact on Fed­eral spending.

      

   • Expand the Com­mu­nity Devel­op­ment Finan­cial Insti­tu­tions Fund. Every year the IRS grants sev­eral bil­lion of tax cred­its to lenders through the Com­mu­nity Devel­op­ment Finan­cial Insti­tu­tions Fund (“CDIF”). This pro­gram is sup­posed to encour­age eco­nomic devel­op­ment through tax cred­its that are earned by lend­ing in low income and blighted areas. Unfor­tu­nately, over the years the CDIF has favored real estate related lend­ing rather than core busi­ness lend­ing. If CDIF was reori­ented to encour­age busi­ness lend­ing, an exist­ing pro­gram that is annu­ally cost­ing tax­pay­ers bil­lions could be con­verted into an impor­tant tool to restart com­mer­cial finance.
     

      

   • Encour­age the SBA to license non-bank lenders and update and mod­ern­ize the pro­gram. The last non-bank lender to receive a new “Sec­tion 7A” license was dur­ing the Rea­gan Admin­is­tra­tion. Under pres­sure from crit­ics, SBA pro­grams have been cut back year after year and are almost totally depen­dent upon banks. The SBA lend­ing indus­try is almost vir­tu­ally irrel­e­vant.
     

      

     30 years ago the SBA had a ter­ri­ble rep­u­ta­tion because its pro­grams were badly admin­is­tered. Since then the SBA has shrunk as a pro­por­tion of the econ­omy. But, the SBA’s poor his­tory doesn’t mean that the SBA can’t restart itself and con­tribute to Amer­i­can busi­ness health. A top down review of SBA pro­grams with an eye towards mod­ern­iza­tion and inclu­sive lender eli­gi­bil­ity, includ­ing non-bank par­tic­i­pants, could fix the SBA.
     

   Geithner’s cur­rent pro­pos­als won’t get bank lend­ing going again and cer­tainly aren’t going to get non-bank lenders excited. The Trea­sury Sec­re­tary needs to get out of his com­fort zone and start to look at sup­port­ing non-bank lenders and investors. They make up most of the mar­ket for con­sumer and busi­ness loans and ignor­ing non-bank lenders won’t get the econ­omy going again.

2. This Week’s Las Vegas Capital Markets Conference Holds The Key To Restarting The Economy

   February 8, 2009 1:00 am 2 Comments

    

   

   Start­ing Sun­day, the rem­nants of the secu­ri­ti­za­tion indus­try will be at the annual Amer­i­can Secu­ri­ti­za­tion Forum (“ASF”) Con­fer­ence in Las Vegas. Just as the secu­ri­ti­za­tion and secu­ri­ties indus­try led the nation into the cur­rent cri­sis, if the econ­omy is going to revive itself, this indus­try needs to lead the finan­cial sec­tor out of the cri­sis. The shadow cap­i­tal mar­kets based bank­ing sys­tem that existed in 2006 and early 2007 dwarfed the capac­ity of the bank­ing indus­try and drove both healthy and unhealthy lend­ing. While it is easy to blame banks for not lend­ing enough to con­sumers and busi­nesses, with­out restart­ing the cap­i­tal mar­kets, banks sim­ply do not have enough capac­ity to turn around the econ­omy. Sim­ply put, for the econ­omy to turn around, the cap­i­tal mar­kets need to restart first.

   Prior to the credit cri­sis, the amount of new credit pro­vided by the cap­i­tal mar­kets to con­sumers, busi­nesses and munic­i­pal­i­ties was esti­mated to be three to four times the amount of new credit pro­vided by banks. How­ever, since the credit cri­sis began, the cap­i­tal mar­kets haven’t worked and the econ­omy has been strangling.

