Hybrid Cars and The Credit Crisis

The current credit crisis—with or without a $700 billion bailout—has already spread from Wall Street to commercial banks, and from the financial sector to other parts of the economy, including to the auto industry. Here’s how the credit crunch is impacting key players in the hybrid vehicle market.

Consumers Are Staying Home

While demand for hybrids remains strong, the overall vehicle market is shrinking. Some analysts are predicting that this month’s sales will be off as much as 25 percent from last year. One of the biggest issues is tighter credit and lending standards. Many buyers can’t qualify for financing, or must pay more for their car loans; in addition, leasing has been discontinued for many domestic models.

The result is that it is more difficult and costly to get consumers into new vehicles. To make matters worse, fewer people are shopping. Some buyers are postponing big purchases in anticipation of an economic downturn, while others have lost jobs or homes and are struggling just to make the payments on vehicles they already own. In this climate, hybrid sales could suffer if consumers continue staying home—or if they opt for cheaper, no-frills vehicles rather than cutting-edge technology.

Dealers Are Getting Squeezed

Many car dealers were already suffering before the recent market downturn. With fewer shoppers on their lots, things have gone from bad to worse. To compound the problem, dealers are now struggling to maintain their own credit. Dealerships use what is called “floorplanning” financing: they buy vehicles for their inventories using credit from banks or captive finance companies. Recently GMAC, Chrysler Financial, and others began raising floorplanning interest rates, a move that squeezes dealer profits and makes sellers think twice about stocking expensive vehicles.

In the future, expect to see dealers use more caution in ordering new, unproven hybrid, electric and alternative fuel models. You can also expect to see more dealers throwing in the towel. The country’s largest volume Chevrolet dealer—Columbus, Ga.-based Bill Heard Enterprises, founded in 1919—shut its doors last week as rising floorplanning costs and falling sales eroded profits on the 88,000 vehicles it sold each year.

Manufacturers Lack Investment Funds

Auto companies live on credit, both in the short-term to sustain operations and in the long-term to invest in new vehicles and manufacturing facilities. For some, that credit has nearly dried up. Two weeks ago, General Motors made a $3.5 billion withdrawal from an existing credit line, raising concerns about the company’s long-term liquidity.

While GM still has billions in the bank, the company burned through more than $7 billion in the first half of the year. And the spending isn’t scheduled to stop. GM will spend nearly $400 million on a new plant to make small engines for the Chevrolet Volt plug-in hybrid and other vehicles. GM, Ford, and Chrysler—with its big plans for electric cars—are hoping that loans from the federal government will replace some of the financing that’s been lost from private sector banks. But if federal loans don’t come through in a timely manner, some new vehicles requiring a lot of R & D spending could be in jeopardy.

Battery Manufacturers Lack Access to Credit

Batteries are a key component in hybrid and plug-in hybrid vehicles, but developing new battery technologies and manufacturing them on a large scale is capital-intensive. A single manufacturing facility can cost $150 to $300 million, and that’s after a company has spent millions to create a viable product. Like the automakers, battery companies now have less access to credit, which means it’s harder for them to invest in new facilities or expand existing plants. The challenge is greatest for smaller companies such as A123 Systems. While their innovative battery designs may hold the most promise for making plug-in hybrids a reality, small battery companies cannot be successful unless they can build the facilities needed to guarantee a reliable supply to large OEMs.

In contrast, large battery makers such as Panasonic EV (a joint venture between Toyota and Matsushita) may have an advantage in the current era. With access to capital from large corporate parents, these firms are better positioned to make new investments in production, allowing them to continue their dominance of hybrid battery markets.

After the Storm Clears

Fear of economic recession has brought oil prices back to earth. Although crude remains above $100 per barrel, US gas prices have settled at under $4 a gallon. While consumers are not likely to forget this summer’s pain at the pump, interest in fuel-saving technologies like hybrids will ride up and down with gas prices. Yet, the long-term forecast is for sustained and consistently rising gas prices.

So the looming question is which auto companies will best be able to weather the storm—and to emerge ready to deliver hybrids and other advanced fuel-saving vehicles when consumers return to dealerships demanding high-mpg vehicles.


  • Samie

    Good article! As for the economy if we see major declines in consumer spending around the holidays we know we have a HUGE problem.

    Government loans or subsides should only go to improve production facilities for Plug-in and EV vehicles. Of course loans or increased lines of credit need to be given to the battery producers that are located in the U.S. In slow economic times we really need to help push EV and plug-ins along b/c funding is crucial to mass production better technology and lower costs in the long run.

    I can’t begin to talk about the problems of decline in real wages and the rise of personal dept. Or the case for a quick buck and the quest of higher returns for risky loans that may not ever be paid back. We got to wild with throwing credit lines around and now we are paying the price. Lets hope this is a short term problem, but sorry to say I can’t be sure of that.

  • srland

    Public Funds for Asset Acquisition

    I say; Government must not engage in Asset Acquisitions, except to recover Government funds wrongfully distributed or used.

    No market, public or private assets should be acquired by Government with tax payer funds.

    Much pain, decontamination and correction is needed and must occur to repair the years without restraint, transparency and regulation to bring a more sustainable market.

    The Government must not interfere, to do so will only prolong the decontamination process.

    The largest sector of the population my middle class (30k to 80k) has little or no market exposure. I don’t know Washington’s middle class 80k plus per year.

    Little attention has been paid to the poor and my middle classes for years now. My middle class only uses banks for checking and have no market assets or retirement.

    Health care, energy, housing, food and education cost and problems have plagued all those earning less than 80k.

