A Mortgage-Crisis Fix with no Taxpayer Liability

PROBLEMS AND OBJECTIVES

The Problem

The problem with financial institutions has been so widely discussed that it is not discussed in detail here. It is assumed that the reader is somewhat familiar with the current crisis.

Essentially, banks, investment banks, and other financial institutions who hold these assets (hereafter “banks”) extended more than a trillion dollars worth of low-quality mortgages and packaged most of them into mortgage pass-thru assets called Collateralized Mortgage Obligations (CMOs). The default rate on the lowest quality loans, called sub-prime and Alt-A are at very high levels and rising and even on prime loans are at unacceptably high levels.

These high default rates have required banks to mark down the value of these CMOs to such a degree that the banks are reporting enormous losses in their quarterly reports, are in some cases failing to meet their regulatory capital requirements, and in the worst cases are unable to attract funding from other banks in the normally healthy inter-bank lending market. Some major banks have already failed and it is anticipated that more will follow without a remedy.

This crisis has become so serious that it is no longer contained within the banking community. It is beginning to adversely affect the global economy at large.

The Federal Reserve System and the U.S. Treasury have taken unprecedented steps to alleviate the crisis, but these steps have so far proven inadequate by themselves.

This document sees the problem as largely a crisis of liquidity. It does not accept the proposal, direct or implied, that those institutions responsible for the losses should be absolved of those losses. Nor does it accept any proposal that these losses should be born by the U.S. Government or those ultimately responsible for funding the U.S. Government, American taxpayers.

The Current Status of the Remedy Proposed by the U.S. Treasury

Over the weekend of September 20 and 21, 2008, U.S. Treasury Secretary Henry Paulson drafted the outline of a bill that will presented to the Congress when it convenes on Monday, September 22. Although this plan will quickly evolve, as of the time of the original posting of this document that plan had three primary features which are reproduced here verbatim:

Sec. 2. Purchases of Mortgage-Related Assets.

(a) Authority to Purchase.–The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

Sec. 6. Maximum Amount of Authorized Purchases.

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time.

Sec. 10. Increase in Statutory Limit on the Public Debt.

Subsection (b) of section 3101 of title 31, United States Code, is amended by striking out the dollar limitation contained in such subsection and inserting in lieu thereof $11,315,000,000,000.

The complete language of this bill might still be available at the Online Wall Street Journal and other internet sources.

The language above does not imply that the U.S. Treasury would be hostile to a plan such as this. This plan would readily fit into the framework of the Paulson proposal (because that plan in the above configuration has few details), except that it may not be necessary to expand the ceiling on the national debt to $11 trillion.

The Object of this Plan

This plan provides a solution that will provide immediate liquidity to impacted banks, allow those banks to defer their losses and find the means to mitigate them over a long period of time and to calm the markets that are reacting to the fear of widespread bank insolvency. In a few words, this plan provides a path to safety and solvency.

The Essence of this Plan

This plan proposes that a federally-chartered corporation be created as a government sponsored enterprise, that the corporation borrow funds, and that the corporation engages in long-term swap contracts with the banks that need liquidity, charging rates for the swaps that are set by market.

THE DETAILS OF THIS PLAN

The Creation of an Institution to Execute this Plan

The U.S. Government will create and provide a temporary charter to create an institution responsible for funding and executing this plan. For the sake of reference, this plan will call that institution the Federal Refinancing Corporation (FRC). The FRC will be a government-sponsored enterprise (gse), which implies that its debt is guaranteed by the U.S. Treasury. The FRC might be structured somewhat like the Resolution Trust Corporation (RTC), created in 1989 and dissolved in 1993, used to resolve in part the Savings and Loan Crisis of that era. Like the RTC, the FRC will be a corporation with an eleven-year life set by law.

Funding the FRC

Upon it’s creation, the FRC will have indirect access to the global credit markets as a gse (indirect rather than direct access is a subtle feature of this plan and will be explained in detail below).  The FRC will have a funding cap set by its charter. Assume that the cap will be set at $700 billion, but could be an amount less or more than that. The financial assets created by this funding will consist of FRC coupon-only notes with maturities of 2, 3, 5, 7, and 10 years, authorized by the FRC but sold by the banks receiving that authority.

Offering and Closing the Swap Contracts

As the FRC funding proceeds, the FRC will offer to interested banks swaps that will exchange the CMOs in the bank’s portfolios for the authorization to sell FRC coupon-only notes, which can then be sold by the banks for the cash and hence the liquidity that they need.

Although the periodic interest payments on these notes will be guaranteed by the FRC, the payments will be made by the bank that is party to the swap.

When the swap matures, which will coincide with the maturity of coupon-only notes to which they are matched, the banks reassume ownership of the CMOs (and will still have rights to any remaining mortgage payments but will also be liable for any remaining net losses in the mortgage portfolio). The FRC obligation to this transaction ends because the coupon-only notes matched to the swap will have matured when the swap expires and there is no final principal redemption with coupon-only notes.

