03 Dec Visions with Lorrie Heinemann: Financial rescue was necessary
Editor’s note: This is Part II of a two-part interview with Wisconsin DFI Secretary Lorrie Keating Heinemann. Part I focused on a developing state plan to boost Wisconsin’s capital formation efforts.
Madison, Wis. – The nation’s financial crisis is about two months old – old enough for some local perspective on what went wrong by the woman who leads the state agency responsible for protecting the consumers of financial services, ensuring the stability of state banks, and regulating financial service providers. Lorrie Keating Heinemann, secretary of the state Department of Financial Institutions, believes the federal government had to act to address a growing liquidity crisis, and said there may be one more financial storm for the nation to weather.
Legislation to address the crisis established the Troubled Assets Relief Program, or TARP, as part of a national financial rescue package. Under TARP, the U.S. Treasury Department had proposed using the first $250 billion of the $700 billion package to rescue troubled assets by purchasing mortgage-backed securities.
On Nov. 12, Treasury Secretary Henry Paulson announced he would shelve the government’s original plan to buy troubled mortgage assets in favor of more consumer-oriented approach that invovles purchasing equity and infusing capital into banks and non-bank financial institutions. This new approach, he explained, would allow the government to use some of the money saved from not buying troubled assets to shore up the market for credit cards, auto loans, and student loans.
Before Paulson announced his change in plans, about a half dozen state-chartered banks in Wisconsin were considering TARP. Banks now have until Dec. 8 to apply to participate in the Capital Purchase Program, which is part of TARP. Thus far, $148 billion has been dispersed into this program.
No matter what shape the rescue plan takes, Heinemann believes the federal government had to act because of the importance of liquidity. Without access to credit, foreign investors that have been sold mortgage-backed securities by our large investment banks would not continue to buy our debt because they would have little faith that we would pay it back.
“Had we not acted, liquidity would have been seriously tightened because of the fact we would not have had access to borrowing,” she explained. “The cost of capital for companies had gone up, and while our community banks continue to lend at a lower level (to small businesses), those bigger deals is where the liquidity has definitely been impacted.”
Heinemann said other initiatives that should help are the Federal Deposit Insurance Corp.’s decision to increase deposit insurance to $250,000 per account, and its plan to put an unlimited amount of FDIC insurance on non-interest bearing deposit accounts. For companies with large payrolls, those deposits would be insured.
Another liquidity boost should come from the Federal Reserve Board’s facility to back liquidity for money market mutual funds. This facility, which Heinemann called a liquidity backstop, will allow larger companies to sell their commercial paper into the market.
According to the FDIC, earnings at Wisconsin’s commercial banks plunged 73 percent in the third quarter, and 49 banks in the state didn’t turn a profit. The FDIC said profits at commercial banks, which focus primarily on business lending, dropped to $284 million, compared with more than $1 billion in the third quarter of 2007.
Some lay the financial crisis at the feet of groups that pressured financial institutions into lowering their lending standards to help economically disadvantaged people finance a home purchase – in many cases, a home they could not afford.
Heinemann said it’s important to note that Wisconsin banks “pretty much have stuck to their best practices,” particularly in underwriting of the mortgage industry. She said the banks with mortgage lenders typically would require a 20 percent down payment, verify income, and examine the borrower’s balance sheet to determine whether monthly payments could be made.
Most of the problems were created through licensed financial service providers (mortgage brokers) and subsidiaries of large, nationally chartered banks that had no affiliation with any one bank, but instead were issuing loans, not verifying the income, and basing their decisions on making money on the transaction.
“Once the transaction was completed, they sold it out into the open market and they were done with it,” she stated. “Going back to our banks, they did not really change their underwriting standards. They continue to lend into the market if the income levels are there.”
The banks do sell out to the market, she noted, but most of them maintain their servicing relationship with the customer.
Although steps have been taken to address disconnects between borrower and lender, the disconnects remain intact and will require federal action. DFI has no authority to regulate mortgage brokers, which are subsidiaries of national banks, that lend to the subprime market.
