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Your bailout questions answered
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Published: September 25, 2008
You asked some great questions about what's going with the Wall Street crisis and how it affects Main Street, and a number of respected local and statewide economists responded. Here are their answers.
Who'll pay for the bailout?
What's the effect on regular folks?
How is the value of a distressed asset figured?
What about Fannie and Freddie?
How will the government pay back the $700 billion?
Who administers foreclosure and resale of homes in default when mortgages are securitized?
Is there a light at the end of this tunnel?
Who'll pay for the bailout?
Q. As far as I know Paulson, Bernanke or any other administration official haven't said where the $700 billion for this bailout is coming from. Can you find out? — Submitted by Paul Whitson
A. According to Saturday's Wall Street Journal cover story, the bond market has already started reacting to the fact that the government will borrow (issue bonds) for most of this money.
However, much or all of this money will be recovered in the long run since the Treasury's plan is to hold these assets until they mature. Remember, these are distressed assets, and the Treasury will buy them at a discount. Whether or how much it costs the government in the long run will depend on how much they pay for the assets now, and how many of them are bad. It is worth noting that most mortgages are still being paid. The problem is that nobody knows which mortgages and mortgage backed securities are bad. The government, by buying so many, is diversifying its risk — Marc Fusaro, assistant economics professor at East Carolina University.
A.The funds will be borrowed by the Treasury issuing additional Treasury securities — bills, notes, bonds. Lenders will be both domestic and foreign. The borrowing will add to the budget deficit — Michael Walden, economics professor at N.C. State University.
A. The money's coming from the Great American Treasury ... in other words, we're going to borrow it from the Chinese.
In all seriousness, however, the bailout fund would be capitalized by the federal government, and since the government operates at a deficit, the additional money necessary to acquire loans from the banks would be borrowed by the U.S. Treasury in the form of newly issued Treasury bills and bonds. These debts will be repaid out of loan repayments and asset sales on the loans that are acquired by the government, and if that total falls short of the amount necessary to fund the bailout (which it will), the remaining balance will be paid out of future tax receipts.
That's precisely the reason why we're seeing so much resistance to the bailout plan, in its current form, from Congress and the general public this week. People are simply unwilling to accept such a huge future liability (estimated at $10,000 for each American taxpayer) without sufficient deliberation and reasonable explanation by the government — Tony Plath, finance professor at UNC Charlotte.
A.No one is really talking about this. In fact, it does not matter from where the money is officially coming; what matters is that it is coming from government indebtedness.
As the money is coming from increased government indebtedness, the choice of how exactly to pay for this will be for the next president of the United States to decide. The next president can raise taxes, cut spending, increase indebtedness or try to get the Federal Reserve to print the money.
If the next president raises taxes, the rest of the economy will have to contract. Business formation will fall and consumers will have less money to spend. If the next president decides to cut spending, whoever was receiving the largess from the government will suffer. If the government increases indebtedness, it will raise the cost of loans to private individuals and businesses and will cause a reduction in investment and consumer spending just as taxes do. It will also put off the problem for the future. If the president succeeds in getting the Federal Reserve to simply print the money, inflation will increase with all of its constituent problems. — Zagros Madjd-Sadjadi, associate professor of economics at Winston-Salem State University.
What's the effect on regular folks?
Q.At the request of businesses, the government made it harder for individuals to declare bankruptcy. How are the new regulations affecting regular people? Is that a reason people are losing their houses and assets?
A.Interesting connection to consider. The new regulations have indeed made it more difficult for individuals to declare bankruptcy, and while this is not the root cause of the current mortgage crisis, it may have added to the problem. The regulations made it more difficult for some people to reorganize their mortgage debt, which may have been an additional hurdle for those facing foreclosure — Todd Cherry, economics professor at Appalachian State University
A. I would characterize the changes as making it harder to dismiss debts when bankruptcy is declared. This is the effect on regular people. Many states have laws protecting your house, so if for example you declare bankruptcy to escape from a credit-card debt, then the credit-card lender can not seize your house in bankruptcy court.