    The sick financial contamination and failed responsible parties of government need cleared out and restructured for sustainability. There will never be a shortage of businessmen or politician to fill the void.

    Anyone earning 80k or more can weather the storm without help.

    The poor to middle class people do not want Government to assist wall street. The wealthy are the cause of the problem and need brought down to a more sustainable level.

    So given the above, government would become the problem prolonging the cure by buying asset? Governments only role would be to prevent another blowout with proper regulations.

  • steved28

    Stuart makes some good points, although I don’t agree with all he said. My wife makes 55K and puts 12% in her 401K, so to say those making less than 80K don’t have interest in the market is probably not correct.

    There will always be certain high ticket items that the average Joe will need to borrow money in order to buy. Houses and cars are the front runners. But I see far too many people buying groceries with credit cards, or buying more house (or vehicle) than they need. And the banks were far too eager to provide the loans.

    Myself, like the majority of people (I believe), purchased our homes within our ability to pay the mortgage, pay our bills on time, pay our taxes, and are now asked to bail out those who did not, as well as the institutions that allowed it to happen for the sake of greed. It sickens me to think that the same responsible people are now asked to bail out the ones that were not.

    How will this effect the auto industry? Perhaps only those who can afford a higher priced vehicle will be able to buy them, what a concept.

  • greengrl_7

    Beyond hybrid cars, this will have an effect on the rate of consumption and energy usage (and therefore greenhouse gas production) around the world. Remember that US residents use more energy and cause more pollution than anywhere else. It could end up being a boon to people who like to breathe, not to mention polar bears and penguins.

  • ex-EV1 driver

    I hope the car companies and dealers don’t completely slit their own throats.
    If they “use more caution in ordering new, unproven hybrid, electric and alternative fuel models”, I think they are sealing their fate.
    I know a lot of people who are making money but are holding out for plug-in and hybrid vehicles in something besides SUVs or sedans. Sure, the car companies can try to wait these people out but they will lose first.
    They’ve been making their profit off of the backs of careless spendthrifts for the past few years, now they had better start catering to thrifty people since the spendthrifts are not in the market.
    I, too, hate the idea that our government would reward the greedy at the expense of the responsible. I pity the responsible people who may get caught in the middle but, personally, I see them as a very small minority despite the way the press and politicians describe it.

  • Anonymous

    ex-1 EV1 driver has a good point. Anyone who is responsible with their money and kept it out of the current crash will have more individual power over the market. Thrifty people tend to be more demanding about what they want when they finally get around to spending their money. The car companies better deliver, because my money is too valuable to use on a compromise.

  • Hal Howell

    You don’t have to worry about the polar bears or penguins. They’re fine and increasing. In fact you better start worrying about people. You have obviously swallowed Al Gore’s lie hook, line and sinker. Wake up and smell the coffee. Due to recent sunspot INACTIVITY we are due for a period of global cooling. Cause more pollution??? Really? More pollution than China? India? The pollution in Bejing was so thick you could cut it with a knife. You obviously ignore the substantial progress in the last 30 years in pollution control. In addition we hardly manufacture anything in this country anymore so, industrial pollution can’t be that high (in addition, our few remaining industries are choked with pollution standards). We had better start drilling for every last drop of oil in our own country or you might want to get used to riding a horse again or using a horse drawn wagon and days instead of hours to get anywhere!

  • Tony

    Stuart, you’re right about one thing and wrong about another.

    First, where you’re wrong. Very, very few people in this country don’t have exposure to the stock market. If you have a 401k, and IRA, or a pension, you have exposure. Given recent legislative changes that allow companies to enroll employees in 401k plans by default as a way of encouraging retirement savings, this means that market exposure extends to almost everyone with a job offering a 401k — which is to say almost everyone.

    What you’re right about is that the government should not be buying private assets. And the kicker is that it shouldn’t even be necessary — certainly not to the tune of $700B. To explain:

    There are two major factors that lead to the situation we’re in now, and both originated with the government. First we have long standing laws not just encouraging but in some cases all but requiring lenders to make loans to people who otherwise would not qualify. In other words, these “bad loans” that the government wants to buy — but not without punishing those on Wall Street who made them — were mandated by the government. In addition, Fannie and Freddie, the institutions that held most of this debt, operated under lax regulation for years. Several former and current officers of these institutions, mostly democrats by the way, engaged in some of the very same behavior for which the CEO of one of my former employers is currently serving a 12 year prison sentence. These activities including accounting fraud intended to hide the true financial condition of the institutions, since these officers’ compensation depended on how well their organizations were performing. So the CEO of CA is in jail, and the former officers in these GSEs are enjoying their plush lifestyles. One is an adviser to the campaign of the man who will most likely be our next president, and another is a top choice for a cabinet position in his administration. So between the government regulations encouraging bad lending, and accounting fraud intentionally hiding the results for the personal enrichment of a few, that explains how we got here.

    The other side of the equation has to do with something called mark to market accounting. This is often cited as the “cause” of the problem. It is the cause of one aspect of the problem, but it is also the reason that the overarching problem described in the last paragraph came to light. Recent accounting rules changes were instituted to require that companies holding assets like mortgages report those assets on financial statements according to their fair market value. Since there’s no market or exchange for mortgages or mortgage backed securities, it’s not possible to accurately determine their value for these purposes. Mark to market is a mechanism for determining the value of something that otherwise can’t be determined. It uses a concept similar to that of using comparables to determine the value of a house. If a house down the street from yours that is similar in many respects sold for $250k, then the value of your house is probably somewhere in the same neighborhood. How mark to market triggered the current “meltdown” is that for the first time it required Fannie and Freddie, and those to whom they repackaged and sold “bad” mortgages, to determine and report the fair market value of their holdings, which basically overnight went from their face value to a fraction thereof.

