I believe we never should have gotten to the point where we required a bail out. I believe it was clear as much as three years ago (and I’m probably being charitable) that we were headed to a major melt-down based on the quality of loans being made. The assumption that real estate prices would continue up indefinitely was an assumption made by fools. The adage that “if it seems to good to be true, it probably is,” is there for a reason. We have tried to pour too many social agendas into a market setting. Those things don’t mix well.

That said, I think that Congress has little choice regarding the bail out. Although every bone of my body says that free markets should be allowed to work, and that “bad guys” ought to pay the penalty for their misdeeds, the American and world publics have had their confidence shaken by the culmination of events over the past three weeks, beginning with rumors and working toward the actualities of company situations. Panic–and I think we’re close to it based on what I’m seeing in my client base–will cause irrational economic behavior among individuals and large institutions.

Irrational economic behavior is an enemy of stability. The American markets have been the best in the world because they have been stable. We cannot afford less.

The bail out plan, while not perfect and while repugnant in its philosophical underpinnings, is necessary to restore confidence. Confidence is our friend. Fear is our enemy. If we allow fear to remain much longer, the world markets will change in long term ways–in technical terms, the (perceived) risk (of investing) will increase; the cost of capital will increase; and the real value of assets will decrease, probably dramatically. In addition, good projects will go begging for money at the very time we can least afford that.

Putting a bail out plan into effect, quickly, is necessary so that confidence begins to be restored before fear becomes an inborn part of the equation as we make financial decisions. Decisive action is required. I think we’ve got to do the bail out, and quickly.

Dr. Forsyth: Thank you for taking the time to outline your concerns about our country’s financial crisis. I am always trying to research the financial markets to sharpen my understanding of what it all means. I then try to simplify my analysis for my clients’ consumption.

Here is an article I recently wrote (because I just had to vent)…

How to tell if Washington is serious of about fixing Wall Street

I was recently perusing a list of economic advisors for Senators Obama and McCain. I scanned the list very quickly, not wanting to see the full list because of wanting to write this article. I did however see one name on the list that only solidified my hypothesis. To be honest, I don’t remember and don’t care which of the Senators had this particular name listed. It doesn’t matter.

What really matters is who CAN’T be on the list and others that MUST be on the list and currently are not.

Let’s tackle the first point. Understanding that this current crisis was many years in the making, and by that I mean throughout a minimum of 3 to 4 Presidential terms, we first must get beyond partisan politics. The list of culprits and enablers is so long that we’re wasting time trying to parse it along party lines. What we need to concern ourselves with is the complete list – and banning tainted participants from “helping” us out of this mess. They helped create it, or at least enabled others to wreck havoc on our financial system. They cannot be part of the solution.

That being said, let’s get down to specifics. Banned people would include anyone from the following institutions (understanding that some entities no longer exist): Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Bear Stearns, Goldman Sachs, Merrill Lynch, Morgan Stanley, WaMu, Wachovia, Citigroup, JP Morgan and many others, but you get the picture. These firms helped create and enable an over leveraged, greed on steroids financial culture that is now threatening to crash the global financial system. They cannot be allowed to have their biased, self-serving opinions given weight by unscrupulous politicians.

The banned list must also include all those politicians that never took a stand to stop this insanity before it grew into the financial Godzilla that is now taking down institution after institution. That list would include many of the senators and members of Congress that fancy themselves as financial experts: For politicians, Barney Frank and Chris Dodd have to be on the banned list.

Now comes the good part. These are some of the people that MUST be included on the list of economic advisers to the candidates and/or included in the Wall Street rescue attempt. These are the elite fighting forces that called this party over many months ago, and for some, years ago. They also have no reciprocity ties to helping their buddies on Wall Street. If only Washington and Wall Street had listened to them back then. Now, they don’t have a choice.

One of the best is Nouriel Roubini. He is a professor at NYU and is a walking encyclopedia about the financial markets. He is very well respected and had the foresight to speak up about the perils that he saw coming, both in live TV interviews as well as published articles. He actually had one article in particular that gave us a sort of financial Armageddon roadmap, pretty much laying out exactly what was coming. Presciently, he has been dead on throughout the crisis.

Of Case/Shiller housing index fame we have Professor Robert Shiller from Yale. Not only did he call the tech bubble early (see his book Irrational Exuberance), but he called the housing bubble early as well!

Texas Congressman Ron Paul is another must have. For years, he has been pounding the financial pulpit trying to get Washington (including the Federal Reserve) to wake up to the calamity that was just around the corner. Some may be at odds over his political views, but at this point we shouldn’t care. He is one of the few politicians that actually understand economics and our monetary system. Get him in the game!