“[The U.S.] Treasury, as one of their regulatory authorities, has the Office of the Comptroller of the Currency. OCC regulates the national banks, and while we have some very good national banks in our particular market, you will see that the state’s ability to write laws, implement laws, and enforce laws is very limited as it relates to the mortgage brokerage industry,” Heinemann explained.
“That’s because of these subprime lending units of nationally chartered banks, which we’ve been pre-empted on. We have no regulatory authority over that.”
Nevertheless, “these are the sorts of things that are starting to be tightened up in the market, Heinemann indicated. Wisconsin, for example, has seen a significant decline in the number of licensed mortgage brokers and issuers, which has dropped from a high of about 14,000 to between 8,000 and 9,000. She expects this market to further contract.
“There are many good players out there in the mortgage industry that have been giving loans to clients for years,” she noted. “But the way it was set up, a lot of people got into the industry that should not have gotten there, and there were abuses because it’s transaction-based. Wall Street was willing to buy it, and Wall Street was willing to sell it out to foreign governments all over the world.”
Pension fund impacts
The impact on pension funds and angel and venture investors has varied. For the first nine months of 2008, the State of Wisconsin Investment Board has acknowledged 15 and 21.5 percent shrinkages in its core and variable funds, respectively, and venture investors worry about their ability to raise money for future funds if there is a prolonged recession.
SWIB has roughly $87 billion in investments under management. Approximately $80 billion of that total represents the assets of the Wisconsin Retirement System, the ninth largest public pension fund in the United States. The system provides benefits to more than 550,000 current or former state and local government employees.
SWIB, which has been criticized in the past for not making more venture capital investments in Wisconsin, gave $25 million to Baird Venture Partners in August, and $15 million will be used for co-invesmtents in Wisconsin portfolio companies.
Heinemann said SWIB has been extremely well run, but is not immune from fluctuations in the stock market. “They certainly were not absent from some of the derivatives back in the early 1980s, when we were in a recession, and I would imagine their portfolio is not going to be absent from some of the securities that are taking a hit right now,” she said.
With a fully diversified strategy, funds like SWIB and the massive California Public Employee Retirement System (CalPERS), which had assets totaling $233.4 billion as of August 31, 2008, should be able to withstand economic downturns. She pointed out that large pension funds continue to have deposits made into them as markets remain down, meaning that they continue to have access to capital when they are buying at a lower price.
Heinemann noted that CalPERS has been admired for years for its ability to diversify investments, and it has been very aggressive in investing in growing industries. She noted that CalPERS put $1 billion into clean energy technology, a strategic investment in what she called “one of the most highly potentially profitable industries in the United States.”
“You can’t make decisions based on short-term abilities in different markets,” she said. “That’s why you diversify your portfolio.”
Even CalPERS, however, is not immune from market fluctuations. In July, the system reported a 35 percent decline in its real estate and housing investments as a result of the nation’s housing bubble.
For angel investors, the news isn’t all bad. “Because capital is tight, what we’re hearing from some of them is this is a good time to negotiate the purchase of companies at a very good price, and of course if you can buy low and sell high at the end of the day, then you’ve made a better rate of return,” Heinemann said. “It really depends on the network, but it is more competitive for angel investors because they should be able to negotiate with the companies.”
Next financial shoe to drop?
Asked whether there are any other financial landmines in the offing, Heinemann laughed and cited credit card debt. Again, this potential strain would be partly due to products that were designed to avoid national regulation. Through the Office of Consumer Affairs, DFI regulates credit transactions under $25,000 in the state as a means of consumer protection. Not only does DFI see complaints rising about mortgage loans, it sees the same thing with regard to credit card companies.
There is tightening with credit cards as well, and for the most part it’s a nationally regulated industry, and a high-risk industry.
“You have all this credit card debt insurance that is out there, and in that particular market as well there have been several products that have been created to avoid regulation on the national level,” Heinemann said. “So again, I think you’re going to see foreclosures continue. I don’t think we have seen the peak of that yet. The numbers are going up, and I think you will see the same thing followed with credit card debt.”