The Run on Bear: Time for Federal Agencies to Start Swinging

Friday morning was shaping out to be the much awaited follow-though day for the 400 point Dow rally on Tuesday.

The equity markets had retraced a bulk of the gain and then bounced back on Thursday. The CPI number on Friday morning was benign and we seemed to be set for the races.

A few minutes before the market opened the news about the Fed led bail-out of Bear Sterns came out. Bear was under pressure throughout the week with rumors of a liquidity crunch. Bear’s CEO Alan Sch wart

z had tried to dispel these rumors earlier this week; however his public statements seemed to have worsened the situation.

Bear’s prime brokerage customers started pulling their cash; traders cut back on trades with Bear as a counterparty. There was a run on Bear and on Thursday night Bear’s executive decided to seek help.

A firm using a large amount of leverage needs time to unwind them. With the credit markets in a spin, it was not possible for Bears to raise the cash.

Bear’s downfall was being predicted in the options market. There were tens of thousands of March put contracts bought at strikes of $20 to $30 below where Bear Sterns was trading. The put-buyers were confident that something big was going to happen very soon. It is not known who bought the puts but I will not be surprised if it were entities related to those who were pulling their cash out from Bear.

There was also some chatter that Fed’s decision on Tuesday to start exchanging AAA rated MBS for Treasuries was in part driven by fear of a major bank failure. UBS seems to have liquidated of large Alt-A mortgage portfolio at a 30% discount to par (PIMCO was the presumed buyer) and subsequent margin calls had decimated Thornburg Mortgage.

Major companies have trouble raising cash using their MBS portfolio as collateral; the liquidation of Carlyle Capital’s mortgage fund which invested in GSEs backed MBS was a prime example.

The Wash-Out Event

Disruptions in markets can simmer on for a long time till a major unthinkable event happens. It catastrophic event washes out a major player or two.

That serves as a wake-up call to higher-powers who typically come out swinging.

We saw that wash-out this week. As I had written in my earlier post, it seems that the beginning of the end of the credit crisis is here. This being an election year, Washington will act, and act soon.

A Perspective on the Size of the Problem

Before going into details, it will help to get a sense of the magnitude of the problem and put it in proper perspective.
• According to Arthur Frank, a mortgage-bond analyst in New York at Deutsche Bank AG , there are $950B of outstanding Alt-A securities, $650B in sub-prime securities and $500B of prime-Jumbo securities. Rest of the mortgage debt is GSE backed paper.

• All the mortgages are backed by homes where people live.

Typically homes do not sell for less than replacement value for too long.

• Federal Spending and Resources:
o The United States has spent more than $500B on the Iraq war.
o The Fed has a balance sheet of $800B of high-quality collateral.
o The 2008 Federal Budget has a total outlay of $2,900B.

Restoring Equilibrium in the Capital and Housing Markets

Until recently, there was hope that the market will sort things through itself. However the disruption in GSE backed paper has meant that the Government is going to jump in.

The root cause of the problem is the decline in the home prices after the easy availability of credit boosted demand and pushed

prices out of the realm of affordability. In order to restore equilibrium the price of homes has to come in sync with the buying power of home buyers.

The equilibrium will be restored by:
• Increase in wages
• Lower mortgage interest rates
• Lower home prices

It may take years for the housing market to find the equilibrium. What Federal Agencies should focus on is to make the re-pricing process orderly, and reduce economic disruptions resulting from it.

The best way to prevent disruption is to reduce the rate of decline of home prices while allowing wages to catch up. At the same time increasing availability of credit to creditworthy borrowers at low interest rates will help increase affordability.

It is imperative to reduce and manage the amount of foreclosed homes which are coming to

the market. A large number of foreclosed homes have a significant negative impact on home-values and overall consumer and market psychology.

Managing Foreclosed Inventory: Long Term Rentals

Until now there has not been too much focus on how to handle properties which have been foreclosed. A silver-lining, if any, is that many of the foreclosed homes are concentrated in specific geographical pockets, especially in California, Florida, and Nevada. Regardless of the housing bubble, these areas are very desirable places to live in and have bullish demographics. This concentration allows the creation of property management entities who can rent out the homes till the markets stabilize.

As home-ownership rates decrease, the number of renters is going to increase. The rental market is quite healthy and showing signs of good rental income growth in the next few years.

In cases where the banks/servicers have already foreclosed, they should sponsor the creation of quasi-independent property management entities which can then purchase the homes at a price which will make them cash-flow positive. These rental properties will then be off-the market and not contribute to the existing foreclosed inventory. The bank will be able to take the loans off their books. Further, the property will become an income-producing property and will be properly maintained.

This approach is different from the traditional approach of banks sitting on the property till they find a buyer.

Banks have not traditionally been in the property management business. However, new challenges require new creative solutions. The property management companies can start selling the homes after a few years once the housing market stabilizes.

There is legislative action being considered to provide up to $10B for states to buy and fix distressed properties. This is a step in the right direction. The scope of the program should be enlarged to encourage the creation of the property-management entities to reduce foreclosed inventory.

Fed Action: Reduce Mortgage Interest Rates

The Fed’s focus is going to be to stabilize the market for MBS which will narrow the spread between treasuries and MBS. Lower spreads will translate to lower interest rates at the retail level and will increase the affordability of homes.

It will also allow the Fed’s interest rate cuts to make an impact on the housing market.

The Term Security Lending Facility is the start since it allows a group of broker dealers to exchange MBS for Treasuries.

If the situation demands, the Fed can also go out and buy the MBS paper, especially the GSE backed

paper, in the open market.

This will provide a bid to the MBS market and lower mortgage interests further.

A number of commentators including Jim Cramer on CNBC have been urging the Fed to backstop the GSE backed debt and restore market confidence.

FHA: Preventing Foreclosures

There are legislative efforts under way to empower the FHA to offer $300B more in new guarantees to help refinance distressed mortgages that banks and mortgage holders have agreed to write-down. This will allow home-owners who are upside-down to refinance into mortgages which give them some equity and skin in the game.

It will also result in lower mortgage payments. Sub-Prime borrowers with good payment records will now qualify for better rates since a couple of years of regular payments will fix their credit score.

This is similar to the idea first circulated by Chairman Bernanke asking bank to write-down under-water mortgages. Write-downs will bring clarity and more visibility into the liabilities of banks and help restore confidence in the markets.

Note that in terms of the losses realized, in most cases it will be profitable for the note-holders to allow the short-refinancing. The foreclosure process can take a lot of time and cost quite a bit of money. Further there is no certainty of finding a buyer at a fair price, especially in auctions.

Allowing short-sales will enable the banks to recognize the loss, get the bad loan off the book and then redeploy the capital. It will help clarify the magnitude of the loss and restore visibility and confidence in the markets.

Credit: Life-Blood of the Modern Economy

There are a lot of pessimism in the air-waves about the state of the US economy, and especially the credit markets.

After sub-prime mortgages, investors expect Alt-A and even Prime mortgages to start underperforming. If the economic slowdown worsens investors also expect credit-card and auto loan delinquencies to soar.

The root cause of this fear is the decline in the housing market. Restoring confidence in the housing market is the key to breaking the vicious, self-feeding spiral. A quantitative analysis of the scope of the problem indicates that the Federal Agencies have enough resources to stabilize the market. There is now increasing recognition that the Federal Agencies have to intervene to unfreeze the credit markets; even die-hard opponents of Federal intervention are reluctantly agreeing.

This intervention will be for the greater good of most Americans; unlike a lot of other ways the government spends our taxes.

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