Yes We Can (Help Main Street); By Karl Denniger

[marketcrazy1]

This is a four-point plan to bring a durable bottom to both the housing market and the economy at large. Let's go through it point-by-point, and expand on the "why" behind each.

First, housing:

The plan would create a 4.5%, 30 year fixed mortgage through GNMA (Ginnie Mae) for all existing homeowners on their primary residence. Any homeowner could refinance any existing mortgage into this note. All mortgages written under this plan would be fully-underwritten for income and assets, and the borrower would have to qualify under no more than a 36% DTI (back-end) ratio.

The government would allow a 50 basis point profit for the banks that originate the loans, and the government would absorb the remainder of the pricing differential between 4.5% and the Ginnie Mae bonds issued into the marketplace to fund these mortgages.

This would be available to homeowners irrespective of their FICO scores or existing delinquencies on their primary mortgage - that is, those who are late would qualify.

In addition the principal would be written down to the lower of the outstanding balance of any existing mortgage(s) or the home's appraised value. Home Equity lines that could be documented to have been spent on improvements would be included in the written-down amount but second lines not used for home improvement would NOT be included and would remain in force (sorry, no free Hummers.) Since these are effectively foreclosures and refinances rolled into one (somewhat like a short sale with a new mortgage) the existing mortgage holders would be forced to book the losses, if any, that would come from this program and their liens would be extinguished.

The program would run for six months. At the end of the six month period permanent regulations would go into force that would require all lenders to foreclose on any property delinquent 90 days or more, and to resell all such foreclosed properties within a further 90 days.

This would cause a "mark to market" of the entire United State housing stock. Within one year we would find a durable and sane bottom for housing prices in all markets across the United States.

Those persons who want to keep their homes and are able to make the payments under sound lending principles at today's values would be able to do so. Those who cannot or do not wish to would be foreclosed upon within 90 days, and their property would be sold off either privately or at auction within a further 90 days.

This would immediately end banks illegitimately holding back on property sales or foreclosures to "cook" their claimed security and loan values, it would force prices to correct to a durable and sustainable level, and within one year ordinary Americans who currently are renting or have been evicted by foreclosure would be able to purchase houses at reasonable and stable prices.

In short, it would clear the market.

This would also almost certainly bankrupt several large banks, who would have their fantasy portfolio values exposed as entirely illegitimate. This is a good thing, not a bad thing, as clearing this debt from the system is absolutely essential to economic recovery. Japan went through a "lost decade" as a direct consequence of their refusal to deal with this very same issue, and we must not make the same mistake.

Second, Usury:

All lenders would be prohibited from making any consumer loan at an interest rate of more than 10% above Fed Funds.

Banks claim they need to be able to "price for risk." I assert in reply that banks that are unable to make a profit at an interest-rate spread ("NIM") of 10% on any given loan are in fact making a loan that is unlikely to be repaid - that is, a predatory loan. Since predatory lending - that is, lending to people who are unlikely to be able to pay you back - is how this crisis occurred, we must prevent that.

This interest rate represents a net interest margin of roughly double that banks are earning now on their lending, and as such is certainly not onerous, but it does prevent nearly all of the abusive practices of the last ten years.

Forcing banks and other lenders to lend only to credit-worthy borrowers through "regulations" is almost impossible to achieve. Such regulations have in fact been on the books during this entire mess, yet they did not prevent the credit bubble, as interpretation of what is a "credit-worthy borrower" is subjective.

This change will make the criteria blatantly objective and impossible to gimmick - if you can't make a profit at a net interest margin of 10% on a given loan then you can't make the loan at all. Since Fed Funds will change over time, the top interest rate that can be charged will also vary over time.

This credit bubble came about due to banks and others making loans they had no reasonable belief would be able to be repaid, relying on the ability to pass these loans off to others in the form of securitization. This allegedly "removed the risk" from their balance sheets. Alleged reforms such as forcing banks to hold some piece of a securitized product does not address the concern, as they can pick and choose which tranche to hold and how to structure the paper - in short, the process can still be gamed.

Capping interest rate margins on the other hand makes gaming the system impossible. Either the loan can be made in a profitable fashion at that rate or it cannot, and if it cannot, it won't be made at all.

This stops predatory lending cold, defined as lending money to someone without a reasonable expectation that they will be able to repay the amount lent on the original terms.

