Monday, December 10, 2007

Two Views of the "Plan"

"But unfortunately, the 'freeze' is just another fraud--and like the other bailout proposals, it has nothing to do with U.S. house prices, with 'working families', keeping people in their homes or any of that nonsense. The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value--right now almost 10 times their market worth. ... The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process. ... There are lots of people who would like to muzzle subpoena-happy [NY] Attorney General Andrew Cuomo to buy time and make all this go away. Cuomo is just inches away from getting what he needs to start putting a lot of people in prison. ... What would be prudent and logical is for the banks that sold this toxic waste to buy it back and for a lot of people to go to prison. ... The goal of the freeze may be to delay bond investors from suing by putting off the big foreclosure wave for several years. But it may also be to stop bond investors from suing. ... They could say, 'Fraud? What fraud?! You knew the borrower's real income and asset information later when he refinanced!'. ... We are on the cusp of a mammoth financial crisis, and the Federal Reserve and the U.S. Treasury are trying to limit the liability of their banking friends under the guise of trying to help borrowers. At stake is nothing short of the continued existence of the U.S. banking system", Sean Oleander (SO) at, 9 December.

"In the specific, the benchmark of losses against which this Treasury/banks proposal should be judged is what would happen if this proposal is not implemented: and that benchmark is one where in the absence of loan modifications millions of households will default, end up in foreclosures and the losses to holders of mortgages, RMBS and mortgage related CDOs would be massive. So the benchmark for investors is not one of being paid in full and in time but rather one of massive bankruptcies and severe financial losses. ... As I discussed before ... it is altogether impossible to follow a case-by-case approach as neither the bankruptcy court system nor the creditors are able to expeditiously restructure on an individual basis millions of separate debt contracts. ... Systemic banking crises always require systemic across-the-board solution and eventually are resolved with such approaches; there is nothing new here compared to any other past banking crisis. ... [S]uch investors are also better off under this scheme--as under the alternative of massive defaults--the losses and NPV haircuts would have been much larger; debtors are not really bailed out either as many of them would have defaulted on their mortgages and would have thus obtained eventually greater relief by defaulting than by keep on servicing their mortgages at the lower teaser rates. ... Systemic market failures and crises require systemic response where government resolve the collective action problems of individual creditors rushing to the exits and causing a disorderly workout of severe debt problems. This mortgage disaster is a case where sound public intervention is necessary and desirable", Nouriel Roubini (NR) at, 6 December.

I largely agree with SO, a San Mateo, CA attorney. However, I don't think the freeze's "sole goal is to prevent owners of mortgage-backed securities ... from suing U.S. banks", even if a major goal. I don't know how close Cuomo is to imprisoning people, but I wish him good luck. The "freeze" may enable banks to run "statutes of limitations" on lawsuits or shore up other potential legal defenses.

It had to happen, but I finally disagree with NR. NR creates a "false alternative", i.e., "in the absence of loan modifications millions of households will default". How does NR know? No one believes the creditors will be "paid in full and in time" today. Why use this alternative? Further, creditors will modify borrowers' terms if the creditors believe the modifications will increase their ultimate collection. Why do we need the "Plan"? Why is it "impossible" to follow a "case-by-case" approach to loan restructuring? If "transactions costs" are the differnce, does the "Plan" only eliminate some paperwork and attorneys' fees? Why is there a "systemic crisis"? What does "systemic crisis" mean? Is "systemic crisis" emotive rhetoric to conceal NR's judgment, NR being a smart guy, that many of our major banks are insolvent and he does not want the public to realize it too?! NR says creditors "are also better off under this scheme ... [than] under the alternative of massive defaults". How does NR know? If he's correct, show the creditors. I remember in graduate school reading a piece by Jack Hirshliefer, then a UCLA professor about what speculators do. A speculator takes his position, shows the market "his proof", the price adjusts, the speculator closes his position and books his profit. I believe the citation is: "The Private and Social Value of Information and the Reward to Inventive Activity", American Economic Review, Vol. 61, 561-74 (September, 1971). If NR thinks the creditors are ignorant, let NR show them "the proof" and they will agree to the "Plan" with no coercion! All in all a surprising piece of special pleading for the banks from one of our better analysts. There's another "stinker" here. The debtors "would have thus obtained eventually greater relief by defaulting than by keep on servicing their mortgages at the lower frozen teaser rates". If so, the "Plan" is against the debtors' interests as they are better off defaulting now! Part of the "Plan" is: deceive debtors to creditors' benefit and keep the debtors out of bankruptcy court!

I have an alternative "systemic response" to the "systemic banking" crisis: put the big banks in receivership! Now!

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