    The reason mark to market is a problem is because it’s not a good way of valuing something like a mortgage. If you have a $100k mortgage on a $400k house, the holder of the paper is guaranteed to either get the full $100k plus interest, or the house. When another institution holding a similar mortgage needs to raise quick cash, and sells that mortgage for $75k, the value of your similar mortgage is devalued accordingly, even though it is logically impossible for such an asset to actually be worth less than the $100k face value. This is where situations like AIG come from. AIG was essentially solvent. They had all the money they needed to meet their obligations. However some of their assets were invested in mortgage backed securities which, due to mark to market rules, they were forced to value at below their actual worth. This triggered additional regulatory rules requiring them as an insurer to have a certain multiple of their obligations on hand as assets. So (using made up numbers), perhaps their obligations were $1B, and their assets were $2B, however due to mark to market they had to treat those assets as being worth only $1.5B. Legally they needed to get an additional $500M in assets, which they ended up getting from the government.

    This, incidentally, is why Bush keeps saying that the bailout isn’t as bad a deal for the taxpayers as it seems. They’re not just going to give away $700B, they’re going to use it to buy mortgages that are valued at $700B or less. However that valuation is at mark to market prices. $700B in mark to market valued mortgages have an actual value that isn’t known, but is definitely more than $700B. This is what Bush meant when he said that the vast majority of these borrowers would pay off their mortgages. He was being a little dishonest when he said that only the federal government had the patience and resources to hold those mortgages until they were paid off. It is strictly true, but the only reason it is true is that federal regulations literally forbid many holders of mortgage debt from exercising that patience. See AIG again.

    So in summary, the GSEs prompted by government regulation made many bad loans. Due to graft, these loans were concealed from those with oversight authority. Mark to market, mandated by government regulation, exposed the problem, which was a positive effect, but also causes these assets to be artificially devalued for accounting purposes, which is a negative effect. In combination with further government regulation regarding how much companies have to maintain in assets, the devaluation of their mortgage backed assets has caused many companies that are otherwise completely solvent to be unable to continue operations. Not because they can’t, but because the GOVERNMENT WON’T LET THEM. So with the exception of graft at the GSEs, every aspect of the problem was caused at least in part by poorly implemented government regulation. Which is not to say that government doesn’t have a role, or that there should be no regulation. But there’s no need for a $700B bailout package. The immediate liquidity problem could all but go away if companies holding mortgaged backed securities were allowed to treat them as having their actual value instead of having to use mark to market. Fair market value is a good thing. The original problems at the GSEs would not have been discovered without it. And mark to market is a good way to determine the FMV of certain assets, but it has become quite obvious that it doesn’t work for mortgage backed securities.

    Thus the very first thing the government should do is eliminate or at least suspend mark to market accounting for these types of securities. You will likely see an immediate improvement. Eventually FMV would have to be reinstated for mortgage backed securities, either using a tweaked version of mark to market or some other mechanism for valuation. The very next thing to do would be to institute some of the specific regulatory reforms to the GSEs that some, including Bush and McCain, have been calling for for years. Barak Obama has for the past week been disingenuously blaming McCain- and Bush-supported (and by the way nonexistent, the most recent deregulation to occur in the banking industry took place in 1999 under Bill Clinton) deregulation for the problem, calling vaguely for “sensible” regulation, while John McCain has consistently held his position in support of the specific sensible regulation that would have prevented this particular crisis — regulation which by the way would have been in place years ago if not for opposition from Senator Obama and others in his party.

    Do this and it’s a virtual guarantee that at least $700B of private money will be available to buy these “bad mortgages” off of anyone who still wants to unload them for less than face value.

  • Old Man Crowder

    The government can find $700 Billion to help some corporate mucky-mucks pushing theoretical papers amongst themselves, but they have a hard time finding a few pennies for green technologies or renewable energy.

    Interesting.

  • Boom Boom

    I like the fact that Tony manages to blame the government for the excesses of Wall Street and tells us all that the bail out isn’t really a bail out, but an investment that is “guaranteed”. I think I heard that from a banker trying to offload sub-prime mortgages once. Then he rounds up his long winded argument with a quick plug for McCain. Less government is good government unless Wall Street needs a loan. The solution: Fix the problem on Wall Street by reducing regulations so they can do it again. Genius!

    Tony, were you paying attention to the house vote yesterday. 2:1 votes against from McCain’s own party. If the bail out is a good deal, and the GOP is the party which has the right ideas on this, then why did they vote against it.

    And Hal, if we’re in for a “global cooling”, I think we should all invest in polar bears to pull our carts after we run out of gas.

    There must be something in the water today.

  • bobajoul

    A nice simple view of the crisis, with emphasis on simple. This cannot be sorted out with “pain” as it will shut down industries and crash the market. The poor and middle class have been living on this credit, in the form of credit cards, second mortgages and overfinanced housing. So for them to blame everyone else is a bit disingenous and so typical of politcial discourse these days. Stuart, do you get a government pension, did you go to school with loans from any bank or the government or do you plan on owning a car, house or bedrooms set? If you do and you want a short term loan, forget it. Your lack of owning assets speaks to your situation, which you want everyone else to share in. I don’t complain when my taxes are used to subsidize healthcare, nursing homes or wars (although I don’t care for those!). But you are on the receiving end, not the giving end and you simply do not understand what is happening to our economy. Your response is “me first” which is the kind of thinking that led to this.

  • Tony

    I know I was a little long winded, but I ask that you read before you attack. I didn’t just blame the government, I illustrated the many ways in which the government contributed to the problem. I also did not come out in support of the bailout, but in opposition to it.