This is the basic role of bankruptcy proceedings, a judge decides which of your assets should be taken to pay off (part of) your debts. This does not apply to a mortgage because the loan was made for the purpose of buying the house; if you do not repay your mortgage, then you do not own your house, the bank does. Therefore, I think the bankruptcy laws are a red herring. However, someone closer to the situation might disagree with me citing specific cases where the two have affected each other — Marc Fusaro
A. The change in bankruptcy laws have had some impact, but the biggest cause of the foreclosures is the weakness in housing prices and the rise in interest rates from 2004 to 2007 (which increased the mortgage payments for folks with adjustable-rate loans, and who got the loans at the bottom of the interest rate cycle) — Michael Walden
A.Because things such as cash and savings account balances are assets, people declaring bankruptcy must spend (i.e., lose) assets to climb out of bankruptcy. While I am not an attorney or licensed to offer financial advice, my understanding is that as of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, a party declaring bankruptcy has a more difficult time qualifying for Chapter 7 (the form of bankruptcy which erases debt).
My understanding is that federal law stipulates that to be forced to sell a house, the bankrupt party must have a homestead valued over $125,000 which was purchased within the 3.3 years prior to the filing. In addition, this bankrupt party must meet any one of the following conditions: earn less than the median income for the state of residence, have less than $100 a month of disposable income, or have less than enough disposable income to repay 25 percent or more of the unsecured debt within five years. Note that filing for bankruptcy can be both expensive and time-consuming. State laws also apply. I doubt these changes are a significant reason for people losing their houses. — David Stewart, associate professor of finance at Winston-Salem State University.
A.The new bankruptcy laws passed a few years ago shift the cost of bankruptcy from financial institutions to individuals who make bad decisions. Normally, their impact would not be significant if the housing prices did not fall to the extent they did. The Fed raised interest rates in 2004-2006 17 times that increased interest payments on many adjustable rate mortgages to the point many could not afford to pay them. This created an avalanche of defaults, especially in the subprime market that spread to the rest of the economy as various derivative products were issued against real estate by Fannie Mae, Freddie Mac and major investment banks. With falling housing prices, those who wanted to refinance those ARMs had to bring money to the table, which they could not. The tougher bankruptcy laws made it easy to foreclose on those who were just one or two payments behind. — Edward Zajicek, an associate economics professor at Winston-Salem State University.
A.While the new bankruptcy regulations may have hurt some people, I don't think that it is the main reason for our current financial crisis. The current financial crisis is caused by the fall in home values that has resulted in a surge in mortgage loan defaults. The rise in defaults means that the mortgage-backed bonds that have been widely bought and sold by financial institutions around the world are no longer worth what the people who bought them originally thought. Because no one can predict default rate on the mortgages included in a mortgage-backed security, it is impossible to determine the value of mortgage-backed securities. The result is that the holders of mortgage-backed securities find it impossible to sell them.
The bailout plan is designed to keep money and credit flowing in the economy by taking distressed mortgage-backed securities off the books of financial institutions. This will free financial institutions to continue to extend credit in the economy. If our financial system freezes up, with banks being unable or unwilling to extend credit, the entire country will suffer, most especially average individuals — Don Jud, emeritus professor of economics at UNC Greensboro.
How is the value of a distressed asset figured?
Q. How is a value established for distressed assets? Obviously, the seller will endeavor to inflate the value. BUYER BEWARE! — Submitted by Bill McKenna
A. We typically think of prices and values being determined by markets. Specifically, the dynamic interactions of buying and selling in financial markets (supply and demand) generate prices which reflect how assets are valued.
When the attributes or knowledge related to an asset changes, the market considers this and adjusts the value and price accordingly. Prices reflect how distressed an asset is! There are alternative, non-market approaches to valuing assets (some more fundamental than others), but in the current situation, it is safe to assume the chosen method will overvalue the distressed assets relative to the market value — Todd Cherry
A. This is an excellent question. Prices are determined in markets. The fundamental problem of these mortgage backed assets is that they are no longer liquid — no longer being traded. If there is no price, there is no (market consensus) for the value of these distressed assets.
