Wednesday, July 30, 2008

Socially Responsible Investors and the Housing Bill (Amy Rosenthal, Peter Murray, Angela Wang)

We anticipate that the Housing Bill will impact socially responsible investors via it's impact on low and moderate income communities. Mortgage borrowers will win; lenders will suffer some losses. Several sections in the law (for example, rules concerning disclosure) will now force lenders to fully explain to borrowers exactly how mortgage loan payments work. In addition, new borrower counseling programs are created to provide advice to borrowers.

The bill’s first impact on social investors will come in the form of block grants given to the states. These block grants are meant to spur investments in troubled neighborhoods. Many times, foreclosed homes drive down property values in the neighborhood, leading to more foreclosures. The grants are targeted to areas with large amounts of foreclosed properties, and will help to prevent domino effect cited above. Low to moderate income communities, which have been hit hardest by the increase in foreclosures, should specifically benefit.

Several tax provisions also included in the bill. One section extends the net operating loss carryback period for businesses to four years from the current two year period. This means that losses recognized this year can be negated by taxes paid in prior profitable years, which would then allow the government to refund taxes paid in the past. The title also provides billions of dollars for new cheap mortgages as well as money to make currently foreclosed homes cheaper and therefore more likely to be taken off the market.

The bill also seeks to help certain targeted populations. It provides relief to people affected by the 2005 hurricanes as well as those affected by recent violent weather in the mid-west. Title IX of this bill is designed to aid veterans. Large amounts of funds will be allotted to maintain disabled or injured soldiers’ homes.

From a socially responsible investing standpoint, Title X is one of the most interesting parts of this bill since it not only helps homeowners keep their homes but it also encourages homeowners to be more eco-friendly. This title introduces the Clean Energy Tax Stimulus Act of 2008. The Act extends tax credits for using renewable resources in your home or business. The deadline for tax credits for investing in solar energy, fuel cells, and micro turbines is also extended by this act. Although this particular title does not directly address foreclosures, it will move homeowners to buy energy efficient appliances and heating systems. These tax breaks will also certainly bring on the development of a new wave of eco-friendly mortgage products. As more people begin to adopt these green technologies, the appliances and heating and cooling systems will become cheaper. Homeowners with these mortgages will also be less likely to default since the energy saving appliances and heating and cooling systems will reduce the monthly electric bill, which in turn would make the already low mortgage even more affordable.

The final part of the bill targets Fannie Mae and Freddie Mac. First, the bill establishes new regulatory oversight for the GSEs, now regulated by the Office of Federal Housing Enterprise Oversight. The new authority will presumably enforce tougher and stronger regulations, and will establish new capital standards to ensure the financial security of the GSEs. Second, the bill creates a temporary FHA program, called HOPE for Homeowners, to help certain borrowers who are at risk of foreclosures refinance their mortgages. Lenders voluntarily agree to participate in this new program. The program will be funded by Fannie Mae and Freddie Mac. According to the Congressional Budge Office’s most recent analysis, the new legislation will cost Freddie and Fannie approximately $710 million in 2009. Thus, the bill leans heavily on Fannie Mae and Freddie Mac to pay for the subprime mortgage bailout; the government is putting a big responsibility on the two corporations to pull the economy through this financial turmoil.

Amy Rosenthal
Peter Murray
Angela Wang

Tuesday, July 29, 2008

Expect other small banks to fail

From Alumni Connections, No. 44 - March 2008. Alumni Connections is a sampling of alumni news gleaned from media online and in print, including news submitted to Chicago GSB Magazine.

"William Michael Cunningham, Social Investing Advisor of Creative Investment Research, linked the failure of African-American-owned Douglass National Bank to the global mortgage crisis, according to a January 28 article in U.S. News & World Report. The bank, which originated in the 1940s, lost $1.3 million in 2007 and $4.3 million in 2006, the article said. Bad commercial real estate loans, not residential mortgage loans, led to recent losses, the article said. “It’s this secondary and tertiary impact of the crisis in the subprime market that’s beginning to impact smaller institutions mainly through [the slowdown in] consumer spending,” Cunningham told the magazine. He said he expects other small banks to fail, as a faltering economy inhibits borrowers’ ability to repay loans. Douglass is the fourth bank to fail since February 2007, the article said."

See: http://www.chicagogsb.edu/alumni/news/archive/archive-ac-march-08.aspx#alumnitoknow

Sunday, July 20, 2008

Foreclosure Prevention Act of 2008 (Peter Murray)

The Foreclosure Prevention Act of 2008 is currently being debated and molded by members of Congress. The bill is a response to the escalating housing crisis which has had damaging effects on the economy as a whole. It was introduced by members of the Senate in February in hopes that foreclosure rates could be brought down and the rippling effects of these foreclosures could be averted.

