Tuesday, March 03, 2009

US Economic Crisis Update: Housing Plan to be Revealed; AIG Requests Billions More

US housing plan to be revealed

By Saskia Scholtes and Alan Rappeport in New York and Sarah O’Connor in Washington
March 3 2009 23:46

The US Treasury is poised on Wednesday to unveil the details of Barack Obama’s plan to help financially stretched homeowners amid concerns that the delay in announcing a market-wide response to the housing crisis has made the problem worse.

The $275bn (€219bn, £196bn) plan to help homeowners in financial difficulty avoid foreclosure is seen as an essential piece of the administration’s economic recovery efforts.

Past attempts to tackle foreclosures have included a shifting array of progammes - involving the Treasury, government-sponsored housing companies and banks - that offered help for narrowly defined categories of borrowers, making it difficult to implement effectively.

Lenders and servicers, who collect mortgage payments, are hopeful the administration will produce a comprehensive plan for easing the crisis, which they say has worsened, in part, because struggling borrowers have held out for a ­“better bail-out” from the government.

But while the industry has publicly applauded the administration’s efforts to design a comprehensive ­programme, some in the ­sector have expressed concerns that it could provide too many concessions for some borrowers, while doing too little for some of the most troubled parts of the market.

The plan, announced in broad-brush terms two weeks ago, has three ­components.

It will provide increased funding to Fannie Mae and Freddie Mac, the government-run mortgage agencies, to expand their mortgage lending. It will also provide low-cost refinancing for 4m-5m homeowners who are up to date on their agency­-issued mortgages, but are unable to refinance because falling house prices have eroded their home equity. These two elements will be relatively simple to implement, as Fannie and Freddie are increasingly deployed as agents of the government’s housing policy.

The third component of the plan will provide $75bn of subsidies for modifications to home loans owned by banks and investors. This effort will provide mortgage servicers with incentive payments to modify loans, and borrowers with inducements to keep up with their payments after modification.

It will also expand earlier efforts to tackle foreclosures by making some borrowers eligible for changes to their home loans, even if they are still up to date on their mortgage ­payments.

It is this component of the plan that worries servicers.

One concern is that servicers who respond to government incentive payments could be exposed to legal risk from disgruntled investors who bought securities backed by mortgages. These investors could claim that servicers eased the terms of mortgages to collect the government payment rather than because a modification was in the investors’ best interest, lawyers and restructuring experts said.

Servicers say they expect Wednesday’s plan details to specify a standard way for them to quantify the cost of a modification versus a foreclosure.

Congress has also attempted to tackle such questions to aggressively modify troubled loans with a separate housing bill. This would allow bankruptcy courts to change the terms of home loans and provide mortgage servicers with legal cover for modifying home loans according to government standards.

The bill was expected to face a vote in the House on Thursday after moderate Democrats demanded provisions to narrow its scope to ensure filing for bankruptcy remained a last resort.

Meanwhile, an index of pending home sales plunged more than twice as much as expected to a record low in January. The data, released by the National Association of ­Realtors on Tuesday, which reflect deals that have been signed but not completed, showed that pending home sales fell by 7.7 per cent ­during the month and were off 6.4 per cent on the year

Copyright The Financial Times Limited 2009

AIG still facing huge credit losses

By Henny Sender in New York
March 3 2009 22:03

AIG, the insurer controlled by the US government, still faces billions of dollars in potential losses on credit guarantees it provided for complex subprime mortgage securities, in spite of its $62bn fourth-quarter loss and regulatory efforts to unwind its holdings, company filings show.

The difficulties the authorities face in dealing with AIG spilled into the open on Tuesday as Ben Bernanke, Federal Reserve chairman, expressed anger with the company in an appearance before the Senate budget committee.

“If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG,” he said. “There was no oversight of the financial products division. This was a hedge fund basically that was attached to a large and stable insurance company.”

The crisis at AIG stemmed from its activities in the market for credit default swaps – derivatives that function as debt insurance. AIG was particularly active in providing guarantees for securities known as collateralised debt obligations, bonds backed by debts such as subprime mortgages.

AIG ran into trouble when its credit rating was downgraded and the value of the CDOs it insured fell, which forced it to post tens of billions of dollars in additional collateral with its counterparties. This process exhausted its resources and prompted the government rescue of the company in September.

In November, the Federal Reserve Bank of New York set up a limited liability company called Maiden Lane III – backed by $5bn from AIG and borrowings of up to $30bn from the Fed – to resolve the situation. The idea was that Maiden Lane III would buy CDOs from AIG’s counterparties and then tear up the credit insurance issued by AIG.

AIG filings this week show that the company retains $12bn in exposure to credit insurance on positions mostly involving subprime mortgages. As of February 18, AIG could have to pay counterparties up to $8bn on these positions, the filing showed.

In the days after the creation of Maiden Lane III, AIG and the Fed approached about 20 counterparties with an offer to buy CDOs.

By the end of the year, Maiden Lane III had paid nearly $30bn for CDOs with a face value of $62bn, AIG said. AIG paid $32.5bn to terminate the credit insurance on the CDOs, recognising a 2008 loss of $21bn.

Counterparties received 100 cents on the dollar for the CDOs, but the prices paid by Maiden Lane III suggested that the CDOs were worth 47 cents on the dollar, said a person familiar with the matter.

On Monday AIG reported a $61.7bn loss and confirmed that it would give the US government a stake in its two biggest divisions as part of a fresh $30bn rescue.

