I was recently challenged by a close friend to propose a solution to the crisis facing us in the housing market. Normally my tag line is “it is not incumbent upon me to come up with a solution to problems”. In truth, I feel it is irresponsible when the public reacts to governmental, political, economic and sociological “problems” with the statement “Worrying about the PROBLEM isn’t going to solve anything. Let’s deal with the SOLUTION”. To understand and develop a viable solution, we must first understand the underlying problem.
That said, I have always considered myself a “solutions” guy. I prefer to deal with solutions, once I understand what the underlying problem is. So, let’s assume we all understand what the problem is. (For a more detailed understanding, see Letter from Leo W. Gerard, President of the United Steelworkers Union, to Treasury Secretary Paulsen, dated October 28, 2008)
In a nutshell, Mr. Gerard’s argument in his letter to Secretary Paulson is that the Secretary failed to exercise sound judgment in valuing the assets for which he was committing taxpayer dollars. Just twenty days before Goldman announced that it would “accept” Treasury’s investment; Warren Buffett invested $5 billion into Goldman Sachs and acquired the very same type of security – preferred stock – with the very same form of “upside” – warrants to purchase common stock. Per dollar invested, Mr. Buffett received at least seven and perhaps up to fourteen times more warrants than Treasury Paulson did and Mr. Buffett’s warrants have more favorable terms. In addition, Mr. Buffett’s preferred stock has a higher dividend rate and can only be bought away from him at a premium, while Treasury’s investment of taxpayers’ money pays a lower dividend and can be repurchased at par.
Mr. Gerard argues the Treasury paid $125 billion for securities for which a disinterested party would have paid $62.5 billion. This means that we, as taxpayers, gifted the other $62.5 billion to the shareholders of the largest nine banking institutions. Even worse, it is expected that the nearly $25 billion per year that the firms pay out in dividends to their shareholders will continue. At current levels, dividends to shareholders will distribute all of the money we invested in just five years.
Out in the real economy, we need to restore the balance of power between workers and business, rebuild the middle class and curb corporate excesses. We need to get the government OUT of the business of running corporate American and prevent our tax dollars going to pay for the cronyism of Washington. Our politicians are freely spending our tax dollars to pad their own coffers and protect the small circle of friends who surround and support them. The $700 billion dollar investments do NOTHING to deal with the causes of the current crisis. So, I propose a solution…
To solve the problem, we should start by halting any more taxpayer funds paid to any of the banks. We should mandate the banks liquidate a portion of their REO (Real Estate Owned, e.g. foreclosed homes that are now bank held properties) inventory holdings within 180 days. Any REO that has been on the books of the banks for longer than 200 hundred days must be liquidated within 60 days.
By requiring the banks to liquidate REO holdings, the banks are then forced to eliminate non-performing assets from their balance sheets. Liquidating REO’s will inject the supply of houses back into the market. The banks are forced to take actual losses on the poor investments they made. The banks are then placed in the same position as any other investor when a trade goes against their interest. Liquidating REO’s converts a non-performing asset into a performing asset in the capital market. By doing this there will be a shift of the risk of fluctuating (or further declines) in housing prices from the banks (who traditionally do NOT like assuming risk) to the market and investing public. Traditionally, banks do NOT like to assume undetermined risk. Furthermore, the marketplace exists to shift risk to the investor and has been the most efficient place to control and manage risk.
In addition, by liquidating REO’s and getting them into the hands of willing investors, the banks would recover some of their losses when the purchasers of these homes seek mortgage financing for their newly acquired asset. This action has a multiplier effect, spurring investment dollars rolling back through the bank and the financial system. The banks now would be converting non-performing assets into new loan generation profits. By taking an initial loss, the banks will be rewarded with revenues in the form of interest rate returns on their lending dollars. This solution prevents the tax payers from being forced to bail out banks who made poor investment decisions. This action also has the added benefit of putting the risky investments back into the hands of those most willing and efficient at handling such risk. The purchase price received on REOs will reflect the increase risk the market must assume as a consequence to increased risk.