   The below table con­tains the amount of new bond issuance for selected types of cap­i­tal mar­kets financ­ing in the first quar­ter of 2007 (before the cri­sis) and the third quar­ter of 2008 (in the mid­dle of the cri­sis) (all amounts in bil­lions of USD). The below data shows that the cap­i­tal mar­kets issuance shrunk by a large amount and, unless we want the econ­omy to shrink by a sim­i­lar amount, cap­i­tal mar­kets lend­ing needs to get mov­ing again. But, the below table doesn’t show how bad things really got because it doesn’t include 4^th quar­ter 2008 data. After Lehman Broth­ers col­lapsed, things got a lot worse in the last 3 months of 2008.

   	Munic­i­pal	Mort­gage Related	Cor­po­rate Debt	Fed­eral Agency Securities	Asset-Backed	Total
   1st quar­ter 2007	107.6	540.4	305.6	265.4	323.2	1542.2
   3th quar­ter 2008	89.6	286.6	82.6	198.8	23.5	681.1
   per­cent­age difference	16.73%	46.97%	72.97%	25.09%	92.73%	55.84%

    Source: Secu­ri­ties Indus­try and Finan­cial Mar­kets Association

   Accord­ing to the FDIC, the total growth of all forms of lend­ing (loans and leases) by all banks dur­ing 2006 was only a lit­tle more than $500 bil­lion. And, 2006 was a bank­ing “bub­ble” year when unsafe and unsound credit was extended. Even if banks sud­denly start increas­ing credit at a peak pre-crisis bub­ble rate, it won’t com­pen­sate for the loss of cap­i­tal mar­kets credit for­ma­tion. But, banks are strapped for cap­i­tal and won’t be able to push 2006 amounts of credit out the door for many years.

   The stakes are high for the U.S. econ­omy. Losses in the auto­mo­bile, motor­cy­cle, RV and plea­sure boat indus­tries are all in part related to the lack of con­sumer financ­ing caused by the drop in asset-backed secu­ri­ti­za­tion. Other indus­tries that are hard hit include edu­ca­tion (the cap­i­tal mar­kets were a mate­r­ial source of financ­ing for stu­dents loans), com­mer­cial real estate (prices are start­ing a down­ward spi­ral because of a lack of financ­ing) and import/export man­u­fac­tur­ing (a high pro­por­tion of trade receiv­ables were “secu­ri­tized” and sold into the cap­i­tal markets).

   The his­tory of how the cap­i­tal mar­kets devel­oped and how they crashed pro­vides clues for how to restart. The first com­pa­nies to crash were the for­merly AAA rated mono-line bond insur­ers (fol­lowed quickly by gov­ern­ment spon­sored enti­ties such as Fred­die Mac and Fan­nie Mae). These com­pa­nies started their lives with a much more mod­est mis­sion; to enhance mar­ket effi­ciency by pro­vid­ing insur­ance on low risk trans­ac­tions. The cat­e­gories of trans­ac­tions included munic­i­pal bonds and tax exempt financ­ings, res­i­den­tial mort­gages, con­sumer loans (such as credit cards and auto loans) and sim­ple busi­ness assets (such as trade receiv­ables and cer­tain types of com­mer­cial real estate).

   The bond insur­ers and gov­ern­ment spon­sored enti­ties com­bined the func­tions of rat­ing agen­cies, under­writ­ers and ongo­ing credit admin­is­tra­tors but with the twist of putting “their money where their mouth was” with a AAA rated insur­ance wrap that guar­an­teed full and timely pay­ment. Investors were able to “out­source” most of their credit work to the bond insur­ers and were still able to be pru­dent because the insur­ers had their cap­i­tal on the line. Mar­ket effi­ciency was dra­mat­i­cally enhanced because the credit and admin­is­tra­tive costs of invest­ing were low. Instead of each investor hav­ing to do their own fun­da­men­tal research and mon­i­tor­ing, which is very expen­sive, they were able to rely upon a sin­gle bond insurer to do it for them. With the effi­ciency of many being able to rely upon the work of one, the cap­i­tal mar­kets devel­oped. For more than 30 years this sys­tem worked in a safe and sound man­ner. There were other gov­ern­ment spon­sored and pri­vate bond insur­ers that existed and for many years did a great job exe­cut­ing their mis­sion includ­ing Sal­lieMae, Farmer­Mac and a range of pri­vate mort­gage insurers.

