The McCain Mortgage Proposal Implodes, Court Action on Mortgages and Bailouts, and the Fed Rate Cuts

Per CNN “To qualify, homeowners would have to be delinquent in their payments already, or be likely to fall behind in the near future. They would have to live in the home in question - no investment properties would be eligible - and have had demonstrated their credit-worthiness when they purchased the property by making a substantial down payment and by providing documentation of their income and assets - no liar loans.”

As I noted before the Congress in July created Hope for Homeowners per the FHA which was expanded in the new Rescue Law and is now up and running has a universe of 400,000 people nationwide. The FHA is already insuring large amounts of no-money-down mortgages right now and more than 66,000 of the mortgages backed by the government in the first half of this year, or 36.7%, were "seller-funded" (as opposed to funded by the home buyer), according to Forbes, these are 66,000 people McCain would throw under the bus and would not have mortgages under his proposal who have them now.

So, how many real people there are who would qualify under this version of the Straight Talk Express? It is probably quite small. The real people this would help are mortgage lenders who did bad things because of the payment of the face value market price paid for the asset.

Payment for any asset in this situation has to have two goals: (i) stop the bleeding and (ii) prevent the problem from happening again by imposing moral hazard. It is important that the principle of moral hazard be observed. When Congress crafted the own landmark housing bill which became law July 31 and took effect Oct. 1 it addressed “moral hazard” while McCain does not. When Hope for Homeowners was adopted to participate, lenders and mortgage investors have to reduce the mortgage principal, thus taking a loss on the loan. To make sure homeowners are “in the game”, the law requires them to share any future profits from the resale of their homes with the government. That is incidentally a defacto “deficiency judgment” on the upside.

The idea is to help people but at a cost to avoid the problem down the road. Congress got it right in July. Senator McCain instead wants to pay face value. To do what McCain wants would cost as much as $1.2 trillion dollars.

As noted in the Guardian, this was a flip-flop by McCain. I read the one page summary of this on McCain’s website and there is no mention of deficiency judgment.

On the litigation front, Mr. Russo reported on Tuesday that Jerry Brown and B of A reached a Countrywide settlement agreement. While this new program comes with an alleged price tag of $8.4 billion this “cost” is much less than foreclosing on homes en masse – and lowers the cost of the McCain proposal. B of A by making 400,000 people happy also adds potentially 400,000 new depositors. Assuming each person has over the course of the year 20,000 in a B of A account under reserve banking B of A is way ahead of the game and it can get interest on these reserves now under the new rescue law.

While B of A shares declined on Monday after the company announced a 68 percent drop in third quarter profit and said it would halve its dividend, B of A sold $10 billion shares of common stock which sold out quickly. I should add that if B of A does this correctly – and the Treasury has any brains – B of A can resell a lot of these redone mortgages into TARP for cash.

On another litigation front, as I indicated last week, Citigroup tried to buy Wachovia [and this has political implications in terms of North Carolina’s electoral votes because as it has tried to diversify it’s economy NC has become a major banking area] and Wells Fargo then made a counter offer. Citigroup then sued Wells and Wachovia claiming that there was an exclusivity agreement that barred Wachovia and Wells from doing any deal. Citigroup was suing Wells Fargo and Wachovia for more than $20 billion in compensatory damages and more than $40 billion in punitive damages.

I do not know on what basis Citigroup is proceeding in New York against Wachovia on a tort theory because as the California Supreme Court noted in 1994 in Applied Equipment Corp. v. Litton Saudi Arabia Ltd. (1994) 7 Cal.4th 503 – New York case law is explicit that a party to a contract cannot be sued in tort for conspiracy to interfere with that contract. In any event, Citigroup obtained an initial injunction in New York State Court which was overturned by New York State Appellate Division [our Court of Appeal in California]. There is now litigation in North Carolina state courts and United States District Court.

In the case of Wachovia, the apparent basis for liability was for breach of contract. In most jurisdictions – including California – you cannot sue in tort another contracting party for the tort of inducing a breach of contract. One way around this in this State was to use civil conspiracy in tort for conspiracy to interfere with its own contract until the California Supreme Court shut down this tactic in 1994 in Applied Equipment Corp. – a decision I agree with. The reason is that conspiracy is not a cause of action, but a legal doctrine that imposes liability on persons who not actually committing a tort themselves share with the immediate tortfeasors a common plan or design in its perpetration.

