Proposal To Eliminate Government Subsidies Hammers Sallie Mae

Shares of student lender Sallie Mae (SLM) are down 42% this morning after the Obama Administration’s newly unveiled budget included a proposal to eliminate government subsidies paid to private banks who make student loans. The subsidies, which cost the government billions each year, would cut government spending by $47.5 billion over the next 10 years. Wall Street is outraged, claiming that getting rid of the subsidies will drown out private student lenders and increase the market for government loans (and therefore government involvement in our economy).

I’m confused. I thought we all want a free market capitalist system? If private student loans are unprofitable (and therefore require government subsidies in order for banks to offer them), wouldn’t the free market dictate that private student lending is not a worthy endeavor for private, profit-seeking banks? Maybe I’m missing the point, but I think reducing any government subsidy, and therefore the budget deficit, would be a good thing, especially for proponents of the free market.

As for the argument that this measure would virtually eliminate private student lending, I guess I’m not convinced. Given how creative and entrepreneurial our private industry is, do we really think they can’t come up with a student lending program that is both attractive to the borrower and also profitable for the lender? I have no doubt that the banks would love to keep getting these subsidies, but the notion that student lending in the private sector can’t be maintained without them seems a bit extreme, and even if that is the case, maybe private lending is a flawed model.

What do you think?

Full Disclosure: No position in Sallie Mae at the time of writing, but positions may change at any time

With Banks Cutting Common Stock Dividends, Look At High Yielding Preferreds

If you’re a bank that took government TARP funds, whether you asked or were forced to take them, you better be very careful about paying for travel or entertainment for any of your employees or clients. Latest example: Northern Trust (NTRS), a custodian bank that had the nerve to send people and entertainment to the Northern Trust Open golf tournament. Of course, now people are irate because NTRS took $1.6 billion in TARP money and is now “using taxpayer dollars to throw parties.”

Don’t be shocked if they give the money back very soon. Northern Trust is not your typical lending institution, but instead focuses on back office services for financial services firms. As a result, the company is actually doing very well and continues to make good profits even in this environment. The company didn’t want or need TARP money, but former Treasury Secretary Henry Paulson didn’t give them a choice, he made them take more than a billion dollars.

We are now hearing that many banks (those that took TARP funds) are cutting the dividend on their common stock to one cent per share per quarter, thanks to the new wave of government involvement in the management of these firms. Since many investors rely on dividends for regular income, and some banks tried to reject the government money and the accompanying scrutiny, these dividend cuts are tough to stomach for the healthier firms and their investors.

There are alternatives though, namely the publicly traded preferred stock of these banks, which pay lofty dividends and aren’t in danger of being cut because the government is getting paid interest in the form of preferred dividends. There is no way Treasury will make banks cut its own dividend payment, so as long as a bank is relatively healthy and is in little danger of being the next victim of the credit crisis, investors can dip their toes into the preferred stocks of the stronger banks.

Not only are these preferred shares trading at large discounts to par value, but the dividend yields range from 10% to 15% in most cases. In order for a bank to stop paying preferred dividends, it really has to be in bad shape, so if you are looking for high dividend yields in the banking industry, look at the preferred stocks of those banks you think will survive the current mess.

Full Disclosure: No position in Northern Trust at the time of writing, but positions may change at any time

No, Canada Isn’t Evil

Did you know that more North American cars are manufactured in Ontario than in Michigan?

Unfortunately, our country’s political tensions are so elevated that anyone who even suggests the possibility that another country may do something better than the U.S. is labeled unpatriotic. Of course, those suggestions are made because the person making them cares deeply about our country’s future, but that point often gets ignored.

Fareed Zakaria of Time Magazine penned an interested piece in the 2/16 issue entitled “The Canadian Solution.” In it he points out several areas in which Canada’s government policies appear to be working better than ours. Maybe if we finally can admit that not everything we do in the U.S. turns out to be perfectly right, we can begin to at least consider other kinds of policies without being labeled un-American.

It became clear from President Obama address last night that healthcare reform will be on his agenda in 2009. A likely focus for such reform will be making sure that every American has health insurance. Such a task will undoubtedly be bad-mouthed by many, labeled as socialism.