Former Fed Chairman Paul Volker is the only Fed Chairman in that last 30 years that did the unpopular but necessary economic crushing feat of raising interest rates high enough to crush the inflationary monster. Known around Washington as Tall Paul, he should be called on during our hour of need.

I understand there will be a need to have some Wall Street and banking types involved in this process. Our criteria should be they either were not involved with creating the residential housing crisis or they called it early, sounding alarms for the wise. There are a good number of them out there; maybe a complete list should be forthcoming.

Clearly, the need for strong fiscal leadership is upon us. As citizens and taxpayers of the greatest country on earth, we need to pay attention to everything going on in Washington during this crisis. Set aside some time to get knowledgeable about financial matters and the machinations of Washington. Stop enabling the politicians by pointing fingers at rival political parties. In this case, both parties have plenty of members who helped fuel this financial turmoil we find ourselves in. The faster the public can rise above partisan politics, the faster we can be on the road to financial recovery. Don’t allow Washington to bequeath this financial nightmare to our children.

Steve Rumsey
Portfolio Manager
Optimus Advisory Group

We have been told that we are in clear danger of a financial collapse by the same source who told us Sadam Hussein would soon detonate a nuclear weapon in New Jersey. We are asked to do something that fundamentally changes the way American Capitalism works and have been given a week to act. The proclamation, coupled with the short deadline, created the panic they were supposed to prevent, just as the earlier proclamation did with Iraq. The Republican Congressmen who managed to keep their wits this time deserve to be decorated as American heroes.

We are likely to join other developed economies who are already suffering another recession. Changing the underpinnings of our economy, toward more socialism, is not the appropriate way to deal with this reality. We survived the bursting of the dot com bubble and we will survive the bursting of the housing bubble. Many of us will suffer in varying ways. What does not kill us will make us better. I have many friends in Russia who assure me that socialism is not a desirable economic system. I believe they have expertise not shared by most Americans.

Regarding the consequences predicted by the Bush administration, I suspect they were dreamed up in the marketing department at Halliburton, the same source as the “mushroom cloud” predicted earlier. I give American’s far more credit than that. In the words of Yogi Berra, “it ain’t over till its over.”

Just Announced: Conference-Call Panel on America’s Financial Crisis (STARTS IN LESS THEN AN HOUR!)

Dear members of the Graziadio School community:

Please join us over the phone this afternoon for a brief prayer and conversation about recent economic events with a distinguished panel of professors.

Date: Tuesday, September 30, 2008
Time: 4:30 – 5:15 p.m. PST
Panelists: Joetta Forsyth, Ph.D., Assistant Professor of Finance Ed Fredericks, Practitioner Faculty of Finance and Portfolio Manager at East Wind Asset Management

David M. Smith, Ph.D., Associate Dean of Academic Affairs and Associate Professor of Economics

Moderator: Ronald D. Ford, Ph.D., Associate Dean of Executive Education and Practitioner Faculty of Finance

Dial-in Number: 703-259-9001; access code 292-198-438

Guests: Feel free to invite and share the access information with family, friends and colleagues

Steve Rumsey,

Don’t we all wish that we could pick ideal people to solve this crisis. The behavior behind this crisis is inexcusable. And your suggestions are very good ones. Unfortunately, we are stuck with the people we have now to solve this crisis. I believe that the risk of a financial collapse requires us to hold our nose and pressure the leaders that we have to put together legislation quickly.

Edward Fern,

You are voicing the feelings of many that we have been misled. Unfortunately, are we in the situation where the little boy cried wolf too many times? Is there really a wolf this time? I am afraid that there is.

Complex answers may be necessary to please the public who won’t understand them, but feel, nonetheless, that they are being “saved” by congress which created the problem in the first place. I have two simple answers, and the majority of the problem will dissolve in fairly short order: Pass HR25 and HR219. Either bill will far surpass all the proposals being argued these days in the hallowed halls.

If you want answers and not promises, look up these two proposals.

Professor Forsyth,

I am an Adjunct Professor currently teaching a course in Management Consulting on the Malibu campus. I read with great interest your blog.

I just wanted to share with you some of my thoughts based on the days of the RTC bailout of the 1990s which cost $160 billion initially. Back then, we were hired by the RTC and helped package the loans by putting together all the supporting documents for the loans being sold. The investors hired due diligence teams (accounting and consulting firms) that would analyze the packages and then make a sealed bid. Auctions were run by other accounting firms or investment banks like Drexel Burnham. The buyers were largely I-banks and large funds.

Based on that experience, I put together 12 questions, most of which need to be addressed at a micro-level.