In this state – and our firm used this several times – the main reason for using the conspiracy theory was not tort damages but injunctive relief. You cannot generally enjoin another party from breaching a contract unless that contract itself is specifically enforceable. See CCP § 526(b)(5). There is a presumption that in real estate transactions that specific performance [mandatory injunction] is the preferred remedy per Civil Code § 3587. However, for the inducing tort since Justice Traynor’s opinion for the California Supreme Court in Imperial Ice Co. v. Rossier, (1941) 18 Cal.2d 33 there is a presumption that injunctive relief is the preferred remedy as opposed to damages.

It is possible to sue an interloper [here Wells] for inducing breach of contract but here the financial rescue bill plays a role. The financial rescue bill in Section 126(c) voids exclusivity agreements to the extent of imposing liability on third parties for offering to acquire a target otherwise bound by the exclusivity agreement – and the Section relates to a United States Code section involving FDIC authority and all three entities are part of the FDIC.

Given that these are all FDIC entities, that means at a minimum that Wells has no liability and to the extent that there is liability it shifts to the United States Government as a defacto taking. Contract rights can be taken under the power of eminent domain which means that Citigroup would then have to sue the Federal Government for just compensation and while that is their right they may not want to exercise that right in this environment because Section 126(c) relates to FDIC authority.

As to this “litigation” CNBC had a list of the shareholders of all three banks and with the exception of Berkshire Hathaway [Warren Buffet] most of the major shareholders in all three institutions were the same entities – primarily banks and mutual funds. And while the Blogs and the lawyers love this type of action, with all the anxiety out there the FDIC, the Federal Reserve and the other owners do not. Indeed, a “standstill agreement” was reached on litigation under “adult supervision” that was extended until Friday.

Because Sheila Bair of the FDIC poisoned the well in her relationships among the 3 banks with her actions in this matter, Federal Reserve Chair Ben Bernanke in effect went to Hank Paulsen and they ejected Sheila as the lead Government person in this. Instead, Bernanke went to his bench in the form of Fed Governor Kevin Warsh [who besides being married to a grand daughter of Estee Lauder] is a competent attorney to put a deal together to shut this down. The idea was and is to split the assets.

Last, but not least, the Fed cut the overnight Fed Funds rate – the rates that banks charge each - to what effect is unclear. The main reason I think the Fed did this was that there are a number of other rates – primarily ARM’s and credit card rates - which are tied to the Fed Funds rate [the interest on reserve provision is so new it has not even entered agreement lexicon] and the Fed does not want to see these other rates increase and further increasing a credit crunch. Interest rates have gotten so low that that the Fed is running out of ammunition here.

What I think is more important is that the Fed use of its new power [really accelerated power] granted to the Federal Reserve to pay interest on reserves and what it means. It is now clear that what it means is that the Fed can take actions as the true “lender of last resort” without having to worry about the Federal Funds rate because of the ability to pay interests on reserves allows it to control the Federal Funds rate without worrying about side effects of doing so under the old rules - as Bernanke noted yesterday.

On the reserve issue, as has been noted repeatedly, bank are required to keep reserves on deposit at the Fed, but traditionally don’t earn any interest on those reserves so they keep as little money there as possible. The Fed long has wanted to pay interest on reserves and finally gotten that power this year. The change will encourage banks to leave more money on deposit at the Fed, and that will give the Fed more maneuvering room to lubricate the financial system and lend to troubled institutions without increasing the total supply of credit in the economy and pushing down the federal funds interest rate, the Fed’s key interest rate tool and ultimately causing inflation.

The interest on reserve power means that the Fed Funds rate on overnight inter-bank lending would never drop below the Fed's reserves rate because it would not make sense for a bank to lend at a rate less than it could earn on its reserves. The Fed could then ease or tighten monetary policy in a simple, straightforward way by lowering or raising the deposit rate it pays on reserves. In contrast, the existing approach is a complex method that requires buying or selling the right amount of Treasury bills on the open market with a lot of collateral consequences. If the Fed sets the reserve rate at a higher rate than the Federal Funds rate, it may be a sign that it understand that the Fed Funds rate cut was really a “cross-referencing” issue.

Without the Fed having to worry about what it does in Open Market operations has on banks because it now sets the interest rate on reserves, it can channel liquidity to hard-to-reach markets and institutions directly through its various facilities such as the Term Auction Facility without worrying that it was driving the fed funds rate too low. Conventional open market operations have been less effective in this crisis because the country's large money center banks have hoarded the Fed's liquidity offerings.

As such, the sum and substance of this is that the interplay between the various interest rates could well will stabilize interest while doing the other things that Team Bernanke-Geithener want to do. The one thing they want to do is get rid of the liquidity crunch which is really a confidence issue. To that end we are still seeing newly powerful regional banks flush with cash for a series of reasons – and Floyd Norris in the New York Times blog yesterday noted this – for a series of reasons refusing to lend to large banks.