Thus, a feature of the government's proposed plan is for the government to buy these assets —create a market. The details are not yet fixed. However, it looks like the government will conduct an auction. Sellers (financial institutions) offer a sale price, and the buyer (treasury department) purchases those with the lowest bid. In this auction — a market — the price and value is determined — Marc Fusaro
A. This is yet to be determined. The problem is there is not an active private market for many of these loans, hence no "market value." If the government "overpays," that increases the cost of the bailout.
But if the government "underpays," banks won't be recapitalized and able to make new loans. The Treasury will have a thin line to walk! — Michael Walden
A. The market still has a price for these assets. It is just that the sellers do not like the price that the market has assigned for these assets. The last time I checked, in this country no one can force anyone to sell assets (unless the individual or business that is being forced to liquidate is in bankruptcy or is behind in payments to creditors). Thus, the sellers will definitely demand a premium over the market value to participate in the bailout. Of course, their mood might change if the value of their assets keeps dropping. — Zagros Madjd-Sadjadi
A. This is a very good question, which has not been adequately explained. The bailout plan proposes to conduct a reverse auction, with the holders of distressed mortgage securities being invited to offer the securities at a price which they are willing to sell them. This is tricky because the securities are non-standardized, and the holders of the securities are in a position to have much better knowledge about their value. Because of this asymmetric information, the government is likely to pay too much, unfairly enriching the holders of the securities. — Don Jud.
A. Value: No way you can determine value now. The government is buying the toxic wastes to save the system. In Indian mythology, Lord Shiva absorbed the poison that arose from the ocean in his own throat to save the universe. This turned Shiva permanently blue. Our Treasury will turn red for long time. Anybody wonders if S&P would lower the ratings of the US Treasury? — Swapen Sen, associate professor of finance at Winston-Salem State University.
What about Fannie and Freddie?
Q. How does the new Fannie and Freddie deal and the possible help from the government help the average person struggling with their mortgage? — Submitted by Linda Bowman
A. It increases the likelihood that more people will be able to purchase homes, so someone struggling to pay the mortgage would have a better chance of finding a buyer.
There may also be — we'll have to wait to see if Congress insists — some possibility of mortgages bought by the Treasury being renegotiated for struggling borrowers. However, this could only occur if the mortgages could be clearly identified (many mortgages have been "chopped up" and repackaged in investments). We'll have to wait to see on this — Michael Walden.
A.It depends on how Fannie and Freddie treat the mortgages that they hold. But we should keep in mind that this summer Congress and the president passed a bill intended to help distressed mortgage borrowers. This bailout is intended to save the financial firms.
The intention is to keep the crisis from (further) spreading to the rest of the economy. In other words, ultimate goal of this bailout is to save your job, not your house — Marc Fusaro.
A.The restructuring of Freddie Mac and Fannie Mae deal may help the average person by avoiding the meltdown of the mortgage market, which may bring the financial chaos and recession upon all of us. As unemployment rises and jobs are lost in the economy, those who struggle but still pay mortgages on time may default also. For the record: restructuring of Fannie Mae and Freddie Mac was attempted by the Congress several years ago. All Democrats in the Senate Banking Committee voted against it and the bill failed to reach the floor. We have to do it now under much more difficult circumstances. — Edward Zajicek.
A.If they have a mortgage, no effect. If they are trying to get one it will probably help. Freddie Mac and Fannie Mae are buying most of the mortgages being originated, and the government will increase that — Robert Bliss, business professor at Wake Forest University.
A.By assuming the debts of Fannie and Freddie, the government simply did what the market had always assumed that it would do, this is, not allow those who bought mortgage-backed securities sold by Fannie and Freddie to lose money. If the government had allowed Fannie and Freddie's creditors to lose money, it would have taken a very long time before money and credit would again flow freely in the mortgage market, and it would have damaged our nation's credit rating for some time to come — Don Jud.
