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We’re a month into the Obama Administration and still looking for a way out of both the banking and housing crises.  TARP didn’t seem to work.  The new housing plan hasn’t been well received, though frankly we don’t have all the details yet.  The good news is that Washington has been asking for suggestions, though without giving out any clear method for submitting them.  So as a blogger I’ll just hold up my hand and say, “Call on me, Mr. Obama, me, me!  I have an answer!”

And I do, or at least I think I do.

You’ll note this is my third try at such an answer since Washington didn’t pick up and run with ideas one or two.  But I’ve got a million of them, folks, so here’s Plan Number Three, called the Not-So-Bad Bank.

It might be good to start with some analysis of why what we’ve done so far hasn’t yet been broadly perceived as working or even enough.  

You could get Rush Limbaugh and his two cousins in a room and even they would say things have not yet started to get better and are probably getting worse.  One reason for this might be that we simply haven’t allowed enough time.  That’s probably true for results, but not for perception.  Nobody’s saying, “Well we’ve taken care of that one, now what about health care or Social Security?”  Nope, we’re still stuck on banking and housing.  It could be we simply haven’t done enough — not allocated enough money.  It could be that what we’ve done so far were the wrong things to do.  All of these possibilities are discussed in the press every day.  What isn’t discussed, I think, is that we may have the wrong attitude.

The financial world, especially, has ways of doing things, and the number of approaches they’ll generally consider to ending a recession is deliberately limited — limited by what are perceived to be the available tools and limited, too, by how the financial establishment sees itself.  These are proud people who think of themselves as smart and on top of most any situation.  Tom Wolfe called them Masters of the Universe and they like that image.  The problem is that now we’re in a situation none of them (or us) have been in before and we (they) are limited by both lack of experience and by the way we see ourselves.  This is why, for example, banks accept Federal bailout money then don’t lend it.  It’s also why our government gives Federal bailout money then doesn’t attach conditions.  That’s not what they do.

Well maybe it is time to start doing things a little differently.  It is time to start looking at the fundamental processes of this financial engine in a new way.  That is done all the time for profit, of course.  Every time a new derivative security is announced it is some company’s way of grabbing a little errant profit they sense in the market — it is a new way of doing business.  New stuff in that context is considered good.  I just think we need new stuff in EVERY context to track down the causes of our problems and fix them.  Alas, when it comes to that sort of behavior the financial establishment gets a lot less creative.

To this point we as a nation have come up with three ideas about how to help the banks: 1) buy their bad mortgage securities; 2) invest lots of money in them to build their capital bases, and; 3) preserve them at any cost as being too big to fail.  These are perfectly fine ideas, but I think we’re limiting ourselves far too much when it comes to exploring how they might work.  We can be smarter and will have to be smarter before the day is over.

My idea involves only the first of those three parts, buying the bad mortgage securities, the so-called “toxic assets.”  I think this is a valid thing to do but by limiting our view of it to how it helps the banks is keeping us from reaping the benefits this process could afford to all of us.

The way most pundits expect the toxic assets to be bought up is through the creation of what’s called a “bad bank.”  The Resolution Trust Corporation (RTC) was our band bank the last time we went through something like this during the 1980s Savings & Loan crisis.  The RTC bought bad assets of those many S&Ls and slowly resold them into the marketplace as houses were sold and mortgages were refinanced.  Though it took 15 years to do so, the RTC eventually got rid of all those toxic assets and even made a small profit, too, by holding those assets effectively to maturity. It was a low-risk process but low reward, too, because it took so long.

That’s the archetype for this next Bad Bank; buy up the toxic assets and dribble them back into the market over time.  The one big issue that’s keeping such a bad bank from being created is deciding what price to put on those toxic assets.  The banks want the government to take all the risk and bear all the cost so they’d like to sell their toxic assets for 100 cents on the dollar, please, which is lunacy since such securities are selling now on the open market (when a buyer can be found) for 15-20 CENTS on the dollar.

If the Obama Administration follows recent tradition, they’ll give the banks a good deal.  This is bad in that the cost will be higher but good in that the Credit Default Swap market will be helped and those costs, at least, will be lower.  So I can see reasons to do it both ways, though frankly I’d like to see these bankers and insurance companies pay a bit for their folly.

The problem with the bad bank scenario is that it does nothing – nothing at all – to help homeowners.  Bad banks just help banks, not people who own houses, which is why I think we need a Not-So-Bad Bank  (a term I just invented) that will help the banks AND homeowners.

