Summary of Solution to Clear MBS from Bank Balance Sheets
The Thrust of this proposal is for a new financial instrument MBS Economic Freedom Bonds. Under this proposed program, the Federal Reserve would fund private financial firms to purchase whole mortgages, private label MBS and MBS derivatives, clearing them from bank balance sheets and establishing a robust market for these illiquid securities. There is an automatic mechanism to recapitalize the banks with common stock as banks sell MBS securities at below book value and decrease their Tier 1 Capital. These MBS assets will later be re-securitized in government guaranteed bonds to remove them from the Fed balance sheet.
Some economists and financial experts believe that this approach is superior to an aggregator bank or government asset insurance for restoring liquidity to the MBS market and health to the financial system. The advantages of this proposal are a superior market-based price discovery mechanism for MBS; re-securitization to attract private capital, a market based pricing formula for government assistance and a transparent approach to bank recapitalization.
This program for MBS is designed to be implemented with a foreclosure relief plan which creates secured lines of credit for distressed homeowner to draw upon when they cannot pay the mortgage. This plan: “A Win-Win Strategy to Mitigate Foreclosures with Minimal Taxpayer Exposure” was published in the RGE Monitor in Oct 30, 2008.”
These programs MBS Economic Freedom Bonds and Workout Loan Bonds – provide a comprehensive systemic solution to prevent foreclosures, place a floor on the residential real estate market, clear MBS from the banks’ balance sheets, and re-capitalize financial institutions.
Synopsis of MBS Economic Freedom Bonds
The Federal Reserve would fund privately-managed investment pools to buy private label Mortgage-backed Securities (MBS) as well as whole mortgages and MBS derivatives. These pools of residential real estate securities will be guaranteed by the Treasury for repayment of inflation-adjusted principal and held on the balance sheet of the Federal Reserve. The Treasury guarantee to the Fed would be made with funds from TARP.
Investment professionals who manage the funds will determine market prices by purchasing and trading Mortgage-backed securities at what they deem to be attractive prices for their funds. Competition among multiple investment pools and with other investors would create a robust liquid market. Purchases could be made with reverse auctions. An outcome of the law of supply and demand is that new demand, created by capital allocated to purchase these securities, will cause prices to rise. The program could be implemented quickly by hiring investment managers already vetted by TARP.
Losses (by government-approved financial institutions) from the sale of MBS assets at below-book would trigger government purchases of common stock to offset losses to bank Tier 1 capital. This provides a clear, transparent mechanism for bank recapitalization. It would reassure equity markets that write-downs will not threaten bank solvency. The pricing mechanism for the equity infusions is discussed in the section on Details of MBS Economic Freedom Bonds.
The underlying MBS assets will be re-securitized and sold to the public as a form of US government TIPS (Treasury Inflation Protected Securities) that could be made exempt from taxes. These will be real rather than fictional AAA bonds – with a government guaranty on the repayment of principal. The profit potential from the improvement in prices of distressed assets – along with the Treasury guaranty and the absence of taxes – will draw investors and create strong demand for these bonds. When issued, the bonds will broaden the market for MBS and provide a mechanism to withdraw liquidity and reduce the Fed’s balance sheet.
The program could be constructed so that bank proprietary trading personnel could, in effect, be re-pricing and swapping MBS assets with other banks – thereby setting prices, removing MBS assets from bank balance sheets, taking write-offs to capital, and triggering the recapitalization mechanism.
The MBS Economic Freedom bonds could be sold back to commercial banks, clearing toxic assets from balance sheets and replacing them with US Treasury guaranteed MBS bonds. This program creates an equivalent solution to government asset insurance, with the premium, in the form of common stock sold to the government to recapitalize the banks. However this program creates a liquid market for MBS and government asset insurance does not.
MBS Economic Freedom Bonds: Program Details
Mechanism for Bank Recapitalization
Financial institutions that receive government approval will qualify to be compensated with equity infusions for the difference between book price and the sale price of MBS, with losses tallied monthly. The program could be applied initially to assist Citibank and Bank of America.
The purchase price of the common shares will be set as the average daily closing price for the prior month. Prices will be calculated on a monthly basis. The price could also be set at the closing price when the capital infusion is made, or by using some alternate pricing formula.