A. The Fannie/Freddie bailout helps stabilize the current mortgage market, allowing people who wish to buy a home in the current market obtain financing to complete the transaction. It's important to point out that in the current mortgage market. Fannie and Freddie are purchasing about 70 percent of all newly originated loans created by the banking industry, which insures that banks will continue lending to credit worthy individuals because they can gain liquidity from new mortgage loans by selling them to Fannie and Freddie. If these government agencies were allowed to fail, many banks would simply stop underwriting mortgages, making it impossible for new home buyers to gain the financing necessary to buy a home. The absence of mortgage financing in the market would send residential real estate values into a free-fall, which would negatively affect the value of all of our homes. Thus, the bailout of Fannie and Freddie ultimately helps preserve the value of residential real estate throughout the United States, providing a benefit to everyone here who owns a home. — Tony Plath.
A. There are a number of arguments. One is that it will help people with mortgages and those seeking mortgages by providing downward pressure on interest rates. Lower rates would help those with adjustable rates mortgages and those seeking mortgages. Some other arguments sound much like those related to the other bailouts — providing confidence and stability in the financial markets — Todd Cherry.
How will the government pay it back?
Q. How does the government plan to pay the money back? — Submitted by Rod Joyce.
A.The assets acquired by the government will eventually be sold — and maybe the government, if it is lucky —will recover half of the $700 billion. The remainder will be a public cost ultimately borne by the taxpayer. — Michael Walden
A.There is a good chance that in the long run, these assets will be worth what the government pays for them. If that is the case, then this is not really a bailout, but rather, the government exchanging liquid assets for illiquid assets.
However, if the government pays too much for these assets, then as with all other government spending, the taxpayers will be on the hook. And since the money will be borrowed, the burden will fall on the next generation — Marc Fusaro.
A. There is talk of the taxpayers gaining an equity stake in the corporations they bailout via purchasing the distressed assets. This could ensure some of the value is retained by the taxpayer as opposed to transferring it to the corporations. This could lower the cost of the bailout to the taxpayer, but the initial funding will be borrowed like other deficit spending and will need to be repaid in a similar fashion.— Todd Cherry.
A. First of all, the government does not have the bailout money. It can only raise it by borrowing from the public and the foreigners willing to invest in U.S. Government bonds and then tax the rest of us (i.e., all of us who pay our bills on time) to cover interest payments — Edward Zajicek
A. The government will sell bonds to cover the cost of the bailout. This action will add to our national debt and raise the annual interest cost of carrying the debt. Because the government is able to roll over its debt when it comes due, it may never actually pay back the money that it borrows. We should remember, however, that the government may very well recover part of the cost of the bailout over time as the economy and the mortgage market recover. The bailout entails the government buying distressed assets from the banks, but the assets are not worthless. As the economy improves, the values of the assets will likely rise and the government may very well be able to sell the assets at a profit in the future. — Don Jud.
Who administers foreclosure and resale of homes in default when mortgages are securitized?
Q.When a pool of mortgages is securitized, who is responsible for the administrative burden of foreclosing on and then re-selling the homes under default? — Submitted by Pam Rogers
A. There is a servicing agent who will normally be a financial institution or some other firm which is responsible to see that the monthly payments are collected and distributed to the holders of the securities. This agent will have the power to enforce the terms of the loans, foreclosing and selling property if necessary. — Don Jud.
A. When mortgage loans are sold by the original lender into the secondary market where they are bundled together into a mortgage backed security, servicing the loans is either retained by the lender or sold along with the mortgages. The industry terms for this practice are "servicing retained" and "servicing released." Whatever entity has the servicing responsibility is paid a fee, which is part of the interest paid according to the mortgage document between the borrowers and the lender. Servicing can and often does transfer multiple times during the life of a loan. When this happens, the borrowers receive a notice from the new servicer instructing them to send payments to a new address. In addition to their record-keeping responsibilities, the loan servicer also handles delinquencies and the foreclosure process. Because servicers handle loans from all across the country, they usually hire local real-estate attorneys to administer the foreclosure process. — Nick Daves, director for the Center of Excellence in Financial Services at Winston-Salem State University.
A. It depends on how the servicing rights of the securitized package are structured. In most cases, the loan originator retains the servicing rights of mortgages that the bank originates (provided the loans are originated by a commercial bank), which means the bank originator continues to collect payments, send out past-due notices, and maintain escrow accounts associated with loans that are packaged and sold in the market. This allows the original mortgage lender to maintain a relationship with the borrower, so that the lender has the opportunity to sell other products and services to the borrower after the mortgage transaction is complete. In addition, the bank that owns the servicing rights collects a fee from the owners of the securitized loan package for providing these services.