Here’s how it works.  The so-called toxic assets bought by the bad bank are, for the most part, bonds called Collateralized Mortgage Obligations or CMOs.  These were created originally by pulling together a huge pile of mortgages about $100 million high and chopping that amount of debt into various classes of principle and interest and risk amounting typically to 4-5 different types of bonds that were sold to institutional investors.  CMOs are types of derivative securities, many of which are protected by Credit Default Swaps (CDS’s), another class of derivative securities sold usually by insurance companies like AIG.  That $135 billion given to AIG to keep it afloat was to cover bad bets of CDS’s, remember, because the CMOs were going down in price, homeowners were defaulting in high numbers, The banks were being forced to mark the asset value of their CMO’s to that depressed market value (mark to market)  triggering claims against the CDS’s, which turned out to be a VERY bad bet for the insurance companies.

One thing important to remember about CMOs is that, as the banks continually explain, they are so complex and so dispersed that there is no way to put them back together again prior to maturity.  Can’t be done.  And since politicians are particularly stupid when it comes to math (being only able to understand deficits, it seems), they buy this argument, which is supported to some extent by experts at the Treasury and the Federal Reserve who I think, frankly, identify maybe a little too closely with the bankers.

The fact is that Wall Street has all the time had the ability to put those CMOs back together again, just like Dorothy was all along able to return to Kansas by simply clicking her heels.  Computers are very good at keeping track of deals like CMOs and they have to because – contrary to what the bankers and brokers tell us — CMO’s are put back together again all the time. This happens every time a mortgage is retired either through the sale of a house or a refinancing.

CMO’s were invented in 1973.  That date stems from the arrival of several market conditions, one of which was having the available technology to both create CMO’s — to tear apart and securitize the mortgage pools — AND TO KEEP TRACK OF ALL THE DISPERSED BITS FOR REPAYMENT.  If we could do it in 1973 we can do it EASILY today and the fact that we are continually told that it is difficult or impossible probably represents either ignorance, institutional inertia, or someone not really wanting to try. 

Think about it: you’ve sold your house, the mortgage is gone (repaid), so the CMO, which is where the mortgage debt obligation actually lies, has to have been repaid, too — every little bitty piece of it, held in different proportions by at least four different bondholders. And as long as there have been CMOs it has been thus.

The funny part is that what is supposed to be impossible happens so easily and so often.  A typical CMO deal involves about 10,000 mortgages, the bank knows the shelf life of those loans is three years, which means they get paid off or adjusted after the first year at about 5,000 loans-per-year or around 15 loans-per-day.

So the CMO that was so dense as to be indecipherable is actually deciphered 15 times per day after the first year.

It takes time and effort on the part of mortgage servicers to figure out CMO’s and it costs them money.  That’s one reason why they want a pre-payment penalty if you pay off your mortgage in the first year. 

Understanding all this, let’s now go ahead and fix the system by first figuring out how to price the government purchase of those CMO’s.

If President Obama wants to be a good guy, which he will if he’s planning on having a second term, he’ll come up with some plan that doesn’t hurt the banks too much, doesn’t hurt the insurance companies too much, oh and by the way maybe even helps homeowners.  That smooth move would be to create a Not-So-Bad Bank (NSBB).

This has to be done by Congress passing a law creating the bank and giving the bank certain privileges and responsibilities, one of which is the ability to buy-up CMOs, not one bond coupon at a time, but as entire offerings, which would be recaptured and redeemed en masse.  Congress can require this by passing a law, but of course the issue is still what price to offer for those typical $100 million (at issuance) CMO deals.  The banks want the price to be $100 million.  The free market says the CMOs are worth maybe $20 million.  Let’s split the difference and have the NSBB pay $60 million.

This price accomplishes three important things.  First, it finally sets a price so the secondary CMO market can get moving again.  The price is set is high enough that though CMO investors lose something they don’t lose everything.  It’s high enough, too, that insurance companies don’t have to pay so much to cover those CDS’s.  Everyone hurts a bit but nobody dies.

Now we have an entire CMO offering held by the NSBB at a value of $60 million.  This type of transaction would be done over and over again, buying-up deal after deal, though it wouldn’t have to be done for all CMOs because the secondary market would have been unfrozen through this government action and private trading of CMOs resumed with a noticeable firming of house prices as a result. 

Let’s assume that the NSBB uses $50 billion or more tax dollars to buy-up CMOs at 60 cents on the dollar, which reflects less the market value of the securities and more the market value of the underlying assets or collateral, the homes.