    Yes, I support McCain, but once again I provided objective evidence as to why. The “sensible” regulation that Obama has called for was called for first by McCain, and then later by Bush, and opposed by Obama and others in his party. This is objective fact. Obama also blames deregulation supported by McCain, for causing the problem. But the problem did not occur in a deregulated, or even an under regulated environment. This again is objective fact. Obama went so far as to specifically blame Bush policies of deregulation, as opposed to deregulation in general, when it is (once again) objective fact that the most recent deregulation to occur in the banking industry happened under Clinton’s watch, and wasn’t even a contributor to the current crisis.

    Bottom line is that the bad loans that were made were mostly mandated, or at least encouraged, by the government. It’s also a fact that, like any “bad” mortgage, the vast majority of this “toxic” debt is in fact backed by a real asset. It’s also a fact that the majority of toxicity of this debt comes not because the debt won’t be paid, or because the asset behind it isn’t worth enough to cover the up front investment, but rather because of how government regulation requires holders to treat the debt. IE there would be nothing “toxic” about a $100k mortgage on a $250k house if the government didn’t require holders to treat it as if it was only worth $75k.

    And while it’s true that there was malfeasance going on, it started and mostly was confined to the leadership of the GSEs, which strictly speaking are much closer to government entities than they are to “Wall Street”. And as I also pointed out, the individuals that are known to be involved from these GSEs are all political types, not Wall Street types, and two of them are tied to one of the presidential nominees that is not John McCain. Although it is also true (according to the New York Times, anyway) that they did also give money to the former employer of someone who currently works for McCain’s campaign, and not just recently but several years ago when this campaign manager was still employed at the firm.

    If you want to read all about how John McCain and George W. Bush are primarily responsible, no matter how inaccurate that portrayal may be, you can go just about anywhere. I’ve provided you objective information as to why that is not the whole story. Blame can come later, there is plenty to go around. Sure Obama opposed the sensible regulation he now demands, and sure Bush and McCain supported it. But if they were really committed at the time (Bush especially), I’m sure they could have gotten something through. At the very least you can blame them for not trying harder.

    As for going forward, it seems like McCain and Obama are both on the same page now, and you can make the case that Obama will have a cooperative congress behind him that will let him get it done. We know from watching the Bush energy policy that neither party is above blocking passage of things they say they support in order to prevent their opponents from getting the credit (there’s little that Obama calls for regarding energy for example that he and others in his party didn’t block when Bush proposed it in 2001). Nevertheless, given their respective records, I happen to think John McCain has far more credibility on the issue.

    And since I apparently didn’t make my opposition to the bailout clear enough, let me try again. If the problems are as I described them (which my research indicates they are — Google is your friend), then the bailout is unnecessary because relaxing or tweaking some of the regulation that caused it would be just as effective without the government having to shell out anything. And if I’m completely off my rocker and totally wrong about the nature and cause of the problem, I’d still have to oppose the bailout because the bailout as proposed was only designed to fix the problem I described.

  • Tony

    Boom Boom, I reread your post and realized that my clarification failed to clarify one further point.

    Yes, the bailout is a good deal — for the government. That makes it a bad deal for the rest of us. To extend my phony number analogy, the government is going to buy up tons of $100k mortgages on $400k houses for $75k each. They’re going to eventually collect, say, $200k on each of them, meaning that if they spend the full $700B they’re going to recoup $1.4T. Meanwhile, the Wall Street firms that sell these loans to the government are going to get $700B for loans on which they doled out $933B (either by loaning that money or buying the loans from Fannie/Freddie).

    The bottom line is that there is nothing conservative, nor is there anything beneficial to Wall Street, in this bailout. All it does is *partially* offset some of the damage which is directly attributable to government regulation.

    That is why I oppose it and why the majority of my party’s representatives voted against it. I don’t think it will stand, unfortunately, but that’s where I’m coming from.

  • TD

    The real problem was not that bad loans were made. Bad loans are made all the time and the financial industry knows how to price and manage risky loans.

    The fundamental problem was that Wall Street took real estate which was traditionally treated like a long term, illiquid asset and chopped up and re-bundled the loans so that they could be bought and sold as short term paper.

    This worked fine as long as housing prices were going up and banks and investors could cash in their short term paper at will. But as soon as the housing market turned and houses were no longer being bought and sold at the price and rate needed to sustain the short term paper trading the scheme collapsed.

    Suddenly we have a situation where investors and banks need to get their short term investments back in order to pay their own creditors, but the underlying asset is a long term asset where they could probably get their money back in the future when the housing market recovers. However, they need the money today to be able to meet their own debt obligations.

    The government’s role in this was looking the other way when the banks began making Ninja loans and allowing the banks to get too big and too intertwined to be allowed to fail (i.e. approving bank merger after merger without adequate checks and balances).

  • Boom Boom

    Tony,
    The “objective” information you provide is only about the values of the mortgages. You don’t provide any objective information about any of your conclusions (i.e. “problem did not occur in a deregulated, or even an under regulated environment.”). Just because you say it is true, doesn’t make it an objective fact… and besides, that statement makes no sense. The environment was regulated or not?

    You clearly have a great deal of time on your hands and probably understand the issue better than I do, but your closing statements seem so clearly ideological (i.e. “Yes, the bailout is a good deal — for the government. That makes it a bad deal for the rest of us.”) that I’m can see that you’re coming at this from a very non-objective viewpoint. (Since when is anything that is a good deal for our nation’s government automatically a bad deal for the “rest of us”?)

