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Paul Krugman Punts

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Paul Krugman, in this morning’s New York Times, tells us (subscription required) that mortgage borrowers in the US are feeling a world of hurt. The pain is moving up the food chain beyond stressed subprime borrowers into the Alt-A pool (which truth be told, never was much better than subprime, so this development was widely anticipated). And he argues that “widespread malfeasance” was a big part of the problem, depicting the rating agencies as enablers, much as the major accounting firms were in the Enron and World Com scandals.

So far, fair enough. But then we get to this:

Yet our desire to avoid letting bad actors off the hook shouldn’t prevent us from doing the right thing, both morally and in economic terms, for borrowers who were victims of the bubble……Consider a borrower who…. is facing foreclosure. In the past,….the bank that made the loan would often have been willing to offer a workout…..

Today, however, the….mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets….. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure….The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts….

The mechanics of a domestic version would need a lot of work, from lawyers as well as financial experts. My guess is that it would involve federal agencies buying mortgages — not the securities conjured up from these mortgages, but the original loans — at a steep discount, then renegotiating the terms. But I’m happy to listen to better ideas.

Lordie. First I have to differ with Krugman’s premise. Borrowers should NOT be rescued wholesale from having participated in a real estate bubble. That is no different that being rescued from participating in a stock market bubble (oh wait, we did sort of do that, via Greenspan dropping interest rates to 1%. But events of last week have shown that wasn’t such a hot idea after all). Yes, there was fraud perpetrated by both lenders and borrowers. And when the lenders defrauded borrowers via inadequate or misleading disclosure, I’m all for ways to rescue the borrower and make the perps pay.

But Krugman is talking about a massive rescue, of the hapless, the greedy, and even the fraudsters. And he airly waves his magic wand and says the government should step in and buy mortgages and arrange workouts.

This is a Herculean, impossible exercise. It wouldn’t simply require a massive rewriting of rules. To cut through the Gordian knot of the complexity of the disposition of mortgage paper (much of it went into collateralized debt obligations, which were resecuritized and sold in tranches, which then sometimes would up as constituents of yet other instruments, such as “CDO squared” (CDOs of CDOs) or “CDO cubed” (CDOs of CDOs of CDOs) or synthetic CDOs (the cashflows from writing protection via credit default swaps on CDOs would be aggregated, tranched, and sold as a new CDO) is impossibly difficult to achieve via modification of specific deals, or rules around particular deals. (And I’m not going to get into what it would take to create a new Federal effort to renegotiate the loans it acquired. Remember the Resolution Trust Corporation of the S&L crisis? All they did was buy bad bank assets and sell them wholesale at the best price they could get. That was still a very big undertaking, but Krugman’s effort would require large scale hiring of banker types to negotiate loans individually.)

You’d need an expropriation of assets. And that would constitute such a major violation of commercial property rights and contractual law as to call into question the viability of the US as a place to sell securities.

But Krugman’s move would have the salutary side effect of scaring an entire generation of financiers away from designing and selling funky paper.

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12 comments

  1. dis

    Yves, this is O, but I would love to
    know your thoughts on todays fed lowering of the discount window rates and extending the lending period from a day up to as much as a month.

    Is this about not letting Countrywide go under and the ensuing mess it would bring? It looks there was a run on their bank yesterday?

    It also look that in their statement today they skipped going to neutral and skipped right to easing bias.

    Poole was conspicuously absent from the one voting for approval. Fisher took his place as his alternate.

  2. Yves Smith

    Thanks for the tidbit about Poole.

    I want to get to the meat of the discount cut but that will take a meaty post, and I am starting on it.

    Frankly, I think this was a bad bad move. This might have been OK given the magnitude of the seize up in the money markets IF the Fed had waived tons of flags in their announcement stressing that this was temporary. But they signaled a shift to easing.

    We are just rolling bubbles into bigger bubbles. This may stay off the reckoning for a while, maybe even a few years, but it will make the eventual collapse even bigger.