The first step that this bill plans to enact is better access to Federal Housing Administration (FHA) loans for families in risk of foreclosure. This will provide safe, fixed-rate mortgages as well as counseling services to homeowners.

Struggling homeowners would then be able to refinance into lower cost, government insured mortgages. The influx of funds to the counseling program could potentially help as many as 500,000 Americans receive advice on how to better manage their home. This government spending also acts as a stimulus to fiscal policy which may consequently help the economy.

Under this bill, a bankruptcy judge would be able to examine how much a debtor owes and then appropriately modify their mortgage.

Peter Murray

Saturday, July 19, 2008

Federal Reserve Chairman Ben Bernanke’s Monetary Policy Report to the Senate Banking Committee (Emerson Bluhm)

In his semi annual Monetary Policy Report to the Senate Banking Committee, Federal Reserve Chairman Ben Bernanke spoke about the current troubles in the economy, the future outlook and the FED’s plans to help the economy return to health. With an average of 94,000 jobs lost per month over the last six months, unemployment at 5.5%, home prices falling, rising inflation, soaring commodity prices and trouble at Freddie Mac and Fannie Mae, Bernanke was less than optimistic about the economy over the next year, forecasting extremely slow growth. While he claimed that the U.S. is technically not in a recession by a textbook definition, he acknowledged the hardships many Americans are facing with extremely low consumer confidence, declining wealth, and rising food and energy costs.

According to the Chairman, the housing crisis and rising commodities prices are at the center of the current economic problems. Bernanke told the committee that he believes the Treasury Department’s plan to backstop the Government Sponsored Enterprises (GSEs), Freddie Mac and Fannie Mae, is a step in the right direction to help the housing sector regain his footing. Bernanke expects the housing sector to bottom out by the end of the year and explained that once this happens, he feels the rest of the economy will largely fall into place. As the economy recovers, he believes that the dollar will strengthen. He expects inflation to rise further in the near term but moderate in 2009 as international growth slows and the commodity market cools down but acknowledged that this outcome is highly uncertain. While slowing international growth could hurt U.S. exports that have been vital to U.S. growth, he claimed it would be a net positive if it could help lower commodity prices. Bernanke cited rising demand and a shortage of supply as the reasons for rising oil prices. Several senators asked about the role of speculators in oil prices, to which Bernanke replied that they have had no role in the increase in oil prices and defended their role in the marketplace. Proposals to regulate the futures markets would have no effect on the price of oil.

Treasury Secretary Henry Paulson spoke to the Senate Banking Committee as well, defending the administration’s rescue plan for the GSEs. With Fannie Mae and Freddie Mac now touching 70% of mortgages and representing the only secondary market for mortgages, Paulson and Bernanke both claimed it was essential to provide a capital backstop to these companies to ensure a recovery in the housing market. The rescue plan calls for an 18 month window where the Treasury has unlimited funds to provide liquidity through a line of credit as well as unlimited funds to buy stock in the two companies if they see a need to raise capital. The plan also calls for reform that will give the FED consultative authority to the GSEs in order to reduce systemic risk.

Several members of the Banking Committee expressed their displeasure with the idea of giving the Treasury Department a blank check from taxpayers, questioning why the current $2.25 Billion line of credit would not suffice. Mr. Paulson responded that this $2.25 Billion was set in 1971 when the GSEs had a market capitalization of only $1 Billion. He explained that this was not enough today as “markets have changed but the architecture has not” and told the committee that the authorization to use unlimited funds shows confidence to the market and makes it less likely that he will have to use them. If Congress wants all the funds to be used, they “can make it small enough and it will be a self-fulfilling prophecy”, claimed Paulson who also likened the funds to a bazooka in the Treasury’s pocket. With the entire world watching the current economic situation in the U.S. very closely, Paulson urged a quick passage of the proposals to help restore confidence.

Securities Exchange Commission Chairman Christopher Cox faced many questions from the Committee about their role in enforcing and investigating claims of manipulation in the marketplace. With encouragement from many members of the committee, Cox also explained the SEC’s recent emergency decision to curb naked short selling in the equities of several financial firms. Concerned that short sales may be pushing the financial sector down too far, Cox said the SEC would move to immediately put an end to naked short selling in the GSEs and 17 financial firms for the next 30 days. The SEC is also considering extending this to the entire market. Cox also updated the committee on the SEC’s investigations and prosecutions of investors spreading false rumors to drive down stock prices, charges that he claimed were the first of their kind. He also described a desire to increase regulation of credit rating agencies and require more disclosure of off balance sheet items.

July 15, 2008. Emerson Bluhm.