  • JohnC

    Tony, your efforts at thoroughness and clarity are greatly appreciated. A couple of questions,

    1. You state, “…we have long standing laws not just encouraging but in some cases all but requiring lenders to make loans to people who otherwise would not qualify. In other words, these “bad loans” that the government wants to buy — but not without punishing those on Wall Street who made them — were mandated by the government. “

    How exactly does the government compel lenders to make these loans? How could lenders resist, and what could be the consequences?

    2. You state, “Recent accounting rules changes were instituted to require that companies holding assets like mortgages report those assets on financial statements according to their fair market value.”

    Why were these changes instituted?

    3. You state, “Since there’s no market or exchange for mortgages or mortgage backed securities, it’s not possible to accurately determine their value for these purposes.”

    There’s no formal, incorporated market or exchange, but isn’t there a de facto one, in the practice of “securitizing” mortgages? Does the practice of “securitizing” mortgages originate with Fannie & Freddie, or did other lenders commence it on their own, as yet another way to raise capital?

    4. You state, “How mark to market triggered the current “meltdown” is that for the first time it required Fannie and Freddie, and those to whom they repackaged and sold “bad” mortgages, to determine and report the fair market value of their holdings, which basically overnight went from their face value to a fraction thereof.”

    Does the decline in housing prices have any effect on the value of mortgages being bought and sold?

    5. You state, “The reason mark to market is a problem is because it’s not a good way of valuing something like a mortgage. If you have a $100k mortgage on a $400k house, the holder of the paper is guaranteed to either get the full $100k plus interest, or the house. When another institution holding a similar mortgage needs to raise quick cash, and sells that mortgage for $75k, the value of your similar mortgage is devalued accordingly, even though it is logically impossible for such an asset to actually be worth less than the $100k face value. “

    If the answer to #4 is ‘yes’, then isn’t what you describe in this last quote logical? The mortgages were sold based not just on the money owed, but on the fact that, if the borrower defaults, the value of the underlying asset, the house, covers the mortgage. But if the decline in the value of the asset threatens this guarantee of the mortgage, then aren’t the value of the house and the value of the mortgage effectively one entity for anyone holding, selling or purchasing the mortgage?

    Also, various things seem to make a ‘bad’ mortgage and a house declining in value: an unreliable borrower, sure, but also a burst real estate bubble, a loss of income, etc. Doesn’t the term “bad mortgage” can contribute to a simplistic picture of the processes here?

    Thanks.

  • JohnC

    Worthwhile assessment of mark-to-market topic,

    “Don’t Blame Mark-to-Market for Banks’ Problems “
    http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aJFrPa3rqhHw

  • Tony

    JohnC:

    I’m not an expert or anything, just reporting on what I’ve found through my own research, but I’ll do my best.

    “How exactly does the government compel lenders to make these loans? How could lenders resist, and what could be the consequences?”

    As I understand it, this came about through a law with a 3-letter acronym like CRA. Community Redevelopment Act, maybe. The gist is that institutions are rated based on how well they serve under-served communities. When an institution wants to do something that requires regulatory approval (expand, open a new branch, merge with another institution — just about anything in the banking industry really), the regulators have to take these ratings into consideration when determining whether to permit the proposed action. So the consequences are that banks may not be able to expand within existing markets or into new markets, or to combine with other banks, or any other regulated activity. How could they resist? I suppose through fraud, or by refraining from engaging in any activity requiring regulatory approval.

    Regarding FMV: “Why were these changes instituted?”

    I’m not sure why, but they make sense. My best guess is that it was a response to the relatively new practice of packaging and trading mortgages as if they were securities. The FMV of a mortgage isn’t as important to a bank that made a mortgage loan and intends to hold it for 30 years until it’s paid off as it is to someone who is buying and selling the loans like stocks.

    “There’s no formal, incorporated market or exchange, but isn’t there a de facto one, in the practice of “securitizing” mortgages? Does the practice of “securitizing” mortgages originate with Fannie & Freddie, or did other lenders commence it on their own, as yet another way to raise capital?”

    Yes, there’s a de facto market, thus the need to somehow determine the value of a mortgage or mortgage backed security. The lack of a formal market is the reason that mark to market was selected as a valuation method instead of the presumably more complex and formalized methods that a formal market would use.

    As far as where the practice originated, the only thing I could find about that was the name of a person identified as a “pioneer” in the field. I believe this person was affiliated with the GSEs, and I know she was identified as a “democratic operative” or some such inflammatory term. (The source was a partisan site with a rightward slant). But I do know that the GSEs were the first and definitely the largest beneficiaries of the practice, because they have held most of the mortgages in the US.

    “Does the decline in housing prices have any effect on the value of mortgages being bought and sold?”

    It surely has some effect, especially for those mortgages that are in default and/or those that are upside-down.

    “If the answer to #4 is ‘yes’, then isn’t what you describe in this last quote logical?”

    In some very very very rare cases, yes. For example, in the example I gave, if the $400k house lost enough value so that the value of the house minus the cost of foreclosing and selling it was $75k, then $75k would be a fair value for that mortgage. And then only if the loan was in default. However, despite the grim picture we get from the news, the default rate is very low. Even the delinquency rate is only about 4%. And while home values haven’t been doing all that great the past year or so, the loss of value of mortgages due to mark to market is orders of magnitude greater than the loss in value of the homes backing those mortgages. Going back to AIG, the problem there was that the mortgages they held were valued far below the lower of the money owed or the value of the home. That was fine if they didn’t want or need to sell the mortgages. But it affected their balance sheet, prompting the government to step in and say “you’ve only got 1.5x your obligations in assets, you need to have 3x your obligations, raise more capital immediately or we’re taking over”.