   The insur­ers and gov­ern­ment spon­sored enti­ties lost their way over the last 10 years and blew them­selves up when they tried to expand their mis­sion far beyond its orig­i­nal scope. The gov­ern­ment spon­sored enti­ties expo­nen­tially expanded their bal­ance sheets and lever­age when they tran­si­tioned from being “insur­ers” to “investors” and the insur­ers stretched their core busi­nesses into eso­teric and dumb trans­ac­tions. Some gov­ern­ment spon­sored enti­ties gave up their spe­cial sta­tus and mort­gage insur­ers totally changed their busi­ness model. Every­one was look­ing for the quick buck and thought that the “grass was greener” in things other than their core busi­ness. How­ever, despite the indus­try fail­ures, a safe and sound restart of these com­pa­nies is the essen­tial first step to restart­ing the cap­i­tal markets.

   The pri­vate mar­ket doesn’t have the will power or cap­i­tal to restart the bond insur­ance indus­try. The Obama Admin­is­tra­tion needs to step in and imme­di­ately license and cap­i­tal­ize gov­ern­ment owned bond insur­ance com­pa­nies to cover the major asset classes that are depen­dent on the cap­i­tal mar­kets for liq­uid­ity. These new com­pa­nies need to be prop­erly cap­i­tal­ized (to beyond min­i­mum AAA lev­els) as well as have an explicit gov­ern­ment guar­anty so that their insur­ance is of unques­tion­able qual­ity. The goal of these com­pa­nies should be to be pri­va­tized within 7 years and the com­pa­nies should only be allowed to pro­vide bond insur­ance on loans and port­fo­lios of loans that were orig­i­nated after Jan­u­ary, 2009 (that way banks don’t use the pro­gram to dump old assets).

   The Obama admin­is­tra­tion should form and license two munic­i­pal bond insur­ance com­pa­nies, two com­pa­nies that insure asset-backed financ­ings made up of con­sumer loans, two com­pa­nies that insure asset-backed financ­ings made up of com­mer­cial loans and trade credit, two com­pa­nies that insure com­mer­cial real estate related trans­ac­tions and two com­pa­nies that insure res­i­den­tial and multi-family real estate trans­ac­tions (i.e., com­pe­ti­tion for Fred­die Mac and Fan­nie Mae).

   So, let’s hope that this week what goes on in Las Vegas doesn’t stay in Las Vegas. It is the rem­nants of the struc­tured finance indus­try that has the human cap­i­tal to staff new com­pa­nies and get financ­ing mov­ing again. With lead­er­ship from the Obama Admin­is­tra­tion (and lots of tight reg­u­la­tion) they can get the job done.

3. A Letter To President Elect Obama – How to restore confidence

   December 4, 2008 8:21 pm Leave a Comment

   Dear Pres­i­dent Elect Obama:

   As you get closer to inau­gu­ra­tion I would like to make a few sug­ges­tions for your admin­is­tra­tion and its future eco­nomic policy.

   Every­one knows that the econ­omy is in trou­ble and con­fi­dence in the future is low. Con­fi­dence in the United States eco­nomic sys­tem and gov­ern­ment is our nation’s most impor­tant asset. Unfor­tu­nately, this asset has been squan­dered through ad hoc and poorly com­mu­ni­cated pub­lic pol­icy ini­tia­tives. You need to focus on restor­ing con­fi­dence in our eco­nomic sys­tem and gov­ern­ment. How you admin­is­ter eco­nomic pol­icy will count almost as much as the sub­stance of your pol­icy in restor­ing con­fi­dence. I believe that com­mu­ni­ca­tion skills mat­ter, details mat­ter and dis­ci­pline mat­ters. Also, Tru­man was right when he said “The Buck Stops Here”. Mak­ing tough deci­sions and explain­ing them to the Amer­i­can pub­lic is your job and can­not be del­e­gated to lower level offi­cials. It’s your admin­is­tra­tion and your eco­nomic pol­icy, not the Trea­sury Secretary’s.