Another benefit of my solution is that the taxpayers are actually the catalyst for returning the median housing price back to parity. The “housing bubble” has resulted in unsustainable housing prices over the past 10 years. Increases in home prices typically keep pace with increases in wages. However, the housing price increases of the last ten years have outpaced increases in wages. National median home prices have increased by more than 45 percent in the last decade (when adjusted for inflation). Median wages per worker, on the other hand, have only increased by 10 percent in the same period. As a result, individuals who are making the median household income cannot afford to buy a median priced home. My solution returns parity to the housing market and permits more homebuyers in the market, thus resulting in more mortgage lending dollars. This is another benefit of the multiplier effect of forcing the banks to take immediate losses on their REO’s in an effort to gain long term profits and benefits from the capitalist markets.
What my solution does NOT include is as important as what it does. Notice, my solution does not require the government to spend money on ANYTHING. The government is merely required to force the banks (e.g. REGULATE) to liquidate their non-performing assets and take the loss on investments that have already been realized on their books. In other words, this solution forces the banks to turn unrealized, paper losses into actual, realized losses. Although the banks are fearful of taking such huge losses, prudent risk management dictates that every investor must first seek self-preservation. Self-preservation means preservation of capital by liquidating losing trades before your trading account is liquidated.
Interestingly, when not subsidized by a large governmental body or bank account, every investor in the world is forced to manage their risk and take losses before losses overtake their capital account. A general rule of thumb of investing is “take your losses and let your profits run”. What this adage means is that you should allow your profits to continue to gain, but you must keep your losses to a minimum. This is also known to the layperson as “playing with house money”. The rationale behind it is that you must never allow your small, manageable losses to become large, unmanageable losses that result in liquidating the entire operation. See the results of large scale trading failures resulting in liquidating entire corporations
Eerily, almost 10 years ago, Kevin Dowd, a professor of economics at the University of Sheffield and an adjunct scholar at the Cato Institute (a Libertarian think tank based on the principles of limited government, free markets, individual liberty, and peace) wrote about the dangers of governmental intervention in a similar financial crisis. (See Too Big to Fail? Long-Term Capital Management and the Federal Reserve, September 23, 1999). In September 1998 the Federal Reserve organized a rescue of Long-Term Capital Management (LTCM), a very large and prominent hedge fund on the brink of failure. The Fed intervened because it was concerned about possible dire consequences for world financial markets if it allowed the hedge fund to fail. In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for them than they would otherwise have obtained. The intervention also had more serious long-term consequences: it encouraged more calls for the regulation of hedge-fund activity, which may drive such activity further offshore; it implied a major open-ended extension of Federal Reserve responsibilities, without any congressional authorization; it implied a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encouraged irresponsible risk taking; and it undermined the moral authority of Fed policymakers in their efforts to encourage their counterparts in other countries to persevere with the difficult process of economic liberalization.
History which we do not understand or remember is destined to repeat itself. Recently, the Federal Reserve, the Treasure Department the Executive Branch of our government have deemed certain industry participants as “Too big to fail”, for fear of the larger implications if such industries or corporations are allowed to fail. What is often overlooked is the fact that market capitalism will always fill voids and gaps in the market. This means that one corporations’ failure and subsequent vacation of post results in another stepping in to take its place. Where large banks were willing to reach their hand in pursuit of never ending greed and profits, smaller regional banks, some privately held “mom and pop” operations, were forced to be selective in their lending practices. These regional niche banks are often not feeling the hurt of the failed investment decisions of their larger conglomerate competition. It is these banks who are poised to reap the reward of their conservative investment decision-making and who will fill the void left by gaps left by vacated conglomerates.
Unfortunately, the banking sector has been erroneously practicing the philosophy of “take your profits and let your losses run”. Add to that “don’t waste the edge with a hedge” and you have a recipe for large scale financial disaster. Unfortunately for the large, ill-advised banks, the losses have become so large, the government has once again deemed them “too big to fail”. Our government has once again fallen into the trap and repeated the mistakes of a decade ago. We have failed to learn from our mistakes which make us even more likely to repeat them yet again.
