Business Law Prof Blog

An Intriquing Legal Issue

Some banks who took TARP I money did so under a clause that allows the government to unilaterally change the terms of the deal.  What is the legal effect of such a clause.  Assume the government now wants to cap salaries and bonuses and demands that the bank do so; the bank does not take any new TARP money.  Must the bank comply?  I would say not. Either the clause is unenforceable (no standards for evaluating whether the government is in breach) or there is no contract at all (no mutual agreement on significant terms).  The bank could refuse and the government cannot vote its non-voting preferred (or common, if it exercises its warrants) stock to force compliance.  In the extreme case, there is no contract and the bank can even ignore the terms of TARP I's deal and force the government to sue for restitution and rescission of the funds (with the result no obvious).  In any event, none of this will happen as the government has the banks running scared of its other regulatory authority. 

Who Is the Sucker??

Now that the new Administration's economic proposals are trickling out we can add them all up and see who is taking it on the chin, who is getting played for the sucker.  The old advice for players at the poker table holds: If you do not know who the sucker at the table is, it is you.  Our economic system runs on voluntary compliance linked to cultural norms, not fear of getting caught and prosecuted.  The cultural norms, in pre-PC days, used to be called the Protestant Work Ethic or the like.  People who put themselves in position to find work and earn some income, did not over-spend their budget, bought and paid for a home they could afford, saved a bit for their children are the suckers.  They will pay for others who did over-spend and saved nothing.  They will pay in increased taxes, both in income and estate taxes (and their social security repayments will be means tested), and in inflation (their savings will be eaten up by inflation).  Those who voluntarily complied with the rules and lived within their means are the suckers.

Obama's Homeowner Affordability and Stability Initiative

The President announced and Treasury published details of a new Homeowner Affordability and Stability Initiative today.  The press is struggling to get the details correct. Here is the basis of the Initiative. To be eligible, a homeowner must have defaulted on his/her mortgage payments (due to economic distress or limited income)  or otherwise hold a mortgage that is "underwater" (there is no equity left in the house once the mortgage obligation is subtracted).  If mortgage owners on such mortgages reduce mortgage payments to 38% of income of the mortgage payee (with reductions on interest and/or principle) for five years, the government will match, dollar for dollar, further mortgage payment reductions to 31% of mortgage payee income.  Treasury would also kick in a "partial guarantee" payment to the mortgage owner for a "reserve" in case the property further declines in value.  The mortgage reductions are standardized under a program to be announced March 4th and the standardization will provide "legal cover" to mortgage "servicers" that act for investors in a mortgage pool and provide guidance to the many government agencies that hold or guarantee mortgages.  All mortgage owners that take government payments under the Initiative must use the program conditions.  The cost of the Initiative is projected at $75 B.

The Initiative comes with a host of modest but significant cash grant incentive payments to mortgage owners to modify mortgages and to mortgage payees to discourage defaults on the eve of modification requests and after modifications have been accepted.

A second part of the plan is designed to help homeowners who have less than 20% equity left in their homes (but do not owe more than 105% of the homes value) and are current on payments.  They can qualify for Fannie and Freddie guarantees if they refinance--remortgage.

The back-end of the Initiative is interesting.  If the program is to the benefit of mortgage owners as well as mortgage payees, then the value of outstanding mortgages should increase once the program starts.  Yet the government is also increasing by $200B, a program to purchase preferred stock issued by Fannie Mae and Freddie Mac.  The government will also buy Fannie and Freddie MBSs through its TALF program.  In other words, the government is pouring money into Fannie Mae and Freddie Mac to support the mortgage modification program because it believes private investors will not.  Why not?  If the Initiative increases the value of outstanding mortgage portfolios, Fannie and Freddie should not need the new funds.

Will it work?  No.  Our real estate problem is and has been that cheap credit (under market interest rates) produced a bubble in real estate prices.  Housing prices in the problem markets have yet to fall enough to new equilibrium level. They have another 5 to 10% to drop.  The market needs to bottom before it stabilizes and returns to modest growth.  Artificially holding up housing prices, as this plan does, will post phone for a short period but will not stop the market from seeking an accurate bottom.  The delay will increase the pain, not mitigate it and there will be new class of suckers, who bought on the way down.      

The Auto Bailout: A de facto Nationalization

General Motors and Chrysler have petitioned the government for another $22 B in loans to keep both companies solvent and running.  In exchange for the new money they have offered restructuring plans that, among other things, fire workers.  GM promises to fire 47,000 workers.  This makes it very tough for the President.  He justifies bailouts are to save jobs and a condition of the auto bailouts is firing workers??  The irony is thick indeed.  The details of the restructuring proposals show what insiders already know -- it is smoke and mirrors. The affected parties, shareholders, bondholders, the union, and management have not come to a workable deal -- they are waiting government direction.  Everyone was negotiating in anticipation of the government bailout, not in anticipation of Chapter 11.  The sensible negotiation strategy is not to put everything on the table until a huge uncertainty, the government's positions, is made clear.  There is no deal yet among affected parties; there is only posturing to government officials.  Treasury officials are pouring over books trying to figure out how many jobs GM should keep, what cars and lines of cars it should drop, how it should treat dealers.  What a mess.  Folks, we do not want Treasury in this position, in  de facto effect, running the auto companies.

One Bright Spot in the Bailout--Commerical Paper

The Fed's program to help commercial funds has worked well. Worried about the Reserve Primary Fund's "busting the buck," the Fed offered to guarantee price levels in money market funds and buy from such funds illiquid assets (ABSs).  The effect has been dramatic; the program has re-invigorated money market funds and the funds are buying commercial paper and short term asset backed securities (ABSs), both of which support operating businesses.  The Fed charges fees for the guarantees and, so far, has not had to make any payments. This site has long favored supporting the commerical paper market. The money market funds hold very high quality short term paper, easy to value and standardized to make it fungible -- the opposite of the mortgage backed securities (MBSs) that are held by our large financial institutions.  I continue to believe that the only way to handle the large banks that hold MBSs is to put the worse ones through insolency proceedings. An important byproduct of the proceedings will, of course, feature bids by vulture funds for the banks MBS portofolio that will help re-establish a market price for these otherwise impossible to value securities.

Kansas and California Short on Cash

Kansas and California have suspendend tax refund checks and appear to be unable to met their state payrolls. http://www.kansas.com/735/story/701750.html They are desperate for cash and can no longer borrow, even against healthy accounts.  This all comes after the passage of the Obama stimulus bill that promises them extra cash.  Several other states are in similar budgetary straights; they just have a better cash flow.

Now We Can Read the Stimulus Bill

After the Stimulus Bill passed Congress in a rush, over 1,000 pages drafted late Thursday night and passed early Friday morning in the House and late Friday night in the Senate, we now have time to read the bill.  There are many, many surprises.  First, Wall Street has "discovered" a late Thursday night insertion by Chris Dodd that substantially increases executive compensation limits on all companies that have or will get federal TARP funds.  {Will the President refuse to enforce the new limits with an "executive reservation" ?] Second, state and local governments have "discovered" that getting a slice of the bailout money designated for states and local governments puts their fate in the hands of obscure federal officials when have substantial discretion. [How to lobby??] There will be more surprises, many more.  I look forward to the President's signing speech Tuesday [he is on vacation]; it ought to be interesting.