A Response To “The Barrons Plan” – An Open Letter To Editor And President Edwin Finn

February 16, 2009

Mr. Edwin A. Finn, Jr.

Editor and President

Barron’s

 

Dear Mr. Finn,

It was 1976 when I became a fan of your paper. The Dow Jones Industrials were below 1,000. Mr. Ableson’s wit made me laugh as he skewered the valuations that would justify a Dow above 1,000. In 1977, the 30-year treasury was trading at a yield around 7.75% on its way to just above 15% only four years later.

Rest assured that I will continue reading your august journal. However, when I read your front page editorial this weekend, I was deeply saddened. Barron’s magazine holds a special place among financial publications in the United States. The depth and breadth of your financial reporting is rarely matched. Your access to the best and brightest minds in business and investing gives Barron’s the ability to inform its readers, industry leaders and government, in a unique and thoughtful way. This weekend, you lost an opportunity to help your readers, our leaders, and the government, really understand the severity and complexity of the current crisis.

The Barron’s Plan presents some bold and seemingly radical ideas. You propose to take $200 billion of the TARP money and reset the principal balances of approximately $850 billion of sub prime mortgages by an estimate of 25%. I applaud your ideas, but I think they fall short of addressing and solving the difficult problems we face.

The Barron’s Plan approaches the problem from the top down. Fix the banks; make them modify mortgages; get cash flow moving; get lending restarted. The problem is that this is the old solution. It won’t work; it can’t work. The banks are no longerthe financial system, but are rather a part of the financial system. And they are an increasingly smaller part of the financial system. Like General Motors, the banks do not understand that the world changed while they were at the party. Now they have to deal with a whole array of institutions that are not banks, but lend; that are not investors, but invest. Increasingly these new entities are the financial system, and they are becoming a larger part of the system every day. They have other attributes compared to traditional banks; they are global, virtual and mostly unregulated. Let me refer you back to your own publication.

First, let’s look at the February 9th issue of Barron’s magazine. There are two articles in particular that warrant review. The first is by Senior Editor Jonathan R. Laing, titled “Advice to Geithner: Don’t Hold Back.” Mr. Laing is absolutely correct when he says, “Likewise, government purchases of banks loans won’t send nearly as powerful a signal as buying, say, asset backed securitizations comprised of hundreds of loans diversified by issuer and geographical locale.” The second article I wish to draw your attention to is Senior Editor Sandra Ward’s interview with Ray Dailo, chief investment officer, Bridgewater Associates, titled. “Recession? No, It’s a D-process, and It Will Be Long.” In this interview, Ms. Ward asks two very important questions. “So where do things stand in the process of restructuring?” and “Is a restructuring of the banks a starting point?”

The Barron’s Plan correctly identifies mortgage principal modifications as a critical first step, but you do not correctly identify, as does Mr. Laing, the entities that need to be effecting these modifications, the vast number of residential mortgage securitizations. Where your plan speaks to the need for government action, you do not address, as does Mr. Dailo, the massive global deleveraging and corresponding asset devaluation that is pounding domestic and global markets and credit. Perhaps a panel discussion with Secretary Geithner, Mr. Dailo, and Mr. Gross of Pimco, as well as some of your Round Table regulars, might be illuminating.

The Barron’s Plan comments on the need to get the economy “back on track” and the “financial system fixed.” Your plan takes a top down approach with a focus on existing banking institutions. Barron’s does not address which economy needs to get back on track? Are you referring to the economy of General Motors (GM) and the mid 20th century? Or are you talking about the economy of companies like GT solar International, Inc., (SOLR) and those of the early 21st century? This is a question about where Barron’s is focused. If Barron’s is looking forward, then they need to be focused on the small and emerging companies and entrepreneurs. These individuals and companies do not get bailouts. They cannot get credit and necessary financing to grow. They cannot come to Washington and ask for help. Consequently, when you refer to fixing the financial system, which system needs fixing? Is it the system of large global financial institutions and the large global clients they serve? Or is it the system of small local banks, finance companies, venture investors, and individuals? Check the data on which of these groups create the most new business and jobs.

Part of the difficulty with “fixing the financial system” is that there may be than one. There is a financial system and economy that is within the United States and governed exclusively by state and federal governments of the United States. There is another economy and financial system that is both within and without the United States, which is governed in part by the U.S. government, but also by other sovereign entities. There is a financial system of regulated entities and a financial system of mostly un-regulated entities. We American citizens and our government can fix the system and economy we regulate and control. We cannot fix the economy and financial system we do not regulate and control.