“Let the free market work, we can’t be socialists like Canada and France!,” they’ll say. The free market is usually great, but if you have been diagnosed with a disease and lose your job and employer-based insurance plan, you often can’t turn to private health insurance provided by the free market. Either the insurance company will refuse to cover you at all (because they won’t make a profit on someone who is sick), or they’ll charge you a few thousand dollars a month, which obviously you can’t afford. The free market works most of the time, but not all of the time, as the sub-prime bubble has taught us so well.

Zakaria’s article uses evidence from Canada to try and show us that sometimes other countries get things right more often that we do. Simply pointing out facts does not make Zakaria unpatriotic, it simply suggests that he believes we should keep an open mind about certain important issues. After all, if our system isn’t working very well, but we refuse to adopt the ideas of other countries, then how can we ever expect to make improvements?

Below are some excerpts from Zakaria’s article:

“Guess which country, alone in the industrialized world, has not faced a single bank failure, calls for bailouts or government intervention in the financial or mortgage sectors. Yup, it’s Canada. In 2008, the World Economic Forum ranked Canada’s banking system the healthiest in the world. America’s ranked 40th, Britain’s 44th.”

“Canada has also been shielded from the worst aspects of this crisis because its housing prices have not fluctuated as wildly as those in the United States. Home prices are down 25 percent in the United States, but only half as much in Canada. Why? Well, the Canadian tax code does not provide the massive incentive for overconsumption that the U.S. code does: interest on your mortgage isn’t deductible up north. In addition, home loans in the United States are “non-recourse,” which basically means that if you go belly up on a bad mortgage, it’s mostly the bank’s problem. In Canada, it’s yours.”

“Ah, but you’ve heard American politicians wax eloquent on the need for these expensive programs (interest deductibility alone costs the federal government $100 billion a year) because they allow the average Joe to fulfill the American Dream of owning a home. Sixty-eight percent of Americans own their own homes. And the rate of Canadian homeownership? It’s 68.4 percent.”

“Its health-care system is cheaper than America’s by far (accounting for 9.7 percent of GDP, versus 15.2 percent here), and yet does better on all major indexes. Life expectancy in Canada is 81 years, versus 78 in the United States; “healthy life expectancy” is 72 years, versus 69. American car companies have moved so many jobs to Canada to take advantage of lower health-care costs that since 2004, Ontario and not Michigan has been North America’s largest car-producing region.”

Why Letting Citigroup Fail Could Cost Taxpayers Hundreds of Billions of Dollars

Why has the government injected $45 billion into Citigroup (C) rather than simply let it fail? Believe it or not, because of how much it might cost the taxpayer to do so. I know that might sound backwards, but consider the largest bank failure so far, IndyMac.

IndyMac had $32 billion of assets and its failure cost the taxpayer a whopping $9 billion (remember, the government insures customer deposits should a bank fail). Well, Citigroup has more than $2 trillion of assets, which makes it about 64 times larger than IndyMac. While the numbers won’t be exactly proportional, if you multiply 64 by $9 billion you get an estimated cost to the taxpayer, in the event Citigroup fails, of a staggering $570 billion.

Considering the FDIC insurance fund stood at $35 billion at last check, you can see the government doesn’t have the money to let Citigroup fail. That is probably one of the reasons why they might prefer to provide aid to Citigroup in exchange for an ownership stake. It is conceivable that would be far less costly to the taxpayer to keep them afloat than it would be to let them fail.

Full Disclosure: No position in Citigroup at the time of writing, but positions can change at any time

Obama Housing Plan Details

Lots of people are already complaining about Obama’s housing plan unveiled yesterday based on the presumption that it is bailing out lenders and homeowners who made poor decisions at the expense of those who are paying their mortgages on time each month. Here are the details of the actual plan, which don’t seem as bad as some are claiming with respect to moral hazard.

1) Allow Responsible Homeowners to Refinance their Existing Mortgage (4 to 5 million households)

You may not think the government would need to intervene in order for this to happen, but Fannie Mae and Freddie Mac do not guarantee loans if the loan amount is more than 80% of the home’s value. This is a problem in the current housing environment because with housing prices dropping so rapidly, home owners who are paying their mortgage on time still may not qualify for a refinance, even if they are current and simply want to lower their payments since interest rates have fallen.

