Bailout in the Public Interest Should Not Reward Profiteers

An Open Letter to the U.S. Congress Regarding the Current Financial Crisis

John P. Hussman, Ph.D.
President, Hussman Investment Trust
All rights reserved and actively enforced.

September 22, 2008

In 2006, the president of the Federal Reserve Bank of St. Louis noted “Everyone knows that a policy of bailouts will increase their number.” This week, Congress is being asked to hastily consider a monstrous bailout plan on a scale nearly equivalent to the existing balance sheet of the Federal Reserve.

As an economist and investment manager, I am concerned that the plan advocated by Treasury is essentially a plan to bail out the bondholders of financial institutions that made bad lending decisions, with little help to homeowners that are actually in financial distress. It is difficult to believe that the U.S. government is contemplating taking on the bad assets of these institutions at probable taxpayer loss and effectively immunizing the bondholders (and shareholders) of these companies.

While it is certainly in the public interest to avoid the dislocations that would result from a disorderly failure of highly interconnected financial institutions, there are better ways for public funds to accomplish this, other than by protecting corporate bondholders while homeowners remain in distress.

Consider a simplified balance sheet of a typical investment bank:

Good assets: $95
Assets gone bad: $5
TOTAL ASSETS: $100
Liabilities to customers/counterparties: $80
Debt to bondholders of company: $17
Shareholder equity: $3
TOTAL LIABILITIES AND EQUITY: $100

Now, as these bad assets get written off, shareholder equity is also reduced. What has happened in recent months is that this equity has become insufficient, so that the company technically becomes insolvent provided that the bondholders have to be paid off:

Good assets: $95
Assets gone bad (written off): $0
TOTAL ASSETS: $95
Liabilities to customers/counterparties: $80
Debt to bondholders of company: $17
Shareholder equity: ($2)
TOTAL LIABILITIES AND EQUITY: $95

These institutions are not failing because 95% of the assets have gone bad. They are failing because 5% of the assets have gone bad and they over-stretched their capital. At the heart of the problem is “gross leverage” – the ratio of total assets taken on by the company to its shareholder equity. The sequence of failures we've observed in recent months, starting with Bear Stearns, has followed almost exactly in order of their gross leverage multiples. After Bear Stearns, Fannie Mae, and Freddie Mac went into crisis, Lehman and Merrill Lynch followed. Morgan Stanley, and Hank Paulson's former employer, Goldman Sachs, remain the most leveraged companies on Wall Street, with gross leverage multiples above 20.

Look at the insolvent balance sheet again. The appropriate solution is not for the government to replace the bad assets with public money, but rather for the government to execute a receivership of the failed institution and immediately conduct a “whole bank” sale – selling the bank's assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.

The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost.

For example, consider Morgan Stanley's balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?

The stockholders and bondholders of the company itself should be the first to bear losses, not the public. That is the essence of what a free and fair market, and a responsible government would enforce. The investors in the companies that produced the losses should be accountable for them, and the customers and counterparties should be protected.

The case of Fannie Mae and Freddie Mac was special in that government had already provided an implicit guarantee to their bondholders, so that bailout couldn't have been done otherwise without harming the good faith and credit of the government, but it's absurd to tell Wall Street “send us your poor and your tired assets, and we will tend to them.” The gains in financial stocks we have observed in the past two days reflects money that those firms expect to be taken out of the public pocket.

A further difficulty with the Treasury plan is that it does little to actually reliquify banks that are at risk. To the contrary, the process of reverse-auctioning bad mortgage debt will provide for "price discovery" about what these assets are actually worth, most likely forcing other institutions to write down assets that are still held on the books at unrealistically high values. As a result, we may observe an increase, rather than a decrease, in the number of financial institutions having insufficient capital.

Replacing the bad assets on the balance sheet with cash, at the market value of those bad assets, may improve the quality of the balance sheet, but does nothing to increase the capital on that balance sheet or the ability of financial institutions to lend. If the objective is to prevent these institutions from bankruptcy or liquidation, or to increase their ongoing lending capacity, then the government requires a method to provide more capital. It is essential that such efforts to "reliquify" the financial system do not place the public behind the bondholders in the event that the institution fails anyway. This might be accomplished by lending to these institutions as a hybrid form of subordinated and senior debt, and altering regulatory capital requirements to allow such debt to be included as capital. In the event of bankruptcy, the government's claims would be placed behind customers and counterparties, but before the company's bondholders. In any event, rather than making small changes around the edges of Treasury's vague and costly proposal, Congress should focus its attention on approaches that will provide capital to viable institutions and expedite the assumption and "whole bank" sale of failing ones.

Among the obstacles to the efficient management of this crisis has been the growth in recent years of the credit default swap (CDS) market. These swaps are essentially insurance policies that pay the holder in the event that an institution's bonds fail. The large CDS market makes it more likely that the failure of one institution will infect another. In many cases the notional value covered by such swaps exceeds the value of the debt of the underlying companies, suggesting that the CDS market is being used for speculation in the same way that one might attempt to purchase life insurance on an unrelated individual. Both credit default swaps and short sales should be allowed for bona-fide hedging purposes when an investor has a related asset that is at risk. However, it is appropriate for regulators to curtail the speculative use of credit default swaps and short sales relating to financial institutions.