    “The mortgages were sold based not just on the money owed, but on the fact that, if the borrower defaults, the value of the underlying asset, the house, covers the mortgage. But if the decline in the value of the asset threatens this guarantee of the mortgage, then aren’t the value of the house and the value of the mortgage effectively one entity for anyone holding, selling or purchasing the mortgage?”

    In theory yes, but due to mark to market these mortgages are being valued at far below the values of the homes backing them. Again, not a problem if you’re planning to hold the mortgage til it’s paid off or til you can foreclose and sell the house. But financial institutions have regulations governing how much they must have in assets.

    “Also, various things seem to make a ‘bad’ mortgage and a house declining in value: an unreliable borrower, sure, but also a burst real estate bubble, a loss of income, etc. Doesn’t the term “bad mortgage” can contribute to a simplistic picture of the processes here?”

    It absolutely does, but that’s what you get when you restrict your sources of information to the evening news. By the way, the normal standards by which lenders offer money take into account many of these factors. The idea of being upside-down, for example, where your house value declines to the point that it’s worth less than you owe, is an unusual situation because outside of the sub-prime market, lenders usually want a minimum down-payment of 20%, more if you want to avoid paying for PMI. In order for such borrowers to be upside-down, their house would have to decline in value by 20%, which hasn’t happened yet.

  • Tony

    Boom Boom:

    Sorry to further confuse you. The environment was regulated, noone disputes that. One side, notably Barak Obama’s camp, claims that the regulation was insufficient and needs to be increased. The other side, where I fall, claims that overregulation, and specifically poorly thought out regulation is the culprit. It turns out that the existing regulations are a big part of why the crisis came to pass. Only an idiot would argue that bankers loaned out money they knew they weren’t going to get back because they could “get away with it”. The incentive to make loans to people who lenders knew probably couldn’t pay them back came in the form of regulation. The regulation had noble aims, but was ultimately ill conceived.

    Furthermore, the requirement that mortgage backed securities by valued based on mark-to-market, rather than any realistic or objective measure of what the holder of the security is likely to get in either of the two and only two possible scenarios (the mortgage is paid or the house is foreclosed), is a regulation. It’s not too much regulation, or too little regulation, it’s just ineffective regulation.

    The requirement that institutions like AIG hold in reserve a certain amount of capital for every dollar of potential liability to which they are exposed is a regulation. This is a good regulation. Noone wants to try to collect an insurance claim only to find out that their insurance company doesn’t have the money and they are therefore out of luck.

    Combine all these regulations together and you get unintended consequences — specifically that institutions holding mortgages as assets aren’t permitted to conduct business because their assets have to be treated as worth less than they really are.

    “You clearly have a great deal of time on your hands and probably understand the issue better than I do, but your closing statements seem so clearly ideological (i.e. “Yes, the bailout is a good deal — for the government. That makes it a bad deal for the rest of us.”) that I’m can see that you’re coming at this from a very non-objective viewpoint. (Since when is anything that is a good deal for our nation’s government automatically a bad deal for the “rest of us”?)”

    First, I’ll admit that I do have an ideological viewpoint. But I think that this is one place in which it hasn’t come into play. Let’s discard the general notion that anything that is good for the government is bad for the rest of us. In this specific case, what we’re talking about is a transaction between the US government, and everyone else. The media generally refers to the other side of the transaction as “Wall Street”, but if you have money in a bank, or in a 401k, or an IRA, then you are part of the entity called “Wall Street”. The government is looking to buy something from “Wall Street”. The government is further looking to buy it at substantially below face value. The government can only do this because they control the regulations, and those regulations make it better for “Wall Street” to sell those assets for whatever the government is willing to pay than the alternative.

    It’s a good deal for the government because they’re going to pay $700B for assets with a face value of $933B (again, fake numbers for the sake of illustration, I don’t know the real face value of the assets just that it’s above $700B). The government will hold those assets and eventually either sell them for more than $700B or keep them til maturity eventually collecting $1.4T.

    It’s a bad deal for “Wall Street” because not only does “Wall Street” not get to hold to maturity and collect the $1.4T that those assets will eventually net, they won’t even get back the $933B that they paid for them in the first place. Now in some cases, this is a gift to the asset holder, because they were trading these things as if they were short term investments instead of long term investments. But others, such as large institutions, who intended to hold those securities long term, they are going to be forced — by government regulation regarding how much they need to hold in assets and how those assets are valued — to sell them for whatever the government is offering.

    Now, most of these assets are held on behalf of regular people who’ve invested their money safely — “everyone else”. I guarantee you, for example, that some of my deposits in my FDIC insured savings account are invested in mortgages. That savings account pays me interest based on how much the bank makes off the investments they make. The loss they will take when they are forced to sell these mortgages to the government for less than they’re worth will translate into lower interest that they will pay me for my deposits. So in other words, every penny of profit that the government takes in on this deal ultimately comes from someone else’s pocket, and in most cases it’s the pocket of an ordinary investor, including anyone with money in an interest bearing account in a US bank.

  • Tony

    By the way, I’ve recently read that the calls to suspend mark to market for mortgage backed securities are now bipartisan.

  • Tony

    JohnC:

    I read that Bloomberg article the other day, it was one of my sources. One thing I noticed is that it confuses (or seems to confuse) FMV with mark to market. FMV is the principle that if you hold an asset, you ought to account for it based on what it’s fair market value is on any given day. Mark to market is a way to determine FMV. The author is responding to critics of mark to market as if they were instead being critical of FMV.

    FMV is sensible, and is how such securities should have been valued from the get go. Mark to market, however, doesn’t seem to make sense for valuing mortgages, since its application has caused the value of such assets to fall to well below anything that could be considered reasonable. (Note that this was not the case back in March when the article was written.)

