A Solution to the Financial Crisis

I am increasingly certain the proposed bailout is dangerous.

As long as it is the only solution on the table, however, you cannot throw rocks at it. A lot of people are throwing rocks at it without having the guts to propose an alternative.

Here's an alternative:

• Freeze all ARMs at their current interest rate level or 10%, whichever is lower.
• Pay off mortgages that exceed 80% of the current collateral value down to 80% of the current collateral value (if a home is worth $200K and you owe $210K, the government will pay your bank $50K and bring your balance down to $160K).
• Increase tax rate of 2% on anyone making more than $150K/year who benefitted from the mortgage payoff for 25 years. This extends to people who are not making $150K today but make it in 5 or 10 years; and it is dropped for people who have their income drop below $150K during that time frame.
• Refinance at current prime all mortgages under $250K for people making less than $100K/year and a 2-year history of being no more than 30 days behind on payments.
• Convert all interest-only real-estate loans less than $500K to 30-year, prime loans.
• Ban ARMs and interest-only loans.

The problem with the Bush administration solution is that it is very inflationary, it rewards bad decisions on Wall Street, and does nothing about the cancer causing this crisis—the plummeting home values.

My solution rewards no one. Everyone who took on a mortgage will still have their mortgage. Everyone who made a bad loan is still reliant on the people paying the loans to make their payments. However, everyone gets a free pass on the actual extraordinary event (the financial hurricane): the massive drop in home values.

As a result, many people who were in a bad position because they were underwater on their home values are all OK. The financial institutions at risk because of this situation will have an injection of cash and a reduction in risk profile. This injection of cash will create new capital that can go into the markets (the whole point of the Bush bailout).

Now, just buying out mortgages so they are not underwater does not address other nasty problem: risky loan instruments. If you could not pay your loan payments at 120% you home value, you probably still cannot afford them at 80%. The reason is because banks created goofy mortgage products that were once affordable for these people but have become completely unaffordable. So, the rest of my proposal addresses two key culprits: ARMs and interest-only loans. Turn them loans into loans people can afford. Reduce the risk profile of the institution and let people keep their homes.

The thing that kills home values is foreclosures. This proposal results in:

• A significant reduction in foreclosures (thus preserving home values)
• An injection of cash into financial institutions that can be used as future capital for investment
• Minimal regulation that prevents the greedy lending habits that created this crisis
• Everyone still be responsible for their own decisions—both Wall Street and Main Street
• It should be much less expensive for the government, meaning fewer new taxes and a lower risk of inflation (it is still an inflationary solution)

Analysis of the Economic Crisis

This economic crisis is every bit as serious as its being billed. The bottom line: if nothing gets done about this situation, no one will lend money. Period.

I know there is a minority of anti-fiat money people who think that is a good thing; but the reality is that it is a horrible thing.

You know in the good ole days the ads that said, "Bad credit? NO PROBLEM! You're approved." Today, those will read, "Good credit? DOESN'T MATTER! WE WON'T LOAN YOU A DIME!"

Why?

To put it simply, our lending institutions don't have the capacity to lend any more money. All of these "trash debts" on their balance sheet have diminished their reserves and put them at great risk. They just can't lend any more money unless the following things happen:

1. They increase their cash reserves
2. They decrease their risk profile

So what happens? Perhaps the most critical things are that:

• Big businesses don't have the cash to operate properly
• Small businesses can't get loans to make payroll or expand
• Individuals cannot buy houses or cars

Net result: an economic downward spiral

Individuals stop buying houses because they cannot get loans. Housing values decrease. Loan defaults increase as more and more people are upside down on their mortgages.

Small businesses simply go out of business because they cannot make payroll. New businesses cannot start (as an aside, one of the saving graces of a traditional recession is that people losing jobs start businesses that inject economic growth into the economy; that won't happen here because people losing their jobs won't find capital).

Big businesses that normally can borrow their way through economic downturns suddenly find they have no place to find capital. They cut jobs dramatically or go out of business.

HUGE job losses.

In short, we are honestly talking economic catastrophe. And I don't see where we recover. Eventually, I believe in America and believe we would recover. But this is Depression-style badness.

The Proposed Solution?

Any solution must create a health financial system capable of providing capital for economic growth. In other words, that has to be the end objective to deal with the short-term crisis.

Obviously, a long-term solution needs to include checks against lending the protect against over-exuberant lending to high risk customers as well so we don't end up in the same bucket the next time we have a real-estate bubble.