Third, Bankruptcy Reform:

The "bankruptcy reform" act must be repealed. Businesses can declare bankruptcy under Chapter 7 and liquidate at any time. It is an outrage that consumers cannot do so; this change in the law was alleged to promote responsibility, but it in fact did exactly the opposite in that lenders no longer cared if you could pay within terms as they could pursue you even if you defaulted!

The Bankruptcy Reform Act was one of the worst pieces of legislation to come down the pike in the last 30 years. By making it impossible for many consumers to declare Chapter 7 and liquidate debts the act removed from lenders the need for scrutiny of a borrower's financial condition. All that was necessary was to know if the borrower's income was over the median; if so, they would be barred from Chapter 7, and the lender would be able to recover under reorganization, or Chapter 13.

While the goal (increasing consumer responsibility) was laudable, the effect was exactly the opposite of what was intended. Instead of increasing consumer responsibility the law destroyed lender responsibility by significantly increasing the odds that a lender would be able to recover from a defaulted borrower in bankruptcy court!

We must repeal this law to restore balance - a bad loan should bankrupt both the lender and the borrower, not only the borrower. Since lenders have more information than borrowers on consumer behavior and far more sophisticated tools with which to determine the probability of default, the primary responsibility for determining that risk must fall upon them. Restoring bankruptcy parity is the only way to achieve this goal.

Fourth: Restore Glass-Steagall

Institutions that take deposits and/or make loans via fractional reserves, or access Federal Reserve credit facilities, must not be permitted to trade in any form.

Those firms that currently violate this prohibition must be broken up into legally and financially-distinct entities.

Lending at fractional interest and taking deposits is inherently a privilege involving the credit of the sovereign, in this case The United States. The FDIC guarantee extends to depositors the full faith and credit of the United States Federal Government, and that base inherently forms the money from which loans are made.

For such a firm to trade inherently leads to the outrage that we saw with Goldman Sachs and other similar companies during this crisis. Many of these firms traded in credit-default swaps issues by AIG, for example, either knowing or in a position to know that AIG's financial products division was not adequately capitalized to cover the book of business they had written.

When these bets turned out to be impossible to cover the banks then turned to the government and claimed "systemic risk" - that is, the Federal Government had to come to the rescue lest either capital markets be severely disrupted or worse, depositor money would be lost. Now some of these very same firms are recording very high profits, which they are keeping for themselves and their associates, after successfully foisting off the losses due to their own imprudent behavior on the taxpayer.

Regulatory surveillance obviously did not prevent this travesty and it will not in the future. Regulatory "capture", along with market participants simply being crafty, insures that a firm that wishes to hide such risks from regulators can do so up until a crisis erupts. We have seen from the government's response that it is absolutely unwilling to indict those who engage in regulatory arbitrage, those who make loans that they have every reason to believe will never be repaid, and those who game the ratings system via various mechanisms. In short people will cheat and our government will not prosecute, so we must make cheating impossible via structural changes to the system rather than rely on the presence of policemen who would indict and jail the bad actors after the fact.

There is only one solution that works: force all firms who wish to trade to do so with their own capital, and never allow them any access to the sovereign's balance sheet in any way, shape or form.

This immediately removes all elements of "systemic risk" from the equation - now a bad bet of sufficient size simply means that the firm involved fails, but there is no risk of a credit or operating loss to the government.

This change also enforces underwriting of loans on the banks. Those institutions that lend via fractional reserve or take deposits now cannot rely on any means other than their interest margin to profit from loans. They can sell loans into the marketplace, but only as whole loans - not as securities. As such they are unable to "cook" the paper in such a fashion as to earn money by other than prudent lending.

The current system allows a bank to intentionally underwrite unsound loans so long as it is able to foist them off on someone else before they blow up. In many cases they can actually make more money doing this - what is in essence fraud - than by underwriting sound loans! This sort of outrageous conduct is why we had a credit bubble and why we are now suffering from a bust, and it must not be allowed to continue.

There is no other means of preventing these abuses than forcing the separation of functions between lending institutions and trading institutions - Glass-Steagall had it right, and we blew it when we repealed the law.

We must restore it.

Expected Results: Bold Action, But For What?