The Obama plan lifts the loan-to-value cap for refinances to 105% from 80%. As a result, responsible home owners who want to refinance their mortgage to a lower rate can do so, as long as their loan balance is no more than 105% of their home’s value. This change will reduce monthly payments for many responsible borrowers and therefore help prevent future foreclosures.

2) Offer Incentives to Lenders and Borrowers to Modify At-Risk Mortgages (3 to 4 million households)

Since not all mortgages are guaranteed by Fannie and Freddie, Obama’s plan provides incentives for lenders to work with borrowers who are at-risk of default before they become delinquent. Currently most lenders require you to be a few months behind on your mortgage before they work with you on a loan modification.

This plan offers lenders cash payments for every modification they complete. To prevent lenders from dropping the monthly payment by a very small amount simply to collect the upfront fee, they are offering another incentive payment if the loan remains current for a year after the modification.

As for what amount the monthly payments should be adjusted to, the government is offering incentives for loans that total no more than 38% of the borrowers income. The government will subsidize the mortgage interest by 7% of income, so that the monthly payment will equal 31% of monthly income.

The lender will still decide if it wants to modify a loan or not, so the government is not forcing them to do anything, but merely providing incentives to try and reduce future foreclosures for at-risk mortgages. If you lose your job and are facing foreclosure, adjusting your payment to 31% of income may allow you to keep your home in some cases, but clearly not all of them. Investment properties owned by speculators do not qualify under this program.

Will Obama’s Stimulus Plan Work?

As President Obama gets ready to sign the 2009 American Recovery and Reinvestment Act later today, a common question is, will it work? Of course we won’t know for a while, but my honest non-partisan opinion is “a little bit.” There is little doubt that parts of the bill are positive for our country and the employment situation, whereas others are likely to not do us any good. I think that the extreme views on either side, that this bill will either bring us out of recession or make it far worse, are both unfounded.

In particular, there are some people that insist FDR’s New Deal in the 1930’s prolonged the Great Depression, and only when World War II began did the economy rebound. They use this argument to imply that this stimulus bill (a mini New Deal of sorts) will further cripple our economy. I just wanted to share the chart below with everyone in order to debunk this myth.

Arguing that government spending does not create jobs is pretty silly. You can certainly take the position that government should not do anything (let the market work!), or that we are spending too much money when we are already in debt (to the tune of $10 trillion!), but denying that building a road, or upgrading a power grid, or funding medical research grants will require incremental workers is a pretty strange assertion.

The idea that tax cuts are a better means to create jobs is odd too because giving a tax cut to an unemployed person (who isn’t earning any money) doesn’t really help them very much, and it certainly doesn’t get their job back. An extra $13 per week (or whatever the number is) might help people pay their bills, but it can’t boost demand enough to force companies to need to hire more workers to meet that demand.

All in all, I think this bill is far from perfect and I don’t think it will have the same impact as the New Deal did on our economy. That said, there is no reason to think it won’t have some impact. Probably not enough to return to positive economic growth and falling unemployment anytime soon, but before we can grow again we have to halt the decline and hopefully this bill can contribute to that goal. Everyone should hope it works, whether you supported it or not.

NYT: You Need $1.6 Million A Year To Live In New York City

It might be one of the silliest stories I have read in a long time. On Friday, Allen Salkin of the New York Times wrote a piece entitled “You Try to Live on 500K in This Town” in which he argues that a family of four needs to earn around $1.6 million just to cover living expenses in New York city.

The article is aimed at criticizing the Obama administration’s proposal to limit the base salary of top executives at AIG, Bank of America, and Citigroup to $500,000 per year as long as their companies are staying afloat thanks to government aid. The argument is kind of short-sighted anyway, given that the executives in question already have net worths in the tens (or even hundreds) of millions of dollars, and therefore forgoing huge salaries for a couple of years is not going to result in their lavish Manhattan apartments being foreclosed on.

Nonetheless, the idea that the very executives who are largely to blame for the financial crisis should not have to make any financial sacrifices, like the rest of the country is being forced to, is pretty ridiculous. I highly doubt the content of this article is going to win any sympathy from the vast majority of people reading it, but maybe that’s just me. What do you think of Mr. Salkin’s argument?