Addressing what we do control, let’s first be clear about the nature of mortgages and the related structural problems. Mortgage debt is a loan secured by title to an underlying asset. If a loan of $100,000 is made at 5% interest and the market rate goes to 10%, the loan is worth, in the market, $50,000. If the same loan is made to a AAA borrower and the borrower’s credit score falls, the market price of the loan falls to reflect that decline in credit quality. If the value of the asset that secures the loan falls, so does the market price of the loan. As house prices fall, the underlying security of a mortgage falls. As people lose their employment, their ability to pay their existing mortgages evaporates.

Until housing prices stop falling, and there is a floor on housing values, the economy will continue to decline in a deflationary spiral. Household wealth will continue to be destroyed; fear and desperation will rule the day. The government must enact a national moratorium on foreclosures. Instead of a bank holiday, call it a foreclosure holiday: No more foreclosures for at least 24 months.

Barron’s is right to identify mortgage principal modifications as a key step in healing our national economic wounds. But the modifications are closer to 50% of face value of the first mortgage and 100% of the second mortgage. If the problem were only with the banks, this might be relatively easy to do. However, the problem lies in the structure of the residential mortgage market and mortgage securitizations. Mr. Laing’s article clearly articulates this problem is in the “Shadow Banking System” not just at the banks. As most residential mortgage securitizations are structured, there is no legal way to fix troubled mortgages. The pool servicer does not have clear legal authority; the pool trustee does not have clear legal authority; the investors do not have the clear legal authority; and no one can act, unilaterally, without significant risk of legal action.

Only the federal government can break this log jam, and Americans must demand that their government act. Most mortgage backed securitizations, holding pools of mortgages on U.S. property, have U.S. domiciled trustees. This means they are subject to control by the U.S. government. I strongly suggest that the government mandate by law that the trustees of the securitized mortgage pools have the authority to modify, change and amend both principal amounts and interest charges on any loans in any of the pools. Further, the trustees must have the clear legal authority to sell, trade, and/or exchange any mortgage held in the pool. The federal government must then redraft the terms and conditions of all securitizations giving the trustee the power and authority to take any and all actions with respect to any and all assets in the pool.

In addition, all tranches of any and all securitizations of U.S. residential mortgages must have a CUSIP number. Market quotes, both bid and ask, must be made available through major services like Dow Jones in lot sizes of less than $20,000 to retail as well as wholesale buyers. Investors and homeowners should be able to see what is outstanding on the pool that holds their mortgages and bid on any of those securities. This will help provide liquidity to a market that is locked up, where the disparity between the bid and ask is extreme. If the market value of these securities is less than homeowners’ estimates of the value of their homes, then homeowners have a strong incentive to buy pieces of the pool and exchange face value of the certificates for face value of their mortgage. And thus will liquidity be provided to the market.

Now let me comment on the economy and financial system that we do not exclusively control. We are past the era of “too big to fail” and are now in the era of “too big to save.” The interview with Mr. Dailo of Bridgewater Associates makes the global problem quite clear—deleveraging, devaluation of assets and global deflation. The current global financial system is like a large housing development facing a wild fire racing up a canyon. In each country, its central bank and regulators are like firemen assigned to specific houses under their jurisdiction. Rather than collectively fighting the larger fire strategically, they focus on their individual houses, seemingly oblivious to the raging destruction about to engulf them.

The interconnectedness of global financial systems makes it necessary for global regulation. At the same time everyone must understand that locking down financial markets and innovation is deeply damaging to everyone, rich and poor alike. Commerce, both local and global, depends on well functioning financial markets, fund flows, trade financing, lending, and credit. As all humans have, by their nature, “the propensity to truck, barter and exchange one thing for another,” so must all people have a well functioning financial system. But how do we get there?

Our global financial system needs to work within a few guiding principals: transparency, free and open access, honest and fair dealing, and strong and effective global regulation. The market participants must have certainty that the playing field is level in all respects. No one likes to play in a rigged casino, unless it is with someone else’s money. The financial press has a responsibility to help shape the developing dialogue and debate about what the global financial system of the 21st century will look like. Barron’s magazine should lead that debate.

Lastly, while this shock to our economic system has been generated by financial excess, the next shock may come from elsewhere. Could Western Europe save Iceland or the United Kingdom? How would commerce, industry and finance react to a pandemic, a devastating drought in China or India, or some other “exogenous event?”

 

The Barron’s Plan takes a needed step forward. It does not stand up and remind everyone; citizens, banks, and government, that we really know next to nothing about identifying and managing risk. And as a long time reader of Barron’s magazine, I think it is fair to say that your lesson to your readers over the years is, “If you do not understand the risk, you cannot understand the return.”

Sincerely,

 

Francis Goldwyn

Managing Director

Quorum Associates LLC

 

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