“The Beginning Of The End”

Dolors & Sense

by Sanford Rose

KISSIMMEE, FL—(Weekly Hubris)—3/29/10—Churchill is famous for phrase-making. One of his better, coined after the victory at El-Alemein, is: “This is not the end. It is not even the beginning of the end. But it may be the end of the beginning.” Based on what we are now seeing in the economy, I think we are finally in Churchill’s intermediate stage: we are witnessing the beginning of the end of the Great Implosion.

One of the reasons is the agreement of Bank of America, announced on March 24, to write down some (perhaps 30 percent) of the principal on its nonperforming mortgages in order to ease payment burdens and help stem the tide of foreclosures. As limned in my column of March 5, I feel that such a step is indispensable to sustainable recovery. If Bank of America’s action is widely emulated, as I suspect will happen, we will emerge from this mess more quickly than I thought.

But at what cost—now and in the future? Whatever the cost, it is manifestly trivial compared to the benefits of raising home values, re-employing people, and closing as quickly as possible the gap between current and potential national output.

To be sure, banks and investors face the loss of a considerable amount of capital which, of course, was and remains phantom capital, a cushion of air thanks to the convenient fictions of historical-cost accounting. Nonetheless, it will appear that banks have lost something, whereas in fact they lost it a long time ago.

Had Bank of America done what it is now doing two to three years ago, it would have salvaged some of the capital that it now must surrender. The lost capital is a proxy for the decline in real estate since 2006. But residential real estate has declined more than it need have.

Indeed, the ratio of house prices to rents in the US is now below its average of the entire period since 1967. So, the inflation in house prices, so evident a few years ago, has turned into a deflation. The market, which overvalued houses up to 2006, is now undervaluing them. That is the way with markets; they are governed by the pendulum effect.

But one wouldn’t have expected Bank of America or any other institution to unilaterally write down its enormous real estate holdings in, say, 2008. Why not?

Local housing values are tracked fairly closely by a couple of national indexes. These measures showed a consistent pattern of decline for the last four years. When market values keep falling, it is foolish and counterproductive to retain obsolete book values. But the banks did it because they obviously didn’t want to show losses.

One can sympathize with them. In previous recessions, banks held to book values and it paid off. Eventually, the bloodletting stopped and market values turned up. Book values that had once looked ridiculous looked less so. But this recession is different; it is of course too deep and too pervasive to maintain an ostrich attitude.

If bank managements were not astute enough to realize their losses and by so doing greatly limit them, others were much wiser and on occasion urged these managements to turn away from the Barmecide of accounting notations. The Federal Reserve told the banks to accept short sales, a much-publicized form of writedown, but that hortation elicited only shocked and stony silence.

Obviously, something stronger than prodding was required. The Congress had a responsibility to the public to push the banks and those who had invested in mortgage paper into action. The push would have saved jobs.

The push could have taken a form that required no overt outlay of public monies. In the 1980’s the Federal Deposit Insurance Corporation helped erase a shortfall in savings bank capital by giving some institutions what were called net-worth certificates. Such certificates were manufactured by the agency and added directly to the capital accounts of the banks which, of course, booked equivalent assets on the left sides of their balance sheets.

There was no initial outlay; the banks simply made modest annual service payments on their new liabilities. Had it not been for this form of phantom capital, which replaced the capital that had been wiped out by the interest-rate crisis of 1979-1980, the banks would have forced to shut their doors.

A similar mechanism was proposed and could have been set up in 2007-2008, enabling the banks to re-mortgage their customers and write down the inflated loan balances while still retaining enough so-called regulatory capital to operate. That this step was not taken is nothing short of scandalous.