When the originator retains the servicing rights, borrowers frequently aren't even aware that their mortgage has been packaged and sold by the original lender, since the lender continues to represent the loan just as if the bank still owned it. In this case, the originating bank would handle the foreclosure proceeding on behalf of the buyers of the securitized package. In cases where the servicing rights associated with packaged loans are sold to another financial institution in connection with the securitization transaction, then the new owner of the servicing rights would handle collection and foreclosure work in connection with delinquent loans in the package. — Tony Plath.
Is there a light at the end of this tunnel?
Q. In all honesty, relatively speaking, is there a light at the end of the tunnel or is the tunnel just getting longer? — Submitted by Rod Joyce.
A. No one knows for sure. The $700 billion is the Treasury's current best estimate of the funds needed to purchase the "bad" loans. But much depends on the direction of housing prices. The more that housing prices fall (in markets where they are dropping), the larger the problem becomes — Michael Walden.
A.The scary part is that nobody knows whether this is the beginning, middle or end of the crisis.
But that is exactly why Treasury Secretary Paulson decided that we need a large solution. Dealing with these failures on a case-by-case basis was not going to be sufficient. Hopefully this large solution will be the end. I just help the solution is temporary. Power you give to the government during a crisis is not power you want the government to have during normal times. — Marc Fusaro.
A. It depends what is meant by the end of the tunnel. It may make one tunnel shorter, but another longer. The bailout may bring the current financial market crisis to a quicker conclusion than otherwise — in the sense of re-establishing confidence and stability in the markets. However, the bailout adds to the federal debt, which likely extends a host of other problems because the additional debt will restrict our ability to deal with other pressing issues. — Todd Cherry.
A. Too soon to tell. It is not a tunnel. It is a panic. Crowds are hard to predict. Once it turns around it will take years to clean up the mess (losses, bad loans, etc). — Robert Bliss.
A.I don't think it is possible at this juncture for anyone to say with certainty that the bailout will make things better in three months, six months or even a year. What we can say is that without the bailout things are very likely to be substantially worse. Looking at the history of past financial crises, things have worked out much better when the government has lent money quickly to bailout troubled financial institutions and keep the volume of money and credit from drying up. If the money and credit are allowed to freeze up, we can be certain that we will have a very long and deep recession. — Don Jud.
A. The tunnel is indeed getting longer, but there is light at the end of it. If the government restricts the bailout plan to mortgages (and does not purchase delinquent car loans, credit card loans, business loans, etc.), it's important to remember that 80 percent of the loans in securitized mortgage packages are performing loans. That means these loans are not delinquent at all; they're simply losing value on bank financial statements because they are illiquid, rather than nonperforming.
Current accounting rules require banks to write down the value of these assets, in spite of the fact that borrowers continue making payments against them. If the government acquires these performing loans, and borrowers continue making payments against them, then taxpayers will recover their investment in these securities as borrowers continue to pay down their loans over time. Since the government doesn't have to mark-to-market the value of the distressed loan packages it acquires, it doesn't face the same sort of accounting losses that banks in the private sector face, and taxpayers can recover a portion of the total cost of the bailout over time.
It's going to take a fairly long period of time for this recovery to occur, however, since mortgage loans are long-term instruments and something like 20 percent of the mortgages the government is likely to acquire are indeed nonperforming loans. These nonperforming loans will present the government with a greater financial loss, even though the Treasury will recover something against our investment when it sells the real property mortgaged in these nonperforming loans. So, the magnitude of the bailout will be quite large, totaling around $1 trillion in nonperforming loans by the time it' finished, and the time period to recover taxpayers' investment is likely to be long, running around 10 or 15 years for complete repayment of the performing loans the government is likely to acquire in the bailout to occur.
We will all live through the current crisis, however; it's just going to take a fairly long time and a lot of taxpayer money to resolve it. — Tony Plath
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