Payments and Guarantees

In this plan banks are offering their CMOs as collateral for the authorization to sell FRC-guaranteed coupon-only notes. Consequently the banks will be responsible for servicing the mortgage loans as they presently do and will be entitled to all payments collected from those mortgage payments. The FRC will neither service the mortgage loans nor collect the proceeds. The banks will be required to make the interest payments on the coupon-only FRC-authorized notes.

The Size of the Individual Swaps

For any given CMO that a bank is offering for collateral, the swap authorization to sell FRC-guaranteed notes will be determined by the bank (subject to FRC approval) but will be capped at 90% (0.90) of the value of the original notional value of the CMO as described in the prospectus of the CMO. In other words, if a CMO was first originated with a notional value of $1 billion, a swap authorization of up to $900 million will be authorized.

This authority will normally be extended even if the present perceived market value of the CMO is less than this amount, and even if the CMO has already been marked down to a lesser value of the books of the bank in question. It won’t do the banks any good to be authorized to borrow an amount that they might currently be able to raise merely by selling these distressed assets. (The FRC must have the right to lower the cap because of extenuating circumstances involving the lender, but normally this wouldn’t be done).

This puts an obligation on the banks to reconcile to implied spread between the collateral value and actual value of their CMOs, but gives them up to 10 years to do that.

The Maturity of the Individual Swaps

The swaps and their corresponding notes will be offered with maturities of 2, 3, 5, 7, and 10 years. It will be up to the banks to choose the maturity that suits them.

Banks will have roll-over privileges subject to the approval of the FRC. For example, if a bank chooses a 3-year swap, at the end of three years if the bank is unable to resume its CMO liability, it can be authorized to enter another swap arrangement for, say, two more years. The total duration of all swaps is limited to ten years.

Pricing of Notes and Yields

As is done for nearly all other securities offered, including U.S. Treasury Securities and gse-sponsored securities such as those sold by FNMA, the market will determine the coupon yields of notes and the inherent pricing of notes that are contingent upon those coupon yields.

The FRC should allow some of the initial offerings to proceed without interference, but if it appears that the market is imposing coupon yields that imply an unacceptably high level of liability, the FRC must give itself the right to restrict sales to Dutch Auctions under FRC supervision subject to rate cap reserves for some sales, or some equivalent of this restriction.

In cooperation with the issuing banks, the FRC will determine the periodicity of the coupon payments on the FRC-authorized notes.

Secondary and Derivative Markets

It is anticipated that secondary and derivative markets for these securities will be quickly developed by the private markets without federal participation.

Orderly Market

Because the private markets may not be willing or able to absorb a large quantity of these notes, and given that the current crisis may require that, the Federal Reserve System must be willing to temporarily make a market for these assets by, for example, participating in some of the bids, acquiring some of the assets, then reselling them later (as they do on a seasonal basis for U.S. Treasury Securities).

However the Federal Reserve System cannot be allowed to take a market loss on such securities, as it would if, for example, they acquired the notes with a 6% coupon and had to resell them for an 8% coupon.

Therefore, if the Federal Reserve System is the party that acquires the notes at initial release, they will pay to the selling bank 50% of the bid value of the notes. For example, if the Federal Reserve System bids and wins a note tender for $1 billion paying 6% coupon interest, it will pay cash or equivalent of $500 million to the selling bank.

When the note is resold by the Federal Reserve System to a non-government buyer, the remaining balance will be reconciled 

FRC Implied Liability

Because the periodic interest payments on FRC-authorized coupon-only notes are guaranteed by the FRC (and hence the U.S. Government) there is certainly an implied FRC liability.

However, any bank that fails to meet its coupon obligations will have the same legal status of failing to meet any other financial obligation, and would have a very strong incentive to make such payments. Because the cash is raised up front the banks would gain some time in meeting such liabilities.

Likewise, a market for default swap insurance would likely develop to spread and mitigate the risk of payment failure. That market has failed in the current crisis but a revived and restructured market could work in this context.

A Swap Insurance Fund

Despite the likely development of a credit swap insurance market for bank FRC-authorized liabilities, the U.S. Treasury and taxpayers have the right to insist upon another layer of protection. This plan therefore proposes that a insurance pool be developed to fund any emerging liabilities of the FRC that arises because of defaulted coupon payments that are not covered by private credit insurance.

That insurance pool will be funded by a one-time fee levied against cash collected at the time of sale of the FRC-authorized coupon-only notes, equal to ½ of 1%, (0.005), of the amount raised in the sale.

The Impact Upon the U.S. Treasury and U.S. Taxpayers

Although the U.S. Treasury is responsible for default on coupon payments that banks fail to make, that is anticipated by the Swap Insurance Fund. There is no other liability. Because the notes do not include a final principal redemption, the FRC has no lingering liability when the swaps are unwound.

Although this plan gives banks, investment banks, and other institutions who hold these CMOs, liquidity and funding presently, it does not absolve them of the need to reconcile their losses. It just offers them much more time, which given the general strength of the core businesses, is all they need.