1. Oversight is considered to be an important function—what organization within the government (or outside of government) has the qualifications to provide oversight over the process, keeping in mind that most of the individuals who have experience in this area until now (SEC, PCAOB, FRB, OTHEO, AICPA, Big 4 Auditors) were either directly or indirectly involved the failure of the system.
2. In the bail-out involving the RTC over 15 years ago, most of the mortgages at the time were not packaged to be securitized and then relentlessly divvied up into multiple pieces (tranches, as the experts like to say). Has Congress identified a way to gather every single piece of the loan instruments back into their original pieces, and if not, how will any deal work without all the pieces to the puzzle?
3. Assuming that Congress can collect all the pieces together, has anyone worked out the logistics of how these loans will be remarketed into the financial markets? Will they first be sold to a firm that will either foreclose on the properties or restructure the payment terms, or will there be an interim firm that will act as a “cushion” by buying the loans in bulk, and then taking action?
4. If an intermediary were to be involved, given that there are no more major Investment Banks surviving, who will the buyers be—Private Equity Funds, Sovereign Funds from the Mid-East and Asia, or are there other sources?
5. Will the Sales of the Loans be performed as bulk sales in sealed bid auctions, and if so, who will be running the auctions? Who will be preparing the packages necessary for investors to review the details and the qualities of the assets? Will these be the very same players (accountants, lawyers, bankers, investment bankers) who were involved in the problems?
6. Since these types of Funds typically require a return of 30% on their investments, will they be purchasing the assets at substantial discounts from whatever the Government is willing to pay to take the assets off the banks’ balance sheets?
7. The bail-out plan will presumably cover a few million mortgages (perhaps 3-4 million given an average value of $200,000 to $250,000). Who will be servicing the loans while the government is holding the assets, and will the servicers be looking at a new boss?
8. Many of the values of the underlying assets are substantially deteriorated, and there is no real mechanism to determine whether the $700 billion value is appropriate. Will the government send out appraisers to re-appraise every home, or conduct a massive ‘desk-top’ guestimation of values?
9. Appraisals of homes typically cost $300-$500 per home for a simple one page appraisal. If the loans are renegotiated, the terms will need to be modified and re-recorded, resulting in escrow and title fees (a few thousand dollars). All the changes in documents will result in legal costs. Foreclosed homes will result in additional costs and fees, not to mention brokerage commissions when resold. Is it the goal of the government to pump money in these real-estate service sectors as part of the plan?
10. The greatest underlying issue coming from the housing crisis is uncertainty, which has led to the inability of organizations to make decisions. How exactly will decisions be made as to how assets will be disposed, and how will Congress ensure that any major decisions are made with proper authority, and what are the qualifications of the people who will be hired to execute the plan?
11. The country is interested in a deal that makes sense for the majority, not just for a limited number of people or corporations. But the success of the plan often lies in the details. Placing blame is a non-starter, but hiring those who were involved in the mess also seems to be a problem. Can an executive who’s financial institution is being bailed out quit, start his own company and make millions? If we block tainted, but talented people, will there be enough people who can manage the bail-out?
12. Does this plan have to happen this week, or can it wait until after the election, or even until January?

In the end, I concur that the current plan, however flawed, adds an element of certainty to the markets that is essential to calm the rampant fears.

Reports are now coming in that the automotive sector is also falling off the cliff. I wonder if GM will be the next bailout target.

Joseph Lee
Adjunct Professor

Professor Lee,

Thank you for adding your first-hand experience with the last bailout into the discussion. I will comment on your questions below.

1. Oversight is considered to be an important function—what organization within the government (or outside of government) has the qualifications to provide oversight over the process, keeping in mind that most of the individuals who have experience in this area until now (SEC, PCAOB, FRB, OTHEO, AICPA, Big 4 Auditors) were either directly or indirectly involved the failure of the system.

RESPONSE: This is a very serious problem, of which I do not see an easy answer. Compounding this is the fact that just about anyone is going to have conflicts of interest.

2. In the bail-out involving the RTC over 15 years ago, most of the mortgages at the time were not packaged to be securitized and then relentlessly divvied up into multiple pieces (tranches, as the experts like to say). Has Congress identified a way to gather every single piece of the loan instruments back into their original pieces, and if not, how will any deal work without all the pieces to the puzzle?

RESPONSE: It’s a horrible mess. No one is completely sure who owns what. And it’s compounded by the fact that often when mortages were sold off to be securitized, the issuer had to agree not to alter the terms of the loan. This means that banks have their hands tied when it comes to giving borrowers relief. It is not clear that a government agency will be able to pull all the pieces together, which will be needed to relax those restrictions. (All holders of a CDO have to agree to have the restrictions relaxed.) However, leaving these CDOs in the hands of a disparate group wouldn’t make the task any easier.

