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The Sky will be Falling…...

We hear that “the sky is falling” but we don’t know why.

Today, President Bush said that:

We have a problem.
- Press Conference, September 26, 2008

Senator Harry Reid said

There is a financial crisis…. We believe something should be done.
-Press Conference, September 26, 2008

The frustrating thing is that we (as taxpayers) don’t know the extent of the problem.  Our elected officials in Washington, D.C. are not telling us but they have no problem saying that it may cost us $700 billion, possibly more.  We do know that banks are failing.  Washington Mutual, one of the nation’s largest banks, failed yesterday.  Deposits were sold to J.P. Morgan Chase.

Now, the word is that the credit markets are frozen.  This means that banks are not making loans to businesses, potential homebuyers, potential car buyers or students.  This is a problem because it can stall economic activity.

Banks are nervous for two reasons: 1) they already have troubled assets on the books via home mortgages and they don’t want any more bad loans; and 2) if the market for “asset backed securities” – particularly the bond market - is bad then they have no way of spreading the risk inherent in loan activity via these securities and receiving more money to make more loans.  Ironically, banks are now conservative with their lending activity.  The bottom line is that banks will not make loans in this environment.

Banks, obviously, make loans such as student loans, mortgages and business loans.  There are other lending institutions such as credit arms of auto makers such as Ford or GM.  These lenders keep some of the loans as assets but a good a portion is pooled and sold to investors in a process called “securitization”.  Securitization typically means “asset backed securities” such as bonds are sold in the market and these bonds are backed by (payment of principal and interest) pools of loans.  A portion of the money that the lenders get in return for these bonds is pocketed as profit but most is used to make more loans.  This is what is meant by liquidity – generate more money to make loans by selling these bonds or “asset backed securities”.

Both the credit market (via mortgages) and the bond market (via mortgaged backed securities) are clogged with bad assets and bad securities.  The federal government may be the only player in both markets that can unclog the problem.  But the issue is what to do about it and at what price.  If the markets are frozen and illiquid then that there is a timing problem that must be addressed immediately.  If Washington does not act quickly then it starts to negatively impact other segments of our economy, particularly employment.

Treasury Secretary Henry Paulson’s proposal, besides giving a blank check to Secretary Paulson, tries provide liquidity to both markets by buying bad securities and the bad mortgage loans.  But his plan seems to indicate that bad mortgages are an after thought and the true focus is on something else.  Could it be the credit default swaps that devastated AIG?  We don’t know.  There is no transparency in the process.

Democrats propose more taxpayer protections such as equity stake in exchange for bad loans and securities, more accountability, and an executive compensation freeze.  But the $700 billion price tag is still there!  No one is explaining why such a huge price tag.  We will probably never know.  The sky may be falling on the heads of our children and future generation because of the actions of our government today.  That is truly sad.

Proposal:

It is probably too late for this but it is offered anyway as a point of discussion

Could it cost far less if we attacked the underlying problem: bad mortgages? 

The federal government should buy all subprime mortgages in default (not foreclosure) and insure (against a default) the rest of the subprime mortgages.  All subprime mortgages should be restructured with standardized loan terms and a fixed interest rate.  Don’t reduce principal amount of loan just the interest rate.  Don’t buy bad securities, especially credit default swaps.  This is “trickle up” economics.

The feds actions should restore confidence in the underlying assets backing these securities.  Borrowers may see some relief in the form of lower mortgage payments.  The markets can re-price the mortgage backed securities based on the government’s actions. 

We should focus on the problem not the symptoms.  When will we ever learn?