If these four points were enacted I expect the results would be:

Some mortgage bondholders would raise hell. And? I believe this can be defended against in court if necessary; the argument that this is a "taking" isn't that hard to address. Insoluble debt and intentionally-false marks taken on an asset constitute fraud and there has been plenty of that - which we must remove from the system. This plan forces realistic marks to the market on those assets with no more game-playing. While I'm sure there will be plenty of squawking, I don't believe it will go anywhere if and when it goes to court.

House Prices would contract to a durable bottom within one year. Americans of modest means would be able to buy modest homes on their incomes, without exotic and dangerous mortgages, within one year. The excess inventory would be cleared from the system and prices would stabilize, albeit at a significantly lower level. Foreclosures would experience one final spasm and, for the most part, be finished. The housing crisis would be over.

Several large banks would immediately fail. But community banks and credit unions, who acted prudently through the last ten years, would see tremendous increases in their business and need to hire many new employees. Wall Street would suffer its just desserts, but Main Street would benefit tremendously. Loans would be made based on actual credit quality, not lies and obfuscations in the hope that the lender could "pass the hot potato" to someone else before it burned him. Profits made from these credit unions and community banks would stay within the local communities and states where they were earned, instead of being siphoned off by a handful of big Wall Street names.

Pension funds and others holding bank debt would get creamed. They're in trouble anyway. The PBGC is going to get a lot of work over the next few years, like it or not. However, since consumer disposable income would be helped a lot due to dramatically lower debt-service costs (see below) this would be mitigated to a material degree, and in addition, housing costs would drop a lot. So while Pension Funds that hold these bonds would be hit hard, and pensions would likely get cut back due to PBGC takeovers, that's coming anyway and the lower cost-of-living from lower housing prices and lower debt service expense would help mitigate the damage.

Consumer lending rates would come down dramatically. Specifically, credit card interest rates. Yes, some Americans, those who are not credit worthy, would see their credit lines dramatically curtailed or even eliminated. But those who are credit-worthy would see their credit costs shrink dramatically and immediately. There would be a tremendous net benefit and consumer spending would increase due to the greatly lessened interest expense in American households, and unlike the exhortations to "lend more", this increase in spending would be durable as it would come from decreased debt carrying costs to the average American.

Total consumer debt would contract significantly. Much of this contraction would come through bankruptcy, but the fact remains that this contraction is both necessary and desirable. Required interest payments severely depress economic activity, while reduced interest payments stimulate the economy. Flushing bad debt from the system would make possible greatly increased economic activity at all levels.

Systemic Risk would be eliminated. Lending institutions would no longer be able to place the nation's balance sheet at risk of loss, nor would they be able to bleat to the government for handouts. If they got in trouble they would go bankrupt like all other companies. Prudent speculation would be rewarded and imprudent speculation punished, as it should be.

Deficit spending to prop up the banks would end. Political realities being what they are, we might not see significant changes in deficits however - the government might well try to direct the money somewhere else. You'd hope not but......

The economy would be re-based to a level consistent with income. Unable to play "debt bubble" via various fraudulent schemes on Wall Street the economy would contract to a level that is consistent with consumer earnings capacity. This is likely around the GDP present in 2000, or roughly $10 trillion dollars. We would then begin to grow organically as productivity increases, without the debt load overhang from unsustainable credit creation, bounded by our ingenuity and inventiveness rather than by whether we can finagle another HELOC out of the bank to pay off our 24% interest credit card.

Tax receipts would base near where they are now. As consumer disposable income percentages rose (due to lower debt burdens) spending would increase which in turn would increase sales tax receipts. The most-burdened corporations (that pay few if no taxes, since you only pay taxes on profits) would fail and be replaced by firms without those burdens - those replacement firms would be profitable and pay taxes.

Municipal government receipts would decline originally, but then stabilize. Property taxes are based off valuations and the adjustment would cause a decrease in property taxes. Municipalities and States would likely have to adjust spending to 2000 levels, and expect modest increases thereafter commensurate with actual organic wage growth. In the intermediate and longer term home prices cannot rise faster than wages; expecting otherwise is idiotic.