With regard to assisting homeowners, purchasing the bad mortgage securities from financial institutions will do nothing to help those homeowners because it does nothing to alter the cash flows expected of them. Congress will be a far better steward of public funds by offering distressed homeowners what amounts to a refinancing, coupled with a partial surrender of future appreciation.
In practice, the homeowner would default on the existing mortgage, but the government would purchase the foreclosed property at an amount near existing foreclosure recovery rates (presently about 50% of mortgage face value). The government would then sell that home back to the owner with a zero-equity mortgage, allowing individuals to keep their homes. Importantly, there would be an additional, marketable lien placed on the property itself in the form of what might be called a “Property Appreciation Receipt” (PAR), which would be provided to the original mortgage lender. Though it would accrue no interest, it would provide a claim to the original lender on any appreciation in the value of the home up to the difference between the foreclosure proceeds and the original mortgage amount. Note that the PAR would only become relevant at the point that the government was fully repaid.

For example, consider a homeowner with a $300,000 mortgage balance on a home now worth less than the mortgage balance itself. The government would buy the foreclosed property at say, $200,000 and mortgage it to the existing homeowner. The original lender would receive $200,000, plus a Property Appreciation Receipt (PAR), giving it a claim on $100,000 of any future appreciation of the property. If the homeowner was to sell the property later for, say, $250,000, the owner of the PAR would receive $50,000, and there would be a remaining lien on future appreciation of that same property, which would be assumed by the new buyer. If the next buyer sold the home for $250,000, no funds would be due to the PAR holder, but if it was sold for $275,000, another $25,000 would be payable. At any point the home was to sell for more than $300,000, the PAR would be fully repaid and there would be no further claim.
Some provision would have to be made for the appreciation of an unsold home, but that detail could be accomplished through some form of equity extraction refinancing. To account for time value, the claim on future appreciation could be increased at a small rate of interest. Though the credit impact of a mortgage default would likely be sufficient to dissuade solvent homeowners from making inappropriate use of the program, the government could impose additional costs or eligibility requirements to avoid such risks.

In summary, the Treasury proposal to address current financial difficulties places corporate bondholders ahead of the public, rewards irresponsible risk-taking, and sets a precedent for future bailouts. Moreover, we know from a long history of economic experience across countries that a major expansion of government liabilities is invariably followed by multi-year periods of extremely high inflation, particularly when it is not matched by a similar expansion of economic production. Such inflation would initially be modest because of the current weakness in the economy, but could pose unusual challenges to the United States in the coming years.

Congress can benefit the American public by maintaining a focus on responsibly assisting homeowners in distress rather than defending the stockholders and bondholders of overleveraged financial companies. It is essential to recognize that the failure of these companies need not result in “financial meltdown” provided that the “good bank” representing the vast majority of assets and liabilities is cut away, protecting customers and counterparties, so that the losses are properly borne out of the capital base of the companies that incurred them.

Again, everyone knows that a policy of bailouts will increase their number. By choosing who bears the losses for irresponsible decisions at these companies, Congress will also choose the scope of the bailouts that follow.

Sincerely,
John P. Hussman, Ph.D.
President, Hussman Investment Trust
Further Commentary and Background

Freight Trains and Steep Curves: July 11, 2003 - "T.S. Eliot once wrote “Only those who risk going too far can possibly find out how far one can go.” It seems that the U.S. financial system is bound and determined to find out. The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses, and the U.S. itself (via its record current account deficit) have accumulated..."

Warning, Examine All Risk Exposures: October 15, 2007 - "There are only a handful of historical periods that fall into this syndrome of conditions: December 1972, August 1987, July 1998, July 1999, December 1999, March 2000, and October 2007. All of the prior instances were followed by steep market losses. When the declines were not abrupt, they were protracted. There is not a single counter-example."

Minding the Hinges on Pandora's Box: January 7, 2008 - "I am emphatic that investors should evaluate their risk exposures and tolerances now, in order to allow for substantial further market weakness. Market conditions presently feature a Pandora's Box of rich valuations, vulnerable profit margins, rising default risk, rapidly deteriorating market internals, failing support levels, and accumulating evidence of oncoming recession. Given that the heavy resets only started in October, we are still about two or three quarters away from the really serious credit losses, foreclosures and writedowns. To imagine that financial companies can simply “come clean” and “just put their cards on the table” assumes that lenders actually know which loans are facing default, and how many. But lenders are still months away from even finding that out."

What Congress and Investors Should Understand About the Bear Stearns Deal: March 31, 2008 - "For Bear Stearns to 'fail' means that it may not fully repay its own bondholders, but it has never meant that Bear Stearns' customers and counterparties would be hurt – their accounts and contracts are precisely what J.P. Morgan is eager to purchase and can easily transfer. The misuse of public funds is assisted by blurring the distinction between 'failure' of Bear's customer and counterparty obligations (which nobody wants and is neither likely nor necessary), and the 'failure' of Bear Stearns's stocks and bonds to be successful investments. Why should investment losses be bailed out at public expense?"

Which "Inning" of the Mortgage Crisis Are We In?: April 14, 2008 - "Clearly, as we enter April 2008, we appear to be quite early in the mortgage crisis, with only about a quarter of the cumulative resets having occurred. That places us near the start of the third inning, where we can expect each of the nine “innings” to be about three months in duration. Unfortunately, the next three innings (quarters) are when the heavy hitters on the opposing team will come up to the plate, as the cumulative amount of resets will surge. With that surge, loan losses and foreclosures will also predictably spike higher."

Republished by permission of the author.

In accordance with Title 17 U.S.C. Section 107, this material is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes.

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