Didn’t the government accounting rules in fact drive companies off the cliff and into collapse, even though they were actually healthy in terms of cash flow right up until the day they were killed? They were compelled to realize paper losses unnecessarily, right?

The analogy I read was this: Suppose you paid $500,000 for a house. And you still owe $400,000. The house has dropped in (presumed) market value to $350,000. Even though you have no trouble making the mortgage payments and expect to live there another 15 years, the bank declares you to be in default if you can’t immediately cough up $50,000 cash to ‘cover’ the paper loss. They turn a paper loss in to a real loss. That’s crazy. Mortgages don’t work that way in real life (thank goodness), so why make banks follow such destructive rules?

http://blogs.ft.com/maverecon/2009/01/the-good-bank-solution/

Buiter’s suggestion is to establish new ‘good banks’ and force the existing banks (the ‘bad banks’) to sell off their good assets to the good banks while they hold on to the bad assets (presumably in the hope of selling them off as time goes on. The leverage the government has over the existing (bad) banks is to revoke their banking licences, thus preventing them from taking on new deposits.

Some of the pluses of this plan: (1) It eliminates the oft-cited problem of having to set a value on the toxic assets — we only need to put a price on the banks’ good assets; and (2) Technically, it’s not nationalization and thus might be more palatable to the American public. Of course, the government would likely have to step in and offer support for loans to the new ‘good’ banks, but they wouldn’t have to take any banks over.

I don’t know, seems like an option that’s worth discussing.

The 60% default rate above is via an obviously unrealistic thought experiment using simplistic aggregates, meant only to point out that thinking in terms of, er, simplistic aggregates can be misleading. As I said, I’m in no position to do the actual loss analysis myself since, sadly, I program computers for a living. The though experiment does show, however, how the concentration of bad loans in CA and other bubble areas makes the mortgage problem worse than it might otherwise appear. A significant percentage of total mortgage value outstanding is concentrated in precisely the areas that will suffer the highest default rates and largest losses.

Can you post a link to Mayo’s analysis? I’d be interested in reading it.

Regardless of our opinions on what the total losses on mortgages (and CRE, CC, etc.) will be, we all agree the core problem is the leverage employed by the banking system.

That’s what it comes down to. Leverage made them an incredible amount of money on the way up and now, in the inevitable credit collapse, they are transferring wealth from the taxpayer (and future taxpayers) to themselves. It is as infuriatingly simple as that. You can understand why, when people realize that that’s what our banking system has done, they become less interested in saving it.

Cheers,
Carson

Firstly, if anything approaching 60% of mortgages default in CA, there won’t be a civilization left and this whole discussion is moot. I recommend that instead of throwing around blunt percentages, we actually go to some reference points that understand the historical default rates over the past recessions and even during the great depression (which we are no where near). I strongly recommend that people go read some research reports written by Mike Mayo, the FIG analyst at DB for some very good historical vs. today analysis. You will see, that yes indeed we are in a terrible position, but we are not talking about such a huge number of defaults. So to answer the original question, how can all this be happening if total mortgages are “only” $10-$15T? Two answers: 1) Leverage and 2) Derivatives. No need to rehash both of those topics.

My last comment on this thread is that you can’t be so myopic on mortgages. Yes that is a big deal and asset devaluation is making every feel extremely uncomfortable and maybe the main cause of the recession (or it is certainly an easy thing to grab on to — but lets not forget the business cycle is actually a good thing). However, if, as this thread started, you want to talk about recapitalizing the bank, you have to look down the pike and look at CRE (commercial real estate), credit cards, and C&I (commercial and industrial). Again, take a look at the hard data. Banks are now projecting total credit card losses to exceed 10% at the through vs. typical 7-8% at the trough. Banks are now projecting CRE defaults to go to 4% at the trough vs. 2.5 historically at the trough (NOTE THIS IS NOT 50-60%!). So this is really what the problem for the government is in recapitalizing the banks. Not only do they have to figure out how to value the “toxic” assets…they have to figure out what toxic means!

Anyways, keep up the great posts and comments, but lets start looking at both source data and compare that to historical vs. making wild claims to fan the fire. Leave that job to the jokers on TV.