The lack of liquidity is a function of a lack of confidence in whether banks or other institutions can pay back loans and I do not think interest rates per se are the issue. There are several ways banks raise cash. First is from depositors who put their money into the bank [including other financial institutions – and the FDIC change helps that by assuring that people know that they are protected. The second is by issuing stock which means that the bank gets capitol to run its operations – but after the bank or any other corporation issues stock and it goes into a secondary market it has no direct control – unless it does a repurchase – of who owns it. Third, banks can also get other capitol from the discount window at the Federal Reserve for emergencies. {When I was in college we actually took a field trip to the Federal Reserve and the discount window actually existed but it was set up in a way so the yentas would not know who went in and out of the room.]

What is causing the lack of liquidity is the lack of confidence – not the lack of cash. A lack of confidence results in a lack of transactions which means that one feeds on the other and results in “deleveraging” whereby people sell stuff at marked down prices to get cash and as a result credit contracts and it spirals down. In sum, a lack of liquidity which is a lack of confidence as I learned in Drew University [Cum Laude Class of 1976] cannot be addressed by rate cuts. If anyone doubts that, look at Japan.

The lack of confidence has resulted in real world interest rate hikes despite the fact that there is a substantial amount of increased liquidity in the market pressing downwards on rates because the higher rates are really a risk premium. Here, what the Fed and the Treasury are doing is trying to keep things afloat while TARP comes into being so that the car crash can be moved away and Happy Days are Hear Again is for the Fed to become the lender of last resort by directly buying up commercial paper.

The reason for this is that commercial-paper market has dropped to a three-year low of $1.6 trillion last week as investors fled even companies with few links to the sub-prime mortgage crisis. Companies such as Gannett and Southern California Edison have been forced to tap credit lines or forego raising debt because of market disruptions. What that means is that the Fed – and this is what the Agrarian Radicals wanted to do in 1913 – is clearly the real lender of last resort because by buying up commercial paper it in effect is directly financing the US economy.

The Fed apparently will have enough of a fund big enough to backstop the entire market. Issuers will be able to sell commercial paper to the Fed up to the average amount they had outstanding in August. The Fed's unit will buy three-month commercial paper, which should help issuers extend the maturity of their borrowing. This will also keep interest rates down. The Treasury's deposit with the Fed's special purpose vehicle will be substantial but the funds won't come from the $700 billion rescue plan authorized by Congress last week.

Finally, in terms of overseas action – asome US actions in terms of increasing FDIC limits, better bank regulation and now interest on reserves, actually encourages capitol inflows in to the US so the British Government in effect “did a Sweden” plus a TARP by buying up banks and by upping the ante in terms of it’s willingness to buy bad debt. Some have stated – and It is not true - that the UK plan contrasts sharply with the approach taken on this side “of the pond” because the US program is aimed at taking “toxic assets” [a pejorative term] off banks' balance sheets, while the British plan is aimed at boosting the banks' capital so they can restart the lending that is crucial to economic growth.

This distinction is really no distinction. As I noted above, Hank Paulsen again stated today that TARP envisions that it can “do a Sweden”. The Treasury has already said it wants warrants in companies [remember AIG] and in the UK – this a Labor albeit “new Labor” government – in terms of what it does will take into account dividend policies and executive compensation packages and will require a full commitment to support lending to small businesses and home buyers. The UK government wants as shareholders seats [as in plural] on the Boards.

Also, the British government as part of the plan provides that the Bank of England will make at least £200 billion [which is $344 billion in current exchange rates] in funds available to the banks through its Special Liquidity Scheme which allows banks to swap illiquid assets such as mortgage-backed securities for Treasury bills which they can use to raise money. That is asset purchase folks.

England has a much smaller economy and is much more finacial services dependent in terms of employment because of the efferts of the British Government to make “the City of London” a major financial capital. British banks have been trying to drastically cut back lending and shrink their balance sheets. In the six months ended in July, United Kingdom bank assets declined by £340 billion [$585 billion in current exchange rate] - the steepest drop on record in absolute terms. British banks are especially vulnerable because they depend more on credit markets and less on customer deposits for the funding they need to make loans. If I could quantify the British rescue package in US terms, it would represent maybe $5 trillion dollars.

Since the mid 1980's Irwin Nowick has worked for the California State Assembly and State Senate on a plethora of policy issues, most notably firearms legislation. He has been described as "The Assembly's resident genius" by a former Speaker of the Assembly and is seen frequently in the Capitol hallways and offices assisting legislators in drafting and amending pending legislation.