With a normal bad bank now would begin the painfully slow process of waiting for people to sell their houses or refinance so the government can get paid back and eventually even make a profit on its $50 billion investment.  Remember this process took the RTC about 15 years to complete.

But we don’t have a bad bank, we have the Not-So-Bad-Bank, which operates differently.  Relying on another clause in the law passed to establish the NSBB, the bank has the right to call all the mortgage loans connected to its CMO portfolio, to force them to be refinanced all at the same time.  No waiting for people to sell their homes or refinance on their schedule, in this case the government says to do it NOW.

Using as an example this one CMO deal for 10,000 mortgages, that would mean 10,000 refinancings all at the same time.  Is that bad or good?

Well it turns out to be very good for at least a couple reasons.  There’s an opportunity here for economies of scale and for mortgage arbitrage. Doing the numbers we can see that the NSBB owns the CMO deal for $60 million or 60 cents on the dollar.  So the NSBB turns around and forces all the homeowners to refinance at 70 cents on the dollar, the difference between those two numbers being the NSBB’s gross profit or about 13 percent.

We’ve already given the banks and insurance companies a survivable level of pain by redeeming the CMOs at 60 cents.  Now we give the homeowners a break, too, by forcing them to refinance at 70 cents.  If they owed $100,000 on their old mortgage, on the new one they’ll only owe $70,000.  Most loans that were under water will be dragged to dry ground by this action because it affects only the loan balance, NOT the value of the house.  People will owe less, their houses will be worth the same or more, so their equity — which may have been negative — will now suddenly be positive, making it easier to qualify for Fannie, Fredd, Gennie, VA, or FHA refinance loans.  And because those loan balances are all 30 percent lower the payments will be 30 percent lower, too, making the homes more affordable to own. That’s homeowner relief.

Lower payments and higher equity will lead to lower default rates, avoiding the current mortgage restructuring problems that appear not to improve default rates at all.

The best part about this process from the standpoint of the NSBB is that those mortgages can be then resold in the secondary market or aggregated by outfits like Fannie Mae or Freddie Mac, freeing up the NSBB capital to be reused immediately to buy and retire more CMOs and refinance more mortgages.

Running on a 90 day buy-call-refinance cycle, the NSBB could reuse its capital four times per year and within a couple years (not 15) be out of business, having shown a substantial profit that would go back into the Treasury.    

The Not-So-Bad-Bank would work better than a Bad Bank.  It costs less money, helps firm house prices, gives relief to homeowners, and tempers the distress of banks and insurance companies.

Why not give it a try, Mr. Obama?

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Go to the bank, any bank, and try to buy a house or refinance your current mortgage.  Most people who go to the bother of applying for a loan think that they have a chance of receiving one.  But approvals right now are running nationally around 35 percent.  So the odds against you being approved are 2-to-1.  And even if you can get the loan, it will end up costing you more than you expect – sometimes a LOT more.

Interest rates are down, we’re told.  A couple weeks ago rates were at a 27-year low. Since then published rates have drifted up by about half a point for no stated reason, but we can guess it is mainly because banks want to limit the number of refinance application. The best way to do that is to make loans more expensive, no matter what the Fed has done. 

Remember those 35 percent approval levels look even worse to the banks, which have time and money invested in three loans for every one that goes through.

But the worst news right now is that loans are generally more expensive to get than is indicated by published interest rates.  It turns out there are lots of hidden fees in these new loans and many of those fees come not from your bank or mortgage company (though they tend to add theirs, too) but from parties like Fannie Mae.

Hey, now that Fannie Mae is effectively nationalized, along with Freddie Mac, aren’t those companies supposed to be the very instruments through which the federal government will act to save us from this current mess?

No.

Fannie Mae, for one, is piling extra fees onto those historically low rates making them not so cheap at all.  The operant phrases here are Loan-Level Price Adjustment (LLPA) and Adverse Market Delivery Charge (AMDC).

AMDC is the easy one.  If you live in a community considered to be an Adverse Market, which is pretty much all of California and Florida for two examples, and you try to get a new loan, AMDC will throw a 0.250 percent charge on top of the loan amount.  That’s a quarter of a point or $250 per $100,000 just because of where you live.

Is that even legal?

LLPA is much more complex but works the same way, adding points to the loan – even to supposed “no points” loans.  Want a smaller down payment? That will be an eighth of a point, please.  Have multi-unit property?  That’s a point.  Have investment property?  That’s 1.75 to 3.0 points depending on the loan-to-value.  Want to take cash-out? That depends on your loan-to-value and credit score but will run from 0.25 points all the way up to 3.0 points, depending.  Want a smaller loan? That will be from an eighth of a point up to 1.5 points, again depending.