By protecting the large institutions from accepting their losses, the banks are permitted to essentially ignore those losses and continue to act as irrational actors in the market. For example, banks facing large inventories of REO’s, inventories which are growing on a monthly basis, have feared the day that they had to liquidate such listings in a fire sale and actually preserve their equity. By stepping in and bailing the banks out of their financial nightmare, the federal government (e.g. you and I as taxpayers) have assumed the risk incurred by the banks. The banks now essentially have not felt any of their losses as they have been alleviated of the necessity to liquidate losing positions. What this means is that REO’s that have been sitting on their books, depreciating every month for the past 11 months of 2008, now have been injected with fresh taxpayer capital. The banks can now continue to hold on to those REO’s in the hope that someone (anyone) will step in a buy them at a price closest to the price in which the bank is holding the note on.
As an example, a bank lends $500,000 for the purchase of a home. The home falls into foreclosure immediately, with the bank holding the note on the home. This home is now worth $400,000 to a willing buyer, but the bank is un-willing to sell at this price. The bank is unwilling to take an immediate $100,000 loss on this home. Instead, the bank is willing to offer this home to a buyer at $475,000 in the hope of minimizing their loss to a mere $25,000. In the meantime, the buyer at $400,000 disappears and the market price (the price at which a willing buyer and seller would exchange goods) drops to $350,000. Unfortunately, the greed and ignorance of the bank keeps its price at $460,000. The bank is only willing to take $40,000 loss for their erroneous initial investment of $500,000. Keep in mind that this is ONE home, and there is another 5 coming every month. The bank simply asks the government to bail them out of this mess rather than take the loss and clear their balance sheets. Thus, the bank has now shifted the risk of loss due to their own poor investment decision to us, the taxpayers, and still maintains their posture of waiting for prices in the housing market to return to the outlandishly high “bubble” period prices. (e.g. “letting their losses run”).
In my proposal, I require the banks to liquidate any home within 60 days if that home that has been sitting as an REO inventory for more than 200 days. In the above example, this home would be forced to be sold to a willing buyer at $350,000. The bank would take an immediate loss of $150,000 and the buyer would assume the risk of further price declines. The buyer would most likely seek mortgage financing, resulting in profits to the banking sector. Any new REO listing would be forced to be liquidated within 180 days. This would give the banks enough time to establish a fair and reasonable price without having to resort to a fire sale that could be abused by buyers familiar with the restraints on the bank owned property. The government would not spend a cent to bailout a banks’ poor investment decision. The government would simply require the banks to comply with the liquidation time periods.
Capitalism must be permitted to work in good times as well as bad. Capitalism is the only way to solve a problem rooted in capitalism. Protectionism will never be able to solve a capitalism problem. We must force the banks to liquidate their REO holdings and put the houses back into the hands of the market participants. We must allow the market to assume the risk of fluctuating housing prices. We must force large banking institutions to participate in the market as every other investor must. This means the banks should be permitted to revel in their profits, but must also accept and managing their losses appropriately. We must not allow the banks to strong arm the American public with statements generating fear and paranoia by claiming our money is not safe. We must not be forced to believe that a taxpayer funded bailout is mandatory if the public wants to have access to their savings. The market will bring the housing prices back to parity, thus allowing more American’s to be able to purchase a home.
My solution is sound and is based on proven principles of capitalism. It does not favor any one business or sector over another. My solution does not reward the wrongdoers, the greedy, the bureaucrats or the lobbyists who push for governmental protection. My solution does not punish any market participant any differently than any other market participant. My solution has integrity and treats all participants fairly under the code of market capitalism. Reap your rewards on your solid investment decisions. Accept your losses on your poor investment decisions. Do not ask for government intervention when things are going against you unless you were willing to share your exorbitant profits when your financial situation was favorable to you.
Now, I request that every reader of this proposed solution write your Congressman and Senator to pass the along this reasonable solution. Today is Election Day. Change is in the process and we need to encourage our leaders to hold appropriate parties accountable and not penalize innocent taxpayers. We need to bring integrity back to our markets and allow market capitalism to work its magic to cure inefficiencies in the marketplace. Market capitalism cannot exist without Democracy and Democracy cannot exist without market capitalism.
Winston Churchill is quoted as saying “America will always do the right thing – but only after having exhausted all other possibilities”. We have exhausted all other possibilities. Let’s do the right thing by allowing market capitalism to work. Let’s avoid governmental intervention except to promote the economic system we have fought so hard to establish.