3. Assuming that Congress can collect all the pieces together, has anyone worked out the logistics of how these loans will be remarketed into the financial markets? Will they first be sold to a firm that will either foreclose on the properties or restructure the payment terms, or will there be an interim firm that will act as a “cushion” by buying the loans in bulk, and then taking action?

RESPONSE: I don’t believe this has been worked out. Many details are still left to be resolved.

4. If an intermediary were to be involved, given that there are no more major Investment Banks surviving, who will the buyers be—Private Equity Funds, Sovereign Funds from the Mid-East and Asia, or are there other sources?

RESPONSES: It remains to be seen who will be left with the funds and inclination to buy. An important question is, at what price will the government buy these securities? This will in turn determine to what extent buyers can make a profit. Of course, the higher the price the government pays to buy the securities, the more tax payers are hurt, but the safer banks are, and the more buyers will be able to come in and take the securities off the hands of the government.

5. Will the Sales of the Loans be performed as bulk sales in sealed bid auctions, and if so, who will be running the auctions? Who will be preparing the packages necessary for investors to review the details and the qualities of the assets? Will these be the very same players (accountants, lawyers, bankers, investment bankers) who were involved in the problems?

RESPONSE: I believe this still needs to be worked out.

6. Since these types of Funds typically require a return of 30% on their investments, will they be purchasing the assets at substantial discounts from whatever the Government is willing to pay to take the assets off the banks’ balance sheets?

RESPONSE: I don’t believe this has been worked out.

7. The bail-out plan will presumably cover a few million mortgages (perhaps 3-4 million given an average value of $200,000 to $250,000). Who will be servicing the loans while the government is holding the assets, and will the servicers be looking at a new boss?

RESPONSE: These CDOs specified who would be servicing the mortgages. I am not aware that someone else will be appointed to service them.

8. Many of the values of the underlying assets are substantially deteriorated, and there is no real mechanism to determine whether the $700 billion value is appropriate. Will the government send out appraisers to re-appraise every home, or conduct a massive ‘desk-top’ guestimation of values?

RESPONSE: My impression is that with the reverse Dutch auction, the government is simply letting the bidding process decide it, where it is assumed that the worst of the lot will be offered up for sale to the government at the lowest prices.

9. Appraisals of homes typically cost $300-$500 per home for a simple one page appraisal. If the loans are renegotiated, the terms will need to be modified and re-recorded, resulting in escrow and title fees (a few thousand dollars). All the changes in documents will result in legal costs. Foreclosed homes will result in additional costs and fees, not to mention brokerage commissions when resold. Is it the goal of the government to pump money in these real-estate service sectors as part of the plan?

RESPONSE: I have not heard that they want to prop up these entities, although it is entirely possible.

10. The greatest underlying issue coming from the housing crisis is uncertainty, which has led to the inability of organizations to make decisions. How exactly will decisions be made as to how assets will be disposed, and how will Congress ensure that any major decisions are made with proper authority, and what are the qualifications of the people who will be hired to execute the plan?

RESPONSE: They are working this out. Unfortunately, it looks like private companies in the finance industry will be involved due to their expertise, who can’t help but have conflicts of interest.

11. The country is interested in a deal that makes sense for the majority, not just for a limited number of people or corporations. But the success of the plan often lies in the details. Placing blame is a non-starter, but hiring those who were involved in the mess also seems to be a problem. Can an executive who’s financial institution is being bailed out quit, start his own company and make millions? If we block tainted, but talented people, will there be enough people who can manage the bail-out?

RESPONSE: This will be the next big issue.

12. Does this plan have to happen this week, or can it wait until after the election, or even until January?

RESPONSE: I am not a political scientist, but I suspect that they won’t actually start buying CDOs and mortgages until after the election. This entire process has been severely tainted by politics.

And now after the bailout has pushed through we are facing round two of this problem. All the questions you asked and answered are being asked all over again regarding the disbursement of the second half of the bailout money.

There seems to be a need for clarity and cohesion with respect to the bailout, considering the gravity of the situation. There is none of either yet.

It seems to me that ‘politics as usual’ is carrying the day. There is no cohesion of message between parties, levels of government or other “experts”. This is adding to the uncertainty.

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Undoubtedly, the United States is facing the greatest financial crisis since the Great Depression. The mindset of working people couldn’t help but wonders “What’s the next woe and where’s it” in these days of financial instability. Especially those aged 40 years old and above. Not just the Americans … it is the same in Europe and Asia. When will it be over and our money can increase safely and yearly … just like before?