Voting or Non-voting Common Shares
The equity could be non-voting (or voting, if policy makers so choose) common shares with no dividend. However, if the equity taken is non-voting common stock, when they are eventually sold in a public offering there will be a provision to convert the non-voting shares to voting common stock.
Warrants and Liquidation Preference
There could also be two long-dated warrants in the unit to compensate for the lack of dividends on the common stock: one warrant would be priced modestly, the other would be priced at a larger premium to the market. If the government chose to be more generous to the equity holders in the banks, warrants could be dropped from the recapitalization financing. The new common could have a feature providing preference over senior unsecured debt in liquidation.
Anti Dilution Provision to Protect Public Shareholders
Present shareholders will be given the option to purchase equity on a similar basis to prevent dilution to their holdings.
Restrictions on Participating Banks
Financial institutions qualifying to have write-downs on MBS matched with equity infusions will agree to pay no dividends and to cap bonuses. These measures will also improve bank Tier 1 capital.
Capital Provided by the Federal Reserve
The order of magnitude required to create sufficiently capitalized funds to clear MBS from the banks would dwarf the second tranche of TARP. Accordingly, the money to capitalize these funds should be loaned by the Fed with repayment of inflation-adjusted principal guaranteed by the Treasury. Private capital will be drawn into the MBS market following the initial funding of the investment pools, decreasing the total capitalization that must be provided by the Federal Reserve.
Investment Managers and Fees
Selected financial institutions will be paid to manage the funds and to underwrite the bonds. A management fee will pay for professional staff to evaluate and invest in assets and to renegotiate mortgages, as well as to cover operating expenses. A percentage of profits will go to the financial institutions through a carried interest. Fund managers could be required to put some capital at risk. Alternatively, compensation could be based on fees without a carried interest. The financial managers could be investment management firms that were pre-selected for TARP, TALF or other asset managers, commercial banks, or hedge funds.
Periods to Deploy Capital
There will be established targets for specific periods for the deployment of capital. For example, it might be targeted that 50% of the capital in a fund must be deployed within the first 9 months.
The bonds will be for a term of 7 years.
Different Bond Issues
Bond issues will be tied to investment pools managed by different financial institutions. Market prices for the bonds will vary with the performance of investment managers.
Other Asset Classes
The program could be expanded to other asset classes, e.g., commercial MBS, leveraged loans, and student loans. The maturities on the government bonds or notes would be matched to the asset class.
The approach outlined above can readily be applied by other nations who have access to reserve currencies and thereby have the ability to clear toxic assets from their banks and recapitalize their banking systems. Other nations, like Iceland, that recapitalize or nationalize their banks under economic conditions of duress, risk a rapidly depreciating currency and hyper-inflation. Measures might be developed to provide liquidity to nations without reserve currencies. Coordinated international efforts will have the greatest chance of strengthening the global financial system and preventing a deep and prolonged economic contraction.
The Economic Context for MBS Economic Freedom Bonds
A critical lesson of the “lost decade” of the 1990’s in Japan is that bad assets must be cleared from bank balance sheets and banks must be recapitalized, if we are to create a stable banking system that will provide capital for economic growth.
The financial system is facing an accelerating threat of widespread insolvency with potentially devastating consequences for consumer and investor confidence, equity and debt markets, and the GDP. There is concern in the capital markets that assets on bank balance sheets have declined below reported values. 60% of US bank assets are in hold-to-maturity accounts and are not subject to mark-to-market reporting (Source: Marc Siegel, Member of the Board of FASB).
The stock market activity of January 20, 2009, which saw one day-declines of more than 20% for the major US and UK banks (a 59% decline for State Street), demonstrates the lack of confidence in the balance sheets of financial institutions. Loss of confidence can influence rising CDS spreads and an increasing cost of capital. As lending decreases and the recession increases, the value of loans and securities on bank balance sheets is further compromised. We are in the midst of a self-reinforcing negative feedback loop which is ravaging the global economy.