  3. Anonymous

    I’m not sure you read Krugman’s meaning right. Given that people are talking about the Fed as market-maker of last resort, I think that all he’s trying to say is that the Fed shouldn’t be a market maker in the funky stuff. To the degree that the Fed (or some Fed brokered agreement using Fannie and Freddie as agents) may act as market-maker of last resort, surely he’s right that it should be a market-maker on its own terms in the underlying loans. Whether all of this could possibly happen in time to help out the underlying borrowers with workouts is an entirely different question.

  4. Yves Smith

    Dear Anon of 1:34 PM
    I think we are talking past each other. My point is that Krugman is dealing on the level of theory, and in theory his recommendation might be all well and good (although I don’t agree even there, I take the issue of moral hazard seriously, and am opposed to a wholesale bailout of borrowers).

    My point is that many (most? nearly all?) of these mortgages haven’t simply been securitized. They have been resecuritized, sometimes twice or three times, and then may have had derivatives written on top of them. There are typically limits on what percentage of the pool can be modified without servicer approval, and in many cases the current default levels have blown through those limits.

    Now with each resecuritization, you have limits on substitution of collateral for the original asset. You have restrictions for each new vehicle on top of the earlier restrictions to protect the investor.

    You can’t simply go buy mortgages. You have to get waivers from all the participants in the food chain. That’s an impossible task, akin to unscrambling eggs. Hence the only other realistic option to do what Krugman wants to see happen is expropriation.

  5. Anonymous

    If being market maker of last resort in something the Fed is likely to be able to understand (like the underlying mortgages) won’t solve the problem, it seems that the Fed simply can’t be market maker of last resort. It’s ridiculous to expect the Fed to do an acceptable job of buying something from a seller who’s the only one who understands the product.

    Then to the degree that market making is the solution to this problem, maybe the Fed should work on getting a proposal out for buying the underlying loans ASAP and wait with nerves of steel for participants to get on the band-wagon. The only ones who can work out the distribution of the remnants of the scrambled eggs (probably over decades in court) are the ones who scrambled them.

    On the other hand, I’m hoping (praying?) that the CBs will pull this off without market making at all.

  6. Anonymous

    I give up. What are you, a knucklehead?

    I’m all for seeing corporations that have bad business models go six feet under. But to say that all the homeowners that were suckered into those deals should fold too, that’s moronic.

    These things used to be regulated before half-wit Ronnie Rayguns came along.

    Either way, the Republicans day is over. And they’ll be buried along with all the bad habits too in 08.

  7. Yves Smith

    Anon of 4:54

    Excuse me, did you read what I wrote?

    Yes, there was fraud perpetrated by both lenders and borrowers. And when the lenders defrauded borrowers via inadequate or misleading disclosure, I’m all for ways to rescue the borrower and make the perps pay.

    Get your facts right before you start shooting.

  8. Kien

    When a debt is securitised many times over, how do the lawyers ensure that the final holder of the CDO own the security for that debt? Or does the CDO owner rely on the bank that first took the security to act as their agent, when foreclosing the security? If the latter, perhaps there is still opportunity for the borrower to negotiate a work out with the bank. Perhaps the only government “intervention” required is a law prohibiting foreclosures except through the original lender to whom the borrower provided the security. From the borrower’s perspective, why should rights to foreclose end up with a third party? Arguably doing so deprives the borrower of the ability to negotiate a workout with the original lender (to the extent such workout was thought possible at the time the loan was originally made).

    This “government intervention” perhaps could at least be implemented prospectively – it may (or may not) be too late to intervene in respect of existing debt that has been securitised. It could perhaps be implemented as a voluntary code that CDO holders could be “bribed” into participating by offering a double tax deduction on debt written off via a workout involving the original lender.

    How does making foreclosure possible only through the original lender help? It might not help very much if the original lender is simply a passive agent for the CDO holder. On the other hand, it may give the original lender (say a bank) an opportunity to step in and propose a workout. This might happen where, with the benefit of other information that the bank may have about the borrower, the work out may turn out to be more valuable than an outright foreclosure. The additional value could be shared between the borrower, the original lender, and the ultimate holder of the CDO.