U.S. Economy Can’t Truly Recover If Policies Turn Protectionist

What a shame. The $800 billion+ stimulus bill being crafted in Congress isn’t that impressive. Sure, there are some very good ideas that made their way into the legislation that will create jobs and improve the efficiency of our economy (infrastructure spending on roads, bridges, and the power grid, for example) but it seems for every good idea there is a bad idea to match it. Thank goodness they took funding for STD prevention out of the bill. There is nothing wrong with supporting the measure, but it certainly does not belong in an economic stimulus bill.

The part that is perhaps getting the most attention is one that would require that all infrastructure projects be completed using 100% American made materials. Somebody even proposed an idea that requires U.S. companies to fire foreign workers first, before letting go of any U.S. workers. These kinds of protectionist policies are absolutely horrible ideas.

It is a shame that our elected officials seem to write laws without ever consulting those who are educated in the area they are trying to legislate. Any economist or CEO will tell you that such policies will backfire. Congress seems to think that requiring Caterpillar to use U.S. steel in their industrial equipment will stem job loss in the U.S. because more steel workers will be needed to produce the steel. Sounds logical if you halt the analysis there.

In reality, though, Caterpillar will have to raise the prices of their equipment under such a scenario because domestic steel is more expensive. All of the sudden, Cat’s prices are above those of their competitors and their customers will start buying from other companies instead to save money. As Cat’s sales drop, they need to fire more workers, hardly the original intent of the policy .

The problem is we are in a global economy and the U.S. is no longer the fastest growing, most financially strong nation in the world. If U.S. companies ignore their foreign customers and competitors, our future will be bleak.

Someone will probably soon suggest that we protect jobs at home by requiring the Big Three automakers use materials made exclusively in the U.S. If that happened, U.S. car prices would be higher than their foreign competition, U.S. consumers would have fewer reasons to buy U.S. cars (in the long run, supporting your country by making a poor financial decision hurts the U.S. more than it helps it) and the Big Three would sell fewer cars, not more of them.

I think most people agree that a properly structured stimulus bill could be helpful for our economy, but couple the pork projects that would do little to boost jobs and growth with protectionist policies and any good measures in the bill could very well be quickly offset by bone-headed decisions elsewhere. From what we know so far, it doesn’t look like this upcoming bill will be anywhere near as good as it could have been, which is truly a shame.

Obama Team Discussing Bad Asset Purchase Program, But It May Be Too Late

I have written here previously that I didn’t understand why former Treasury Secretary Henry Paulson abandoned the original plan for the Troubled Asset Relief Program (TARP); buying troubled assets from banks to free them up to have more lending flexibility. CNBC reported Tuesday evening that the Obama economic team is preparing a plan to do just that. While it is the better idea, it is also a shame that we have already plowed through $350 billion in preferred stock investments in the banking sector.

The preferred capital injection idea was doomed from the start because it did two things that hampered the banks. First, the preferred stock carried interest rates of 5%-10%. A bank taking $10 billion from TARP might have to pay out $1 billion in annual interest to the government. Sure, that helps the government get its money back sooner, but it requires the banks to hoard capital to ensure they can pay out the interest on time. When capital is so scarce, making the banks pay out more in interest is not going to help them.

But the banks can lend out the vast majority of the TARP money they receive, right? Not really, which brings us to the second problem; with the troubled assets still on the banks’ books, they need to hoard capital to cover future losses that will be incurred on those assets. Without helping to relieve the banks of the sub-prime assets that are causing most of their losses, the new capital is just going to be eroded away as further losses mount. If someone comes into the emergency room with a dislocated shoulder, you don’t just give the patient painkillers, you pop it back in place to help relieve the source of the pain!

The first part of TARP simply treated the symptoms of the problem, not the source. As a result, we have blown through $350 billion already and don’t have much to show for it. It is encouraging that the Obama team is trying to find a solution for the troubled assets even though it is a complicated idea, but it just might be too late. We’ll have to see what the plan looks like (if it even comes to fruition), and more importantly, how receptive the nation’s largest banks are to participating in it.