Professor Nouriel Roubini and Elisa Parisi-Capone of RGE Monitor estimated (January 20, 2009) that the US banking sector is exposed to likely losses of $1.1 trillion from unsecured loans and $600 to $700 billion of losses from securities write-downs. They calculate that FDIC-insured bank capital (as of Q3 2008) was $1.3 trillion, with capitalization from TARP of $230 billion and $200 billion of new private capital. They estimate that the banking system requires between $1 trillion and $1.4 trillion of new capital.
The current macro-environment of close to zero percent interest rates pursued by the major central banks, combined with quantitative easing, is unprecedented. Economic history provides limited guidance on unintended consequences of policy initiatives in this environment. However, one useful lesson can be drawn from Japan’s collapse of asset prices, deflation, and liquidity trap: even with massive fiscal stimulus, economic growth did not recover until toxic assets were removed from the balance sheets of the banks.
Other Economic Lessons from Japan
Another lesson from Japan is the importance, when crafting a fiscal stimulus, of distinguishing between government spending and government investment that reinvigorates an economy. Policy makers might place more emphasis on a fiscal stimulus program that increases the productive capital stock of the economy rather than simply increasing short-term spending. Not only do different expenditures have different short-term and-long term multipliers, but government spending which creates environmentally benign industries and strengthens the productive capacity of the US economy creates future tax revenues to repay deficits. Productive investments would be favored by the capital markets, preventing CDS spreads on US sovereign debt to rise and supporting the confidence of investors to purchase long-dated Treasuries without requiring substantially higher interest rates. This would give the Federal Reserve latitude to purchase long-dated Treasuries to bring down mortgage rates without being concerned about inflationary expectations from increasing the money supply. Nobel Laureate Paul Krugman shows, in his paper on Japan’s lost decade, that inflation can be positive in a deflationary environment with a liquidity trap and zero interest rates. Inflation will cause negative real interest rates, which will stimulate consumer spending and GDP growth.
Synopsis of Workout Loan Bonds
The MBS Economic Freedom Bonds program is intended to be implemented in tandem with the Workout Bond Program. It will effectively prevent residential foreclosures and stabilize the residential real estate market. Workout Capital Bonds are described fully in a separate 20-page white paper. In brief, Workout Loan Bonds would provide US government-guaranteed workout financing to distressed homeowners, as part of a comprehensive solution that includes loan modifications. Workout capital financing provides a line of credit to assist homeowners when they cannot make a mortgage payment.
Workout Capital loans are provided through the mortgage servicers, to take advantage of legal covenants in their agreements with owners of MBS. This is a fiscally prudent and cost effective program of foreclosure relief in which government loans are protected by a first lien on the underlying real estate. This allows the government to deploy substantial capital with minimal losses to actually stem large numbers of foreclosures. This program applies workout capital a financial instrument from corporate finance to residential real estate.
Recent history has shown that loan modification alone, are insufficient to assist unemployed or economically-distressed homeowners stay current on their mortgages. The workout loan program, which includes loan modifications, is designed to keep mortgages current for a 5- to-7-year period, long enough for a recovery of both the economy and the residential real estate market. Workout Loan Bonds are discussed in a separate white paper.
Combining inflation-adjusted MBS Economic Freedom Bonds with Workout Capital Bonds would provide a powerful pair of programs that would aid distressed homeowners, clear MBS from the banks, and help restore financial health to financial institutions, the real estate market, and the economy. These should be accompanied by sound fiscal and monetary policy.
Vantage Partners is available to work with key stakeholders and financial policy experts to develop these preliminary ideas into a detailed program.
Michael Jaliman is a Senior Adviser with Vantage Partners, a spin-off of the Harvard Negotiation Project at the Harvard Law School. Michael was a Democratic Party Candidate for Congress in 2004; in his campaign, he warned of an impending financial crisis. Michael was formerly Senior Managing Director at Fujitsu Consulting, Director of Strategic Planning at KPMG, and an economic researcher at McKinsey & Company. At Fujitsu, he headed the regional financial services practice and led a consulting team in the merger of Japan’s Mizuho Financial. Michael has a BA with honors in economics from the University of Wisconsin at Madison (where he studied with Nobel Laureate Gunnar Myrdal), and an MBA from the Harvard Business School.
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