    Also, as I think I said already (but I may not have been sufficiently clear) it is not mark to market accounting that is to blame, it is the sudden, all at once application of mark to market accounting to hundreds of billions of dollars worth of assets that had previously been accounted for at face value. Thus the people that I trust are the ones calling not for elimination of FMV or even mark to market, but for suspension of it long enough to get a handle on things. Right now we’re facing the prospect of massive financial institutions being driven out of business quite literally on a technicality. It seems to me that before we through $700B down the hole, it makes sense to at least try removing the technicality.

  • Tony

    To anyone still interested, I just found the following, which pulls a ton of stuff that I found in my earlier research into one article, with lots of additional information.

    http://www.realclearpolitics.com/articles/2008/09/financial_bailout_would_impose.html

  • Samie

    Hope Tony is not getting ready to retire. Tony do you have a 401K? What if you are a first time home buyer? How does decline in credit help anyone? Last I checked our economy is a credit economy. Love when people spin something so much that it actually starts sounding true. Tony look at the Library of Congress website and see the actual voting record concerning regulation of markets for your candidate.

    If McCain becomes prez ha we will have the same Regan theory cut every social program that doesn’t involve the elderly or the military. Sorry poor peps or those who need mental health services.

    Business needs to be responsible for investing soundly and loans should be carefully given. No question but we can’t let industry fail because that creates larger implications on society. I still say loans to the auto industry are not bad but we should have forced the auto industry to accept higher fuel standards, also mandate switching some fleets to hybrid and EV’s in say 10 years. Agree that markets need to naturally “cool down” but we have to look at what will happen if we don’t try to address the problem. Sorry to Tony but I’m not confident in his guys approach to protecting the little guy over corporate greed too bad McCain had to marry the neo’s to become prez. Scary to say this is not from someone who exclusively votes only for D’s. Must say to be fair how silly was it for Pelosi to give that speech the other day before the vote, how dumb guess Washington will always be Washington!

  • Tony

    Sammie, yes I have a 401k. And if I was getting ready to retire, it would be invested mostly in cash and bonds right now. Not sure what that has to do with anything.

    Not sure what you think I’ve “spun”, but everything I said is true, and is verifiable.

    I haven’t represented anything about McCain’s record that isn’t true regarding regulation or anything else. He did support the only kind of regulation not in place that would have prevented the crisis, and that is further regulation on the GSEs who caused this thing from the beginning. It’s also a fact that Obama has opposed those regulations. His preference was and (according to his own words) still is to tighten regulations on private entities beyond what the government is constitutionally permitted to do, while continuing to allow free reign to those entities that have demonstrated repeatedly that they NEED additional regulation, such as Fannie/Freddie.

    “If McCain becomes prez ha we will have the same Regan theory cut every social program that doesn’t involve the elderly or the military. Sorry poor peps or those who need mental health services.”

    I don’t disagree, but I don’t think that’s a bad thing. But you can’t have it both ways. You can’t say “I will oppose John McCain because he won’t spend money on things that are wasteful but that I personally like”, but then also turn around and complain about the poor economy that results from the kind of excessive spending and government social engineering that you so desire. For all his talk about change, the bottom line fact about Barak Obama is that he’s running on a promise to make the same mistakes as his immediate predecessors, only on a much much bigger scale. If that’s what you want, so be it, but understand what the consequences are before you pull that lever.

    Based on the overall tone of your comment, it certainly sounds to me like you favor more regulation. Yet you also say:

    “Business needs to be responsible for investing soundly and loans should be carefully given.”

    This is the very definition of deregulation — particularly the deregulation that McCain has sought. Recall, as i said earlier, that most of the “bad loans” given out by businesses were loans that they were required to give by government regulation.

    So I guess I’m asking for clarification of your position. Do you believe in the deregulation that you tout here, or do you prefer the regulation that prohibits businesses from being responsible, investing soundly, and lending carefully?

    “Sorry to Tony but I’m not confident in his guys approach to protecting the little guy over corporate greed”

    No need to be sorry, you evaluate the facts as you see them and you have to make your own decision just like the rest of us. It’s all a judgment call anyway, and there are no guarantees. Lord knows I though Bush would be a more conservative president than he turned out to be, and I daresay that most of Clinton’s supporters thought he would govern from a position far closer to his moderate ideology and rhetoric than he did.

    As for the current race, I am far more confident in McCain’s approach that Obama’s, primarily because McCain’s approach has been tried and succeeded before, and Obama’s has not. But also because to the extent greed played a part in the current crisis, it was associates of Obama who were involved, and because it was McCain and Bush who tried to regulate them and Obama who opposed that regulation. In other words, Clinton voters had far more reason to believe his “I will not raise taxes on the middle class to pay for these programs” pledge than anyone right now has to believe that Obama will do anything to reign in corporate greed. His record simply doesn’t give him any credibility on the issue. Even if I liked the guy’s rhetoric, which I don’t, I think I’d still be inclined to say “give him another 4 or 8 years in the senate to see how his actions measure up to his words”, rather than just roll the dice and put him in the WH next year. Especially given that the alternative is John McCain, who isn’t exactly Newt Gingrich, or even Ronald Reagan. In other words it’s not like your choice is Obama or some right-wing nut job.

  • Hugh

    Tony,

    I really appreciate your input. I have listened to countless TV and radio shows, read many articles, and have not come across anyone who has spelled out the aspects of this as clearly as you have. Some here have said that you are biased. What I appreciate is that you openly told where you are coming from, unlike the news anchors who also have a bias but pretend to be objective.