I’m getting my data from here: http://www.federalreserve.gov/Pubs/supplement/2008/12/table1_54.htm

Roughly 12 trillion in vanilla residences and 2.5 trillion in “other.” Perhaps I’m not understanding the data correctly though.

Again, I think you are making a statistical mistake in thinking about “30% of mortgages defaulting.” Housing prices in CA are 5-10x what they are in other parts of the nation and, thus, CA makes up a disproportionate amount of the total outstanding residential debt. Just as a simple thought experiment, consider if CA and OH had the same number of houses, but CA houses were on average 5x the cost of OH houses. CA houses would account for 83% of total mortgage debt if all homes were mortgaged 100%. If the 30% of all defaults is concentrated in 100% in CA, this means that 60% of all mortgages in CA default. At a total loss of 50% on them, you get 83% * 60% * 50% = 25% total losses. If only 20% of total mortgages fail, again all concentrated in CA, it would give you 83% * 40% * 50% = 16%

So, to do the real loss analysis, you have to know where loans are, what amount they are and what the realistic prices will be. I’m in no position to do that, but given a few simple assumptions regarding I can see how we get well above the 10-15% figure you sited earlier. I’d also encourage you to take a look at some of the places with run ups in CA, places like the flood plain north of Sacramento, the outer inland empire, and the central valley. It is possible to envision total devastation in many of these areas, with houses cratering 70% in value or more and damned near everyone just packing up, if they ever moved in in the first place.

In any event, I agree with you that, were this only a US residential collapse, the banks would only need a “minor” (say, 2T) bailout to continue on business as usual. But, as I said in my first post, they all levered up obscenely on the way up and took their bonuses and payouts, and now, on the way down, the piper must be paid. (We can thank our recently retired Treasury Secretary for lobbying congress to relax leverage restrictions on ibanks in 2004. Way to go Hank!)

Taxpayers, start your checkbooks…

Cheers,
Carson

(First, the relevant number to look at isn’t the drop in banks’ market capitalizations, because that is a reflection of expected future cash flows, not current asset values.)

The derivatives markets are a possibility. If you were selling insurance on bonds that are likely to default, you are now looking at large losses. Over the system as a whole that is a zero-sum game, but it’s not necessarily zero-sum for any particular portion of the system.

With the entire economy in recession, banks will take loan losses on many assets beyond home mortgages and mortgage-backed securities. The worst-case scenarios include severe losses on credit cards, auto loans, commercial loans, corporate bonds, some government bonds, etc.

There were housing bubbles that have since collapsed all over the world, so global losses will far exceed losses on U.S. assets. U.S. banks will suffer some of those global losses; of course, some of the U.S. losses will be suffered by overseas banks.

Thanks for engaging in the debate. I’m looking at the data now, and HH motgages are $10.5T. So, I get that some areas are crazy. But I just don’t buy that an number anywhere close to 30% of people are going to walk away completely from there mortgages and that the land and house will be liquidated for 50% of it’s value. In CA, sure. Pheonix, a wreck. Suburban Minneapolis or Chicago, no way.

How many people do you know personally, who are going to walk away from their homes.

I really struggle to get to the losses that we are talking about. I’m sure that it lies somewhere in the derivatives exposure, but I’m just not sure how.

Cheers,

EW

Total mortgages outstanding, last I looked, was closer to 15T. 10% total loss on that, given that we are going to collapse by 50% or more in aggregate on the underlying asset value, seems like a low end estimate. Given the “walk away” culture we are currently inculcating, I wouldn’t be surprised to see 20% losses or more. Remember, the most likely to default mortgages are in bubble areas like CA and FL. These make up a very large percentage of the total value of that 15T, so thinking in terms of “30% of those mortgages” is misleading. You should think in terms of percentage of that total value. There were homes selling in the inland empire for 1M+ that are, by any rational accounting, worth ~200k. It’s these homes that are going to really blow holes in the banks balance sheets, with 70+% loss on million dollar loans (which are probably I/O and thus accounted for favorably on the banks balance sheet. Ooops.)