Additional reporting by Alan Beattie in Washington

Copyright The Financial Times Limited 2009

To nationalise or not – that is the question

By Martin Wolf
March 3 2009 19:52

Lindsey Graham, the Republican senator, Alan Greenspan, the former chairman of the US Federal Reserve, and James Baker, Ronald Reagan’s second Treasury secretary, are in favour. Ben Bernanke, current Fed chairman, and an administration of liberal Democrats are against. What is dividing them? “Nationalisation” is the answer.

In 1978, Alfred Kahn, an adviser on inflation to President Jimmy Carter, used the word “depression”. So angry was the president that Mr Kahn started to call it “banana” instead.

But the recession Mr Kahn foretold happened all the same. The same may well happen with nationalisation. Indeed, it already has: how else is one to describe the actions of the federal government in relation to Fannie Mae, Freddie Mac, AIG and increasingly Citigroup? Is nationalisation not already the big financial banana?

Much of the debate is semantic. But underneath it are at least two big issues. Who bears losses? How does one best restructure banks?

Banks are us. Often the debate is conducted as if they can be punished at no cost to ordinary people. But if they have made losses, someone has to bear them. In effect, the decision has been to make taxpayers bear losses that should fall on creditors. Some argue that shareholders should be rescued, too. But, rightly, this has not happened: share prices have indeed collapsed. That is what shareholders are for.

Yet the overwhelming bulk of banking assets are financed through borrowing, not equity. Thus the decision to keep creditors whole has huge implications. If we accept Mr Bernanke’s definition of “nationalisation” as a decision to “wipe out private shareholders”, we can call this activity “socialisation”.

What are its pros and cons?

The biggest cons are two. First, loss-socialisation lowers the funding costs of mega-banks, thereby selectively subsidising their balance sheets. This, in turn, exacerbates the “too big to fail” problem. Second, it leaves shareholders with an option on the upside and, at current market values, next to no risk on the downside. That will motivate “going for broke”.

So loss-socialisation increases the need to control management. The four biggest US commercial banks – JPMorgan Chase, Citigroup, Bank of America and Wells Fargo – possess 64 per cent of the assets of US commercial banks. If creditors of these businesses cannot suffer significant losses, this is not much of a market economy.

The “pro” of partial socialisation is that it eliminates the risk of another panic among creditors or spillovers on to investors in the liabilities of banks, such as insurance and pension funds. Since bank bonds are a quarter of US investment-grade corporate bonds, the risk of panic is real. In the aftermath of the Lehman debacle, the decision appears to be that the only alternative to disorderly bankruptcy is none at all. This is frightening.

The second big issue is how to restructure banks. One point is clear: once one has decided to rescue creditors, recapitalisation can no longer come from the debt-into-equity swaps normal in bankruptcies.

This leaves one with government capital or private capital. In practice, both possibilities are at least partially blocked in the US: the former by political anger; the latter by a wide range of uncertainties – over the valuation of bad assets, future treatment of shareholders and the likely path of the economy. This makes the “zombie bank” alternative, condemned by Mr Baker in the FT on March 2, a likely outcome. Alas, such undercapitalised banking zombies also find it hard to recognise losses or expand their lending.

The US Treasury’s response is its “stress-testing” exercise. All 19 banks with assets of more than $100bn are included. They are asked to estimate losses under two scenarios, the worse of which assumes, quite optimistically, that the biggest fall in gross domestic product will be a 4 per cent year-on-year decline in the second and third quarters of 2009 (see chart). Supervisors will decide whether additional capital is needed. Institutions needing more capital will issue a convertible preferred security to the Treasury in a sufficient amount and will have up to six months to raise private capital. If they fail, convertible securities will be turned into equity on an “as-needed basis”.

This, then, is loss-socialisation in action – it guarantees a public buffer to protect creditors. This could end up giving the government a controlling shareholding in some institutions: Citigroup, for example. But, say the quibblers, this is not nationalisation.

What then are the pros and cons of this approach, compared with taking institutions over outright? Douglas Elliott of the Brookings Institution analyses this question in an intriguing paper. Part of the answer, he suggests, is that it is unclear whether banks are insolvent. If Nouriel Roubini of the Stern School in New York were to be right (as he has been hitherto), they are. If not, then they are not (see chart). Professor Roubini has suggested, for this reason, that it would be best to wait six months by when, in his view, the difficulty of distinguishing between solvent and insolvent institutions will have gone; they will all be seen to be grossly undercapitalised.

In those circumstances, the idea of “nationalisation” should be seen as a synonym for “restructuring”. Few believe banks would be best managed by the government indefinitely (though recent performance gives some pause). The advantage of nationalisation, then, is that it would allow restructuring of assets and liabilities into “good” and “bad” banks. The big disadvantages are inherent in organising the takeover and then the restructuring of such complex institutions.

If it is impossible to impose losses on creditors, the state could well own huge banks for a long time before it is able to return them to the market. The largest bank restructuring undertaken by the US, before last year, was that of Continental Illinois, seized in 1984. It was then the seventh largest bank and yet it took a decade. How long might the restructuring and sale of Citigroup take, with its huge global entanglements? What damage to its franchise and operations might be done in the process?

We are painfully learning that the world’s mega-banks are too complex to manage, too big to fail and too hard to restructure. Nobody would wish to start from here. But, as worries in the stock market show, banks must be fixed, in an orderly and systematic way. The stress tests should be tougher than now planned. Recapitalisation must then occur. Call it a banana if you want. But bank restructuring itself must begin.


More columns at http://www.ft.com/martinwolf

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