And all these fees are cumulative.

Let’s say, then, that you bought your house in Florida three years ago for $170,000 with 10 percent down on a 30-year fixed-rate mortgage at 6.875 percent.  While your house appeared to appreciate after you bought it the market has since tanked and your property is worth five percent less than you paid for it.

Now let’s do the numbers.

The house you paid $170,000 for three years ago is now worth $161,500 and your loan balance is $151,000.  Compared to a lot of Florida properties that’s pretty good.  At least your property is above water – you have positive equity of $10,500 from your residual down payment and the $2000 you paid down the loan principle in the last three years.

You want to refinance your $151,000 balance to take advantage of super-low rates of 4.875 percent that you saw in the newspaper – a whopping TWO PERCENTAGE POINTS less than you signed for only three years ago.

But wait, you live in Florida; that’s a quarter point added to the loan balance for AMDC.  The base rate is 4.875 percent, but to get a 30-day lock on that will cost you another 0.875 points.  The only way to get the 4.875 rate is to take a chance that it won’t change by the time you close.  Your FICO score is 660 and your loan-to-value is above 90 percent, so that’s another 1.75 points.  It’s a good thing you don’t need cash out or that your credit score isn’t 659 – you don’t even want to know what those would cost.  Finally, your loan amount is under $164,999 so that will cost you another eighth of a point.

Okay, we’re done, so let’s add it up 0.250+0.875+1.75+0.125=3.00 points or $4,530 added to your “no points” loan. If you don’t have the cash to pay this fee directly it gets rolled into the balance of the loan, which goes from $151,000 to $155,530.  And that $10,500 in equity you so proudly retained is now down to $5,970 and you still haven’t paid for an appraisal or any of the other fees mandated by folks other than Fannie Mae.

Uh-oh!  Financing $155,530 on a $161,500 property is a loan-to-value of 96.5 percent!  Fannie Mae won’t go over 95 percent.  Even though the additional dollars are going straight back to Fannie Mae in fees, it doesn’t matter.  LOAN DENIED.

It happens every day.  FHA loans are somewhat easier to get because they’ll finance up to 97 percent, but the same sort of fees apply.  This isn’t your bank doing this, it is Fannie Mae.  These aren’t numbers I made up, either they are taken directly from the January 8th rate sheet of a national lender and confirmed against the Fannie Mae Selling Guide for the same date.  And here’s the worst part: these fees are going to get even higher!  Fannie Mae has a new fee schedule going into effect as of April 1^st that will charge even more.

Hey, these are mindless bureaucrats just slowly doing their jobs.  Many of these charges were in the works long before the current financial crisis.  But if that’s the case, why haven’t they been adjusted?  Good question.

So if you wonder why you can’t get a good loan despite record low interest rates, this is probably one of the reasons why.

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We’re in trouble and by “we” I mean the whole darned planet. What started as a mortgage problem in the U.S. has blown into global financial paralysis that threatens us all with recession and maybe even with depression. I know I’m feeling depressed, how about you? The crisis seems immune to any and all efforts to fix or end it. NOT passing a $700 billion mortgage bailout can send Wall Street into a tailspin, for example, but then finally passing the bailout didn’t seem to improve things, either. The Federal Reserve and Treasury Department are running out of tools and time yet still the system flirts with suicide. So I say it is time to take a completely different view of the problem and to look to a new leader to solve it, in this case Jack Welch.

Jack Welch is the retired chairman and CEO of General Electric who took the company during his 23-year tenure from being worth about $14 billion to about $410 billion by really MANAGING the business and concentrating on creative use of capital. I’ve written columns and columns deriding managers as a profession but none of that applies to Jack Welch and GE, where managers really manage — they manage the heck out of the place and to generally good effect. Jack Welch built that system, he has time on his hands, I say let’s give him a new job.

There is very little difference, in fact, between the global financial system and General Electric. Welch saw GE entirely in terms of cash flows and the application of capital to those parts of the business where it would do the most good. Welch also thought in terms of continuous quality improvement, which is virtually unknown on Wall Street OR in Washington, where such things aren’t even talked about, much less measured.

