Economy--How do we fix this boat?

I finally threw in the towel (along with the shorts, sunblock, and sandals) this week, and headed to Hawaii, to get away from all the negative economic news. Just took the week off. But I still couldn't totally escape the news of the economy.

As it turns out, though, long flights, and tropical paradises are a good way to take a step back, and start to evaluate things. I read 2 great books, and 3 great magazines on what is happening, and I think I have started to come up with a workable solution to the economic solution.

The good news? Obama's team is starting to make the moves to get there. The bad news? He needs to step up the speed of delivery.

The OVERT Issues:

• People are losing their jobs
• The Stock market is dropping
• House Values are dropping

The COVERT Issues:

• Consumer Confidence is shattered
• Toxic assets are killing bank's ability to lend

What to do to fix it:
For the past few months, we have been focused on the right issue, but the wrong side of the issue. The Obama plans are a first step to addressing the issue, but don't go far enough. Here's what I mean.

Our banking system is in this mess in part because of the securitization of mortgages into Collateralized Mortgage and Debt Obligations (CMO's and CDO's). What does this mean? It means that the banks you used to trust your mortgage to, no longer actually service mortgages. They simply package up the payments that you make, into a fixed income product, that they can sell in the open market. Other banks and financial institutions buy these securities, and hold them as assets on their balance sheets.

The problem comes in when determining what these products are actually worth. If I am a financial institution, and I bought a package of someone else's mortgages (which is really what a CMO is), I may have paid $100 for a single CMO "security" or "bond". I expect that it will pay me back a rate of, say, 6% over the next 5-10 years (the average life of a mortgage).

What is happening, is that the bank that made all those mortgages (the initiator bank) get their monthly payments (interest and principal), on the first of the month, and "pass through" those payments to the CMO "packager", or the institution that bought the mortgages and sold them in a CMO, to me. That pass through happens around the 15th of the month. The initiator bank gets to earn interest on the money being passed through, and the packager skims some of the interest as well, leaving me with my 6.5% interest payment each month. All is well, as long as everyone makes their mortgage payments, right?

Unfortunately, not everyone is making their payments these days. "...but Mr. Pundit", you may ask, "aren't foreclosure rates still REALLY low, like 3-4%?". I would respond, "you are absolutely correct, but the increase in foreclosures from 1% to 3% is in fact a 200% increase, and is causing two major issues:

First, the number of defaults increasing so much, and so rapidly, is causing fear and concern in the overall market place.

Second, and most importantly, the ability for a secondary market to buy and sell these securities has completely frozen. There is NO activity, no buys, no sells, other than companies SO DESPERATE to move these securities, that they will take any price. Why is this important, you ask? Because without a functioning market, there is no way to value these securities. Without a way to value these securities, these bank's auditors are forcing companies to write down the value of these securities to the lowest possible values. In other words, they are being valued at "fire sale" prices.

Put another way, I may have a brand new, Plasma television that I want to sell on eBay. I know it's worth $2,000, but if I HAD to sell it tomorrow, to, say, bail my wayward brother out of jail, and the best bid I could get for it was $300, guess what I have to value the television at? $300. Is it fair? In reality, it's really the only way to get a true market price these days.

The same thing is happening in the market place. There are trillions of dollars floating around in these "CMO's", and there is no real market place to buy and sell them. Everyone is worried about the underlying value of the bonds. With no functioning market, companies are being forced to value them at rock bottom, and unrealistically low prices. This is killing the bank's ability to loan money, since they have to use all of the TARP, and other fed funds to simply improve the asset reserves they lost in this horrible valuation write down.

So Hank Paulson started with the idea of simply buying up these terrible assets from banks. The idea makes all the sense in the world. After all, if there is only a 3% default rate, then 97% of the assets the federal government buys will make money. That's an incredibly successful investment.

There's only one problem with the logic. What do you PAY for these assets? Valuing a CMO isn't like putting a value on a 2004 Chevy Malibu with 50,000 miles on it. You have to determine the probability of future cash flows in an increasingly deteriorating housing sector. That sounds a little like trying to catch the wind in your mosquito net. As Paulson and his pal Neel Kashkari found out this fall, the task proved to be much more difficult than just giving banks money to lend.

But pushing dollars out to banks is a little like trying to fill up Lake Michigan with a garden hose. A bank that has lost $100 Billion in asset valuation isn't going to start lending just because the federal government gave it $25B. Especially if it sees mortgage default rates rising 300%, and unemployment rates going higher.

So what's a Fed, and a President to do?

Instead of looking to solve the problem at its end point, let's try to solve it at the beginning point. Focus less on the mortgage provider, and more on the Mortgage PAYER. How can we guarantee more of the payments going into these securitizations will pay off? Well there are a few things Obama and Geithner can do. Some they are already doing:

1. Keep "upside down" mortgages paying, through a mortgage cram down, and renegotiation--many people who have the capacity to pay their mortgages are walking away from their debts, because they are "upside down". In other words, they paid 10% down on a $200,000 house ($20,000), that is now worth only $150,000. They now owe $180,000 on a $150,000 house. For these people, it is easier to walk away from this house than to keep making payments on an investment that is under water. Obama's plan is to renegotiate these mortgages with the banks down to $150k, to give people incentive to keep paying. This could fix PART of the problem.

2. Allow ALL credit worthy investors to renegotiate mortgages at 4%. This, in my opinion is THE way to solve a few problems at once. First, it allows all of the good creditors, who are paying their mortgages on time and in full, to put as much as a few hundred dollars A MONTH back in their pockets. Second, it allows default rates on many of the mortgages in these CMO's to decline, and increases confidence in the securities. Third, it gives the market a better opportunity to evaluate the underlying value of these securities, and in many cases, can be an INFLATOR of valuations, back to the point that banks will be more capitalized. In essence, it is a "split the difference" solution.

3. Message to the Treasury--Start picking winners and losers. Save the winners, nationalize the losers. Yeah, I said it. Nationalization of some banks. It's going to have to happen. Save JP Morgan, Wells Fargo, Goldman, Morgan Stanley, and Nationalize Citibank and AIG. Bank of America is a toss up. This is Geithner's plan. But it is going to need to be evaluated soon. I think you try steps 1 and 2, and immediately. Step 2 should give the markets a boost, and could lead to enough euphoria and additional cash flow, that some of the economic problems take care of themselves. Step 2 should act as a shadow tax cut, and will reward those people most fiscally responsible. Not a bad way to make government work for you, eh?


In the end, I think this is where the Obama team will end up. They don't want to be running banks, and now that they have their initiatives moving (green technologies, SCHIP, infrastructure, etc). A healthy economy should give them the kind of political capital that would allow them Reagan-like carte blanche in the years ahead.

Republican or Democrat, who wouldn't want a better economy, more money in their pocket, and reduced dependence on foreign oil? Sounds like a winner to me...