Monday, July 14, 2008

Freddie and Fannie: What should be done now

Our recommendations for dealing with the housing GSEs are as follows:

1. Freddie Mac should be closed. Having a second housing GSE was supposed to provide competition and serve as a check on the first housing GSE, Fannie Mae. Clearly, this did not work. No need to continue, so:
2. Merge Freddie and Fannie. Instead of two failing agencies, we now have one. Allows for a concentration of focus, effort. Stabilize the resulting institution.
3. After one year, move Fannie back into HUD. Fannie Mae was separated from HUD in 1968. Time to reverse this. Moving Fannie into HUD extends the full faith and credit guarantee umbrella.

Time to revise the housing GSE experiment.

Saturday, July 12, 2008

Guiyang Pharmaceutical Company (Feinan Xu)

On June 26, 2004, China CCTV reported a serious pollution accident caused by Baiwen, a pharmaceutical company in Guiyang, China. On June 8th, residents near the factory noticed “black snow” in the sky. Some began to have respiratory problems. The Guiyang environmental protection office started an investigation and found that the incident was caused by the factory: they neglected to install equipment required to get rid of the sulfur and other chemicals. This led to the leaking of large amount of sulfur. The local government then ordered the factory closed for further investigation.

After a month, the company installed the required equipment. The local government then released them from prosecution and fined the company 150,000 RMB.

One must know what duties he or she has toward his or her organization, as well as which duties the organization has toward the society to which it belongs, before he or she can begin to practice. In a community, reinforcement of good practices and punishment of the bad practices set a boundary and helps us define what virtues are. An ethical person, confronted with a choice, does not calculate the impact virtue will have. Being virtuous, in and of itself, is good. Being uncompromisingly committed to being trustworthy, courageous, etc is then the only way to be sure that you are doing the right thing.

By installing the required equipment, it is true that the pharmaceutical company was doing the right thing to protect the citizens from harm, but social morals and laws played a significant role in driving the company to do so. If there were no punishment, would the company have adopted the same solution? It’s plausible that the company might have done the same thing out of empathy, but it is more likely that without local government’s punishment, the company would disregard the residents’ rights and only care about their profits. Beneath the company’s fear of being punished is the fear of losing face and reputation. Reputation is closely related with their position in business. Bad reputations means losing of shareholders, customers and government support. The company, hence, had no choice but take action to protect their reputation. We see from this case that social norms and rules help the society shape virtues and behavior. Through society’s rewards and punishments, we obtain the habituation of telling what is virtuous and practice virtuous moral characters.

Society is based on lawful practices. Thus, maximizing profits cannot be the only goal of companies. Socially responsible companies who perform lawfully will benefit the society as a whole. Goodwill, in the long-run, will win a good reputation for the company and therefore return more profits to the shareholders. The pharmaceutical company’s initial behavior was irresponsible, and shows that disregarding social responsibilities has a negative effect on the company. The company is responsible for the harm it does to other people and also has the responsibility of protecting the environment. This is the basic law that the company should recognize. The public interest is very important. Reputation is crucial. Fortunately, the director of the pharmaceutical company corrected the mistake it made. Though the decision to install the equipment might decrease their profits, the company would regain its’ reputation and in the long-run benefit shareholders.

There are several other feasible solutions. First, the local government can appropriate money to help the company install the required equipment. In return, the factory might pay higher taxes every year. In this way, shareholders, employees and residents would not be directly involved in creating a solution: the only two parties that would need to compromise are the local government and the factory. This is a “win win” solution for both parties. The local government can collect more taxes and the factory can solve the pollution problem from the root without too much burden. The other feasible solution is to search for substitute equipment. Or, the factory could make a down payment on the equipment and pay the balance in say, 30 years. In this way, the factory won’t have a large economic burden and the quality of their products can still be guaranteed. The third option is that the pharmaceutical company can add the cost of installing the pollution equipment to their product costs. This will probably cause some complaints by customers. But since the products of this factory will be of better quality than those of other pharmaceutical companies in the city, the customers may accept this change. At the same time, all the other parties’ rights would be protected.

Corporations have duties to shareholders. Managers are in an agency relationship with shareholders and must operate lawfully. Shareholders’ benefits are paramount. They have the right to require the company to maximize return on investment. Decision makers have to minimize harm done to the shareholders. However, maximizing profits should not be company’s only aim. Companies that do not obey social morals and laws are doomed to fail. Being responsible to citizens, society and the environment might sometimes conflict with short run profits, but will do more good in the long-run. Besides the duty to shareholders, companies also have duties to stakeholders. Stakeholders whose basic rights are violated should be given priority. Solutions that produce the greatest ethical utility are optimal. To realize excellence, habituation of virtuous behaviour is required. The reinforcement of good practices and punishment of bad practices is critical in shaping our understanding. Companies should follow the socially responsible path and implement in the decision making processes. Only by doing so can companies maximize profits over the long term.

By Feinan Xu, Master of Accounting student at George Washington University.