    I agree with Yves Smith’s reservations about the practicalities of the intervention that P Krugman seems to contemplate. There seems to be an information issue which a government agency will be in no better place than the ultimate CDO holder to address. The best person to undertake the workout would be the original lender, and the most the government can do is to give the original lender an opportunity to organise a workout using whatever information that lender may have about the borrower.

    Just a suggestion from an anti-trust lawyer in Australia. (I’m not a banking & finance lawyer.)

  9. Anonymous

    “Get your facts right before you start shooting.”

    Eh, maybe you’re right Mr. Yves. But it didn’t sound exactly like you were advocating for the consumers in the following paragraphs.

    “…But Krugman is talking about a massive rescue, of the hapless, the greedy, and even the fraudsters. And he airly waves his magic wand and says the government should step in and buy mortgages and arrange workouts.

    This is a Herculean, impossible exercise. It wouldn’t simply require a massive rewriting of rules. To cut through the Gordian knot of the complexity of the disposition of mortgage paper (much of it went into collateralized debt obligations, which were resecuritized and sold in tranches, which then sometimes would up as constituents of yet other instruments, such as “CDO squared” (CDOs of CDOs) or “CDO cubed” (CDOs of CDOs of CDOs) or synthetic CDOs (the cashflows from writing protection via credit default swaps on CDOs would be aggregated, tranched, and sold as a new CDO) is impossibly difficult to achieve via modification of specific deals, or rules around particular deals. (And I’m not going to get into what it would take to create a new Federal effort to renegotiate the loans it acquired. Remember the Resolution Trust Corporation of the S&L crisis? All they did was buy bad bank assets and sell them wholesale at the best price they could get. That was still a very big undertaking, but Krugman’s effort would require large scale hiring of banker types to negotiate loans individually.)

    You’d need an expropriation of assets. And that would constitute such a major violation of commercial property rights and contractual law as to call into question the viability of the US as a place to sell securities.

    But Krugman’s move would have the salutary side effect of scaring an entire generation of financiers away from designing and selling funky paper….”

    But then you do quote the FT quite abit, and Brad DeLong had a piece on you, so maybe you’re alright after all. Can’t be too careful what we read these days.

    Btw, who are you and where the obligatory “About” page? Did I miss that?

  10. Yves Smith

    Dear Anon of 7:45 PM,

    If you have the time to troll around the blog a bit, I am actually pro-consumer and pro-regulation. Deregulation has gone beyond the optimal point. Early in the subprime mess, I wrote some posts in favor of much stronger consumer protection and disclosure, and whenever possible, savage the credit card industry.

    My beef with Krugman’s piece (and I am pro-Krugman too, and have cited him often on income inequality, health care, and trade economics, where his work is first rate) is that it’s obviously unworkable AND feeds into the hands of critics of the left. Even a guy like Krugman can have his off days, and this appears to have been one of them.

    Now there are things that could be done to help borrowers that would be VASTLY easier to implement than his proposal. If you want to have a legislative fiat, the numero uno useful move would be to lift the limits on loan modification in all mortgage backed securities deals. Some deals have no restrictions, but many (wish I had data here, but I’ve never seen any stats) either prohibit loan mods altogether or limit them (5% is a common level). With the meltdown in subprime, the belief out there is that many MBS will run into their mod limits.

    Loan modification allows the loan servicer to salvage the borrower if at all possible (it’s always better to restructure a loan than foreclose IF there is a viable level of income. Some of these homeowners have borrowed so far beyond their means that it might not be possible to rescue them).

    The other thing that needs to be done is modify the bankruptcy laws (yours truly is a big critic of the changes put in effect in October 2005). Too long to go into here, but there is good stuff on the blog Credit Slips on this topic.

    You can find out about me if you click on “Contributors,” then on my name. But I’d rather be like the blogger knzn and not admit to any identity at all.

  11. Yves Smith

    Per the comment above, I should have known there was a fly in the ointment with the idea of simply waiving the mod limits.

    It’s still (if I do say so myself) a good idea, but not so easy to implement. It turns out that while the securities offering falls under Federal law, the contract that governs what the servicer does for the trust that holds the mortgages is governed by state law, so you’d have to change the rules in 50 states (or some 80/20 subset, like Delaware plus any others that have a lot of mortgage servicers, such as California.)

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