I’ve been thinking about this crisis and a lot of it comes down, I believe, to a fear of failure especially on the part of the banks. There is no credit available to anyone, anywhere, no matter what the credit rating or score. This is because the banks are frozen by fear to the point where they won’t even lend to each other much less to customers. This fear of failure seems to be pretty much guaranteeing failure. And the regulators are now throwing what will soon be trillions of dollars at trying to break these bankers out of their paralysis. But I think there is a better way: use this very fear of failure as a motivator.

Before we get to Jack let’s deconstruct this current psychological crisis on the part of the banks. They aren’t lending money because they are afraid it won’t be repaid. They won’t lend even to each other because banks seem to be failing all over yet there hasn’t been an instance yet when an overnight loan has resulted in default. So what’s the problem? More properly, what is the outcome the banks fear?

They fear going out of business either through honest failure or through being forced to merge or having their deposits taken away by the Federal Deposit Insurance Corporation (FDIC). In short it comes down to fear of losing their licenses, because as a highly regulated industry the banks can only do business at all with the permission of government. Right now they are totally fixated on the idea that if they lend money and it isn’t repaid the government will pull their licenses. Yet the government has made it clear that the most important thing is to LEND MONEY, breaking this credit paralysis. All the banks know this but none of them want to be the first to take the big risk of lending money.

You do it! No, you!!

Enough of this crap. What if Jack Welch was the U.S. banking czar? We know the result of all such crises these days in the U.S. is the appointment of a czar — a new government official drawn from industry and charged with cutting across agency lines and streamlining an ultimate solution. We did it in energy and terrorism and I’m sure we’ll do the same thing now so let’s just think ahead a bit. Let’s assume that’s the case here and that whatever President is in office names Welch. What would Jack Welch do?

If Welch ran the U.S. banking system like he ran GE, he’d kill the bottom 10 percent of banks every year and fire the lowest 10 percent of bankers.

What impact would that have on the system? Would it make it better or worse? Well it couldn’t be worse, could it?

Doctors have a way of measuring pain. It seems our brains can only focus on one pain source at a time, so if you have a pain in your gut you really don’t notice the pain in your ankle. So there is a device called a palpometer that goes on your arm or leg and is calibrated to produce standardized and replicable levels of pain. Put this gizmo on, turn up the pain, and when you get to the point where the patient suddenly goes from saying, “My head hurts,” to “My leg hurts,” then you know how much pain they are in.

This was all pre-waterboarding mind you.

Right now all the bankers are afraid to lend money because they are afraid of failure. As the new banking czar Jack would much rather have them be afraid of HIM. If the bottom 10 percent of bankers were fired every year and the bottom 10 percent of banks had their branches and deposits redistributed, wouldn’t they be more afraid of THAT than of making bad loans? Their motivation would still be to make GOOD loans, but the penalty for making NO loans would be there, too.

Our problem then is that we’re throwing money at something we should be handling using a different regulatory tool — licensing.

U.S. bank regulators should go to all the banks this afternoon and say, “You aren’t making loans, which is part of the definition of what it is to be a bank. If you aren’t acting like a bank by tomorrow we’ll take away your banking license and transfer your deposits to another bank that WILL make loans.”

Problem solved overnight.

It’s only one part of the problem, of course, but this solution will cost a lot less than $700 billion. It will cost nothing.

And if you think it won’t work, then you don’t know Jack.

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       My mortgage is a 5/1 ARM, which is a type of Adjustable Rate Mortgage where the interest rate is fixed for the first five years then can adjust once each year thereafter.  I got the mortgage when I bought my house in July 2004.  My initial interest rate was 5.375 percent, but the five year anniversary is coming in July of 2009 and that’s what has me worried.  Now that my WAMU mortgage is going to be owned by JP Morgan Chase, are they going to adjust my rate so high that I can’t afford the monthly payment?  Probably not.  But my mortgage is a jumbo (bigger than the FHA would touch under the old rules) and nobody seems to be approving jumbo mortgages these days, so I am feeling vulnerable.

       Ironically, I might have been better off with a worse loan.  You see my mortgage isn’t technically sub-prime OR Alt-A, the two nefarious loan classifications where homes seem to be foreclosing at a furious rate.  JP Morgan Chase just announced a program to convert THOSE loans to fixed-rate with lower payments.  But not mine.  Bummer.

       Right now, by the rules of my loan, I should just sit tight and let it readjust.  And that’s what I’ll do except I just don’t trust the lender.  I know that if any mortgage can get screwed-up it will be MY mortgage.  So that’s why I need to learn all I can to be ready to refinance BEFORE the reset in July, just in case.

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Insert money, flush, repeat.

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