   Enact­ing the below rec­om­men­da­tions will require tough deci­sions and a thick skin. You will be crit­i­cized by the “talk­ing heads” who are more inter­ested in stir­ring up con­tro­versy than find­ing solu­tions. Stim­u­lus alone isn’t enough to solve our prob­lems. With­out fun­da­men­tal changes in how we do things, I believe the cur­rent eco­nomic prob­lems will get pro­gres­sively worse in wave after wave of bad news.

   My sug­ges­tions for fix­ing the econ­omy are below.

   1.  Pass fis­cal stim­u­lus now and make sure it is mas­sive. The econ­omy is rapidly falling into a defla­tion­ary death spi­ral. Defla­tion is like pour­ing hydrochlo­ric acid on the econ­omy. Half mea­sures won’t work; you need to force feed demand. So please, go for the gusto. $500 bil­lion+ is needed. If the stim­u­lus is too small or doesn’t force demand to rise it will actu­ally make the prob­lem worse because con­fi­dence will be destroyed, peo­ple will get more scared and fur­ther hoard­ing of cash will take place. While imme­di­ate and mas­sive stim­u­lus is needed, it would be nice if the spend­ing also was in projects and pro­grams that actu­ally might have some long term benefit.

   2.  Go slow on bank­ing and secu­ri­ties reg­u­la­tory over­haul; Push hard on enforce­ment. The United States has plenty of rules and reg­u­la­tions but lacks the will to enforce them. It is inex­plic­a­ble why the SEC and other Fed­eral reg­u­la­tors have refused to enforce exist­ing rules that pro­mote full and fair dis­clo­sure, dis­cour­age mar­ket manip­u­la­tion, man­date safe and sound bank­ing prac­tices pre­vent con­sumer fraud and have other com­mon sense objec­tives. For some rea­son, tried and true enforce­ment was sac­ri­ficed on the altar of “free mar­kets”. But, free mar­kets aren’t sup­posed to be crooked mar­kets and it is time that Fed­eral reg­u­la­tors did their jobs and enforced exist­ing law and reg­u­la­tion. I believe that when the cur­rent rules and reg­u­la­tions are enforced you will find that the reg­u­la­tory gaps are small. 

   Oh, by the way, the SEC is a bas­ket case and needs to be restaffed with pro­fes­sion­als that believe in its mis­sion of pro­tect­ing the lit­tle guy, mak­ing sure that mar­kets are free and fair so that the cap­i­tal mar­kets work to everyone’s advan­tage and not just for a few Wall Street insiders.

   3.  Account­ing rules mat­ter; Sus­pend mark to mar­ket account­ing and reform secu­ri­ti­za­tion account­ing. Please get rid of mark to mar­ket account­ing now; it is a bad account­ing rule. When you announce that you are con­sid­er­ing get­ting rid of this rule, watch who gears up the PR cam­paign oppos­ing its elim­i­na­tion. They will be the peo­ple who have been prof­it­ing from mark to mar­ket account­ing. I am will­ing to bet that almost all of the lob­by­ists will be bankrolled by traders and fund man­agers that make money from the rule’s car­nage. After all, mark to mar­ket account­ing makes bet­ting on cor­po­rate value destruc­tion a near certainty.