The Stock Market will correct, irrespective of this plan, to fundamental values. The S&P 500 currently trades at a P/E of 134! Nobody in their right mind believes that is sustainable and those arguing for continuing dramatic stock market increases are arguing for earnings rising by literal hundreds of percent (yes, multiples of 100 percent!) If we do not act in this fashion, and do it soon, we could see the S&P decline in price to a P/E between 10 and 20, which would imply the S&P trading around 150 or less! That would be a catastrophe of unbelievable proportion; this plan will prevent some, but not all, of that damage.

The question is often asked if there is an easy way out of this mess - some way to prevent or mitigate the pain.

The answer is, unfortunately, no.

The decisions of the last 20 years cannot be un-done nor can the damage they did be painted away with more cheap and easy credit. You cannot solve a drunk's problem with a bottle of whiskey, with any attempt to do so bringing only momentary relief. Yet that has been the prescription of Ben Bernanke, Treasury Secretaries Paulson and Geithner and both President Bush and Obama.

We have tried these tonics now for two full years, and they have failed miserably. Unemployment is over 10% in a number of States and will continue to rise. Hours worked are down to the lowest levels ever recorded. Despite 30% interest rates on some credit cards, charge-off rates have reached as high as 13%. Mortgage defaults, originally thought to be "contained" to subprime, are now accelerating at a frightening rate in prime, 30 year fixed loans, as unemployment skyrockets and capacity goes idle in the economy. The so-called "green shoots" are in truth marijuana plants and commentators on the web and in the mainstream media have been smoking them by the bushel, choosing to ignore the truth - credit carrying capacity hit the wall in 2007, and yet all the tonics thus far prescribed are simply "more of the same" - more credit and more lending, even though the consumer and business both are incapable of servicing the debt they hold. Desperate to not admit failure, our government has attempted to hide the insolvency of major institutions by shoveling the bad debt under the carpet of The Federal Reserve and Treasury, exactly as Japan did in the 1990s with disastrous results.

Eventually China, Japan and other nations who we rely on to finance our deficits will find themselves unable to do so. Many people complained about George W. Bush's $400 billion deficits, but this year we have already surpassed $1 trillion, or $1,000 billion, and are headed for $1,800 billion to $2,000 billion ($1.8 to $2 trillion) by the end of the year, or more than five times what George Bush ran during his administration. All this deficit spending has not been to prosecute a war but rather is to do nothing more or less than cover up the insolvency and fraud through our financial system.

Should we not reform our monetary and banking system, and deal with our housing and capital markets before this happens, we will experience a catastrophic economic event unlike anything in United States history. It will be many times worse than The Great Depression, in that we will be forced to shrink our Federal Government by some 50% immediately. This will in turn further crash tax receipts and force further reductions.

While some people may look toward a contraction of our government to a budget of $1 trillion a year or less as a laudable goal, nobody with an ounce of sense wants to see it happen overnight - and yet that is what we face if we do not act now.

The four points above will be unpopular with Wall Street and their cronies in Washington DC. Nonetheless, they are the only means by which, at this point, we can stop the ponzi-style financial games being played on Wall Street and divert the legitimate business that remains to Main Street where it can be used to offset the rising unemployment and general economic malaise.

There is much more we must do, such as health care reform, entitlement reform and fundamental changes in our tax code. But until we put a stop to the outright fraud and theft that takes place every day in our capital markets - the literal pick-pocketing of America via our banking and financial services industry - any attempt to address these other issues is immaterial. Without removing the overhang of excessive debt, it is impossible to stabilize either housing or the economy. We are headed straight for a repeat of the 1930s, but coming from a level of systemic debt far higher than we had in 1929, the catastrophe will be far worse than The Great Depression if we do not act now.

Do not be fooled - the crisis is not over, and we have solved nothing - we have merely been granted a short reprieve in which to do so, or suffer the consequences of our failure to act.

Come join us on Blogtalk this afternoon at 3:30 Central for a live discussion on this and other related topics.

Monday, July 20. 2009
Posted by Karl Denninger in Editorial at 07:22 - http://market-ticker.org/archives/1236-Yes-We-Can-Help-Main-Street;-Text-Edition.html

[marketcrazy1]

1. this is pretty good stuff

I am sure it went out to a slew of congress critters, to bad none of them have the balls to adopt this plan.

[dixiegrrrrl]

2. For the most part, Deninnger has made a lot of sense of this mess.

[snot]

3. 100% correct.

I don't always agree with everything Denninger says, but I agree with all this.