That in mind, if the banks only did missionary-style mortgage finance, you would be correct and this wouldn’t be such a crisis. It’s the sucking chest wounds in highly leveraged secondary markets that are really killing them. That’s why I’m very much against just “recapitalizing” them and in favor of simply starting new banks: our existing banks made their beds on the way up, and should sleep in them on the way down.

Caveat emptor: I’m an engineer with only a layman’s familiarity with economics and finance.

Cheers,
Carson

Leverage doesn’t explain how morgages that, in total, are $10T could be written down by more than $1.5T. U understand leverage. What I don’t understand is why we think the actually losses on mortgages will exceed a number like $1.5T in aggregate.

Leverage would explain how people exposed to the secondary markets went under. What I don’t understand is how the loss on the mortgages themselves exceeds a number like $1.5T

Thoughts?

EW

Unfortunately, there isn’t. Shareholders of banks who took (in hindsight) too much risk/leverage have to pay the piper and now have to feel the rest of the pain (on top of the pain they already felt). Unfortunately for all of the smart fixed income guys, so do the creditors, to some large degree. What scares me the most is the assumption that there is some magic bullet that if we think harder/wait longer the pain will go away. Sorry, but all we’re doing is delaying the inevitable.

One final comment on Ms. Whitney’s suggestion. Sorry, but that’s like spitting in the ocean. Raising capital by selling crown jewels to private equity firms sounds like something that the bobbleheads on CNBC would say. There just aren’t enough crown jewels, or enough private equity, to make a dent in what really ails these banks (lack of capital). Juat as an example, say KKR decided it wanted to buy some division of Citibank for $10 billion. OK. Now Citibank has an additional $10 billion, but now it has sold the only part of the bank that is actually making money. And they still have a problem that was many many multiples more than $10b. It is a hollow suggestion, and shouldn’t have been included in your list.

If your solutions to the problems mean spending more money than the IMF and US government can raise, then they are not really solutions. If they mean rewarding the undeserving at the cost of the taxpayer, they are not solutions either.

Fareed Zakaria’s Sunday GPS show on CNN from Davos began with an observation on Russia and China’s unusually direct criticism of America’s role in the creation of the global economic crisis.

So let us pause a minute, what is going on here? Were all these financial and regulatory institutions so stupid, greedy and corrupt? If so, and seems to be the conventional view, then Russian and Chinese criticism is well deserved.

An alternative view is that the behaviors that lead to this catastrophe were largely unconscious and driven by some simple rules. First, as you noted, quoting Andrew Lo, if you were Chief Risk Officer of a bank and did not sanction these kinds of highly profitable transactions then you would not have held onto your job for long. The (UK) Times newspaper’s insider account of Dick Fuld and the last days of Lehman Brothers echoed this point. The second factor was the game of chicken: not owning up to a problem in the hope that a greater problem will quickly supersede it. These two rules lead to the suicidal, Lemming-like behavior that created this crisis. In the jargon of complexity science, the stock market is a complex adaptive system and this phenomenon is “emergent” behavior driven by a few simple rules.

If the global economic crisis is indee the outcome of emergent behavior (not simply ubiquitous stupidity, greed and corruption) there are two important implications.

First, that interventions top down and from the centre (like the bank bailouts and the Troubled Asset Recovery Programs) are unlikely to help but, on the contrary, are more than likely to have unintended and unwelcome consequences.

Second, that the only effective way forward is to put the problems back in the community – who will have to solve them anyway when all these grandiose gestures have failed – encouraging collective mindfulness by making it safer to talk about the issues.

I think the concern is that the shareholders are not just small number of greedy rich people. 401Ks and Pension Plans are some of the largest holders of these stocks. Putting aside the stories of 60 year old grandmas who can’t retire because the government nationalized her bank and made her shares worthless, it is almost a case of robbing Peter to pay Paul. We’d fix the banking section for the public good, but do massive damage to the public’s retirement plans and probably end up having to bailout failed pension plans (which we’ll probably have to do anyways if valuations stay where they are for the next several years as the baby-boomer retirement wave hits full steam).