   If account­ing rules mat­ter, bad reg­u­la­tory account­ing rules mat­ter even more. About 20 years ago bad reg­u­la­tory account­ing rules were enacted that apply to all banks and have the unin­tended side effect of encour­ag­ing the worst excesses of the secu­ri­ti­za­tion mar­ket. These rules reward banks that use the OPM model (i.e., “other people’s money”) to finance assets and penal­izes banks that want to cre­ate well cap­i­tal­ized invest­ment struc­tures. These bank reg­u­la­tory rules vir­tu­ally man­date the “orig­i­nate and sell” model of finance and need to be fixed imme­di­ately. Gen­er­ally accepted account­ing prac­tices have run amok try­ing to work around the bad bank reg­u­la­tory rules. The account­ing indus­try is about to “reform” the rules relat­ing to secu­ri­ti­za­tion account­ing in FAS rule 140 but the new rules con­tinue to make a mess of things. An inter­a­gency ini­tia­tive is needed to fix this mess. And, inter­a­gency coop­er­a­tion will only hap­pen with Pres­i­den­tial leadership.

   4.  Imme­di­ately out­law naked credit default swaps and other credit deriv­a­tives that aren’t tied to own­er­ship of under­ly­ing assets. What­ever ben­e­fit we get from naked credit default swaps is more than off­set by mar­ket abuses from the casino men­tal­ity they encour­age. In a naked credit default swap nei­ther coun­ter­party owns any of the under­ly­ing secu­ri­ties of the com­pany whose credit is being wagered upon. Gen­er­ally, the big money pro­po­nents of naked credit default swaps are spec­u­la­tors who jus­tify them­selves by claim­ing that “price dis­cov­ery” can only be achieved in the CDS casino. I think that prices should be estab­lished by buy­ing and sell­ing actual assets. There is no rea­son to have CDS book­ies tell us what things are worth. By the way, I can’t find any­one who is an insur­ance expert that can explain why credit default swaps aren’t a form of insur­ance con­tract and why they shouldn’t be reg­u­lated as an insurance.

   5.  Form gov­ern­ment spon­sored bond insur­ance com­pa­nies and return Fred­die Mac and Fan­nie Mae to their orig­i­nal mis­sion. Bond insur­ance com­pa­nies played an impor­tant role in the devel­op­ment and oper­a­tion of the cap­i­tal mar­kets. For years these pri­vately held com­pa­nies were the grease that made the wheels of munic­i­pal and con­sumer finance turn. It is not a coin­ci­dence that since the col­lapse of the “AAA” rated bond insur­ance com­pa­nies the cap­i­tal mar­kets have been a sham­bles. For decades the bond insur­ance com­pa­nies had a good busi­ness model. Unfor­tu­nately for a few years the bond insur­ance com­pa­nies did a bad job and as a result blew them­selves up. But, a few years of bad exe­cu­tion doesn’t change the fact that the basic busi­ness model pro­vided value. The gov­ern­ment needs to form and cap­i­tal­ize new bond insur­ance com­pa­nies with the goal of pri­va­tiz­ing them within 5 years when the cap­i­tal mar­kets recover. By the way, this will be the low­est cost and biggest “bang for the buck” mar­ket stim­u­lus that the Gov­ern­ment can do to free up the cap­i­tal markets.

   When they were formed Fred­die Mac and Fan­nie Mae were a form of bond insur­ance com­pany that made it easy for investors to pur­chase mort­gages and mort­gage backed secu­ri­ties. How­ever, over the last 20 years Fred­die Mac and Fan­nie Mae expe­ri­enced “mis­sion creep” and started directly invest­ing in mas­sive amounts of mort­gages. As their bal­ance sheet exploded, Fred­die Mac and Fan­nie Mae crowded out banks, thrifts and other mort­gage lenders and became the world’s largest investor of res­i­den­tial mort­gages. The orig­i­nal idea behind Fred­die Mac and Fan­nie Mae was sound and if re-implemented in a ratio­nal man­ner will pro­vide pri­vate investors with a chance to again put money to work in the insured mort­gage market.

   Mr. Obama, hope­fully you agree that my sug­ges­tions strike a bal­ance of short term stim­u­lus and struc­tural reform so that we don’t have a repeat of the last few years. Good luck as you lead the nation in what will hope­fully be a new and great chap­ter in our history.