    If the mark-to-market regulations are temporarily suspended is there enough liquid and willing capitol to save the failing banks(other than the government)? Is this even necessary, or do they simply continue on with business using the face value?

  • Monir Mamoun

    Tony, in turn, you are wrong about one thing.

    Mark-to-market is not an accounting fiction the government magically mandates into existence and back out.

    The $100,000 mortgage being worth $75,000 when sold is also not an artificial mechanism causing all other $100,000 mortgages to be repriced downward.

    The mark-to-market process is in fact, completely logical economically.

    Follow this logic :

    The reason MORTGAGE mark-to-market is valid is in fact because the US government has destroyed the value of the dollar.

    The MOST IMPORTANT mark-to-market has happened to the value of the dollar itself as chronic, unchecked deficit spending has come to the point where the entire global financial market has marked-to-market the entire US debt of $10 trillion as worth less money in terms of other currencies. This is why the dollar has lost 30-50% of its value over the last few years versus most currencies.

    Understand this one point — the global financial market’s MOST IMPORTANT MARK TO MARKET effect involved RECLASSIFYING THE US GOVERNMENT DEBT from “DEBT” to “MONEY PRINTING.” Think about it. When a government is expected to pay back debt, i.e. shrink the money supply back down in the future, debt is truly debt. But when the global financial market loses this faith, because our executive and legislative leaders have shown ZERO will to control deficit spending, only a fool or a liar would continue to call it debt, when in fact it is seignorage — pure inflationary money printing.

    All this portends SERIOUS DOLLAR INFLATION and subsequent devalution. How? Well, consider the $100,000 mortgage, which pays a fixed amount month to month (most mortgages are fixed, right?). To price it correctly in the face of a MATHEMATICAL GUARANTEE that the dollar will be worth less tomorrow, interest YIELDS MUST RISE TO MATCH ANTICIPATED INFLATION.

    In order for yields to rise with a fixed payout, it means the core security must drop in value. You know — interest rates up, bond prices down, right?

    So the $700 will fix NOTHING. It will ONLY add fuel to the fire. It adds money to what is already a highly-inflationary, soon to be hyper-inflationary system.

    The cruel irony is — all these bankers who would be getting this cash under this bailout ALREADY KNOW THIS. They ALREADY KNOW the dollar is on the verge of massive inflation and they would be IDIOTS to go right back out and issue more 6% paper (a rough average of mortgage rates for the last few years) when all they need to do is wait a year or two for the era of 12% paper.

    And you are wrong when you say there is no secondary market. These banks sell collateralized loan obligations back and forth all day long to reprice and redistribute risk. No banker worth his salt will buy the 6% paper out there now at par — that is why the secondary market has dried up.

    These guys are waiting for yields to go back up. It is only a matter of time.

    And Paulson knows all this. He is a hyper-sophisticated banker who is selling the biggest con job of all time, a radically unjustified cash giveaway of taxpayer money, to a Congress composed — literally — of people who cannot balance their own checkbooks.

    Sophisticated banker vs. financial illiterates with an infinite checkbook. A big-spending Congress in firm cahoots with a president who does not want to take responsibility for blowing apart the dollar with endless war.

    Guess what? The bailout will not do a damn thing one way or another, and we are still screwed.

    A balanced budget, a vastly shrunken government sector (we have 40% government control of the economy now, so don’t hold your breath), and a period of austerity for the economy to sort itself out is the only solution. And even then, we’d need stringent financial regulations on private debt lenders — mortgage and credit card debt lenders primarily — to control the wild credit addiction of the American public.

    All this… is extremely unlikely to happen. People barely understand the problem, to say nothing of the political will and public will necessary to fix the complete collapse of the dollar.

    And guess what? OUR NATIONAL DEMOGRAPHIC IS AGING AND FEWER WORKERS ARE SUPPORTING MORE AND MORE RETIREES.

    Long story short: the dollar’s demise is a mathematical guarantee.

    The overwhelming likelihood is that we will soon enter an era of dollar hyperinflation followed by a refactoring of the American currency, quite possibly to a unified North American currency governed by a new US-Canada-Mexico economic union.

    Goodbye, Dollar. All hail Amero.

    Monir Mamoun

  • Samie

    If McCain becomes prez ha we will have the same Regan theory cut every social program that doesn’t involve the elderly or the military. Sorry poor peps or those who need mental health services.

    Tony says “I don’t disagree, but I don’t think that’s a bad thing. But you can’t have it both ways.” You have to provide basic services for all of society if Tony you want to create efficiencies fine but to say slash and burn is a great approach to governing think again. Mental Health Services are probably not what you think of lets say a battered womens shelter needs some federal funding but you limit this which infects dangers in our society. Your views like many others like you base political theory on what things represent your beliefs and don’t bother to consider those who may not share the same moral or economic ideals that you do. Not to criticize you Tony personally but your points show no real individualistic ideas of your own that you justify things as right as the other side is wrong. Ideology is fine but to look at things intellectually you need to be able to question those who try to influence you. Say like this what is the right amount of regulation that protects ALL citizens of the United States.? Or how can we reduce spending but keep vital social services and have a moral obligation to protect all citizens from injustices? Not easy questions to answer but remember you are obligated to govern all people of the country not just a selected few.

  • hybridman2

    Over 70% of the people in this country manage their money, pay their mortgages and are responsible. Unfortunately now with this Bailout, they will also be expected to pay for those who are not so responsible.

    There are a lot of people who actually WANT a Hybrid, need one. But because of the clamp down in lending and slow down of the economy, they will not be able to afford the extra $3000- $6000 a hybrid can run over conventional cars.

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