The proposed solution involves having the government buy off these "trash debts" at a fairly absurd price. For whatever reason, Paulson has proposed buying these things out at above the institution's carrying price (the carrying price is what the bank values the debt at on its balance sheet). The market price is well below that rate. For some reason, Paulson claims the market price undervalues these debts. I think that's bullshit. The market price is the right price.

At any rate, the government buys these debt instruments and then collects the payments. In an ideal world, everyone ends up paying back their loans and the government makes a profit. If the rate of return on the profits exceeds the interest the government is paying to borrow all these money, the US government ends up making a net profit.

In the mean time, the financial institutions are relieved of the burden of these risky debts AND they have money to loan into the economy.

Good news?

Well, three problems:

1. As mentioned above, Paulson is currently seriously overvaluing the debt. As a result, the government will overpay for these bad debts. That means more interest the government is paying on the money it is borrowing, and the harder it will be for the taxpayer not to get saddled with higher taxes to pay off this loss.
2. That's a lot of money being injected into the economy outside normal channels. I honestly fear two things:
   1. Inflation will kick in
   2. The Fed will have to hike interest rates a lot, thus making capital hard to get!
3. The proposal as I understand it now lacks important checks and balances. As a result, there is a lot of opportunity for corruption. If you are a Republican and don't care that Paulson has absolute authority over $700B, keep in mind it could be a Democratic appointee in the near future with that control. Either scenario is untenable. Beyond the risk for corruption is simply the risk of incompetence. Even with the best intentions, $700B in the hands of incompetents without any oversight is a bad thing. And finally, without tying any strings to this buyout, we risk these financial institutions turning around and making the same stupid mistakes.

Who is to blame?

Everyone is to blame. Not simply Republicans and Democrats. Managers and home owners, farmers and financial gurus.

It does start with the relaxation regulations governing financial institutions that began in the 1980s. These regulations were put in place in the 1930s in response to the excesses that caused the Great Depression.

Remember, in the 1920's we had a rapidly expanding economy with little regulatory oversight over financial markets. The result of the two things combined helped cause the Great Depression (among many, many, many other causes).

Fast forward to the 1980's. We relax many of the regulations meant to prevent another Depression. That relaxation continues through the end of the 1990's. In the mean time, we have an amazing period of economic growth.

So, what happens? Lots of capital is sitting in our financial markets as a result of rapid economic growth. Low inflation means that the cost of lending is low. And the lack of oversight combined with phenomenal growth in real-estate values makes financial institutions more and more willing to accept inappropriate loans (the real-estate values are key; they create the illusion that the loans are less risky than they really are).

So, now combine lack of regulatory framework with bad business decisions.

And add to that bad personal finance decisions. People are accepting way too much debt because they believe their home values will double in 5 years or something stupid.

So, we have:

• Lack of regulatory framework
• Rapid economic growth
• Rising real-estate values
• Low inflation
• Bad business decisions by financial institutions
• Bad personal finance decision by individuals

Remove 1 from the mix, and things are likely not so bad. Mix up the cocktail, and BOOM!

Drill Drill Drill?

Here's a thought experiment for you...

Let's say there is this natural resource called "shmoil". There is only a limited amount of shmoil in the entire world, and one day it will dry up. Nevertheless, shmoil is critical to the basic function of our economy and our nation would fall back into the dark ages without access to shmoil.

If you were President of this country, would you:

a) Elect to use the shmoil of other nations while shmoil prices were relatively low, in the mean time working hard to identify replacements for shmoil and thus guaranteeing you have shmoil reserves through the very end?

OR

b) Open up full exploitation of domestic shmoil early on, resulting in your nation being the first to run out of shmoil and thus being at the mercy of other nations at a time when shmoil prices are sky high due to the great lack of supply?

I vote for a).

Here's the cold reality. The USA has 3% of the world's known oil. It has 25% of the world appetite for oil. We need to be prepared to drill all 3% if it comes to it, but we don't want to open everything up  and end up having no oil reserves when the real oil crunch hits.

Ideally, we develop alternate energy resources and don't ever need to fully deplete the Earth of its oil. But we can't plan for the best and ignore the possibility of the worst. We need to manage access to our natural resources so we are guaranteed to be the last nation on Earth with oil.

We need the oil companies to drill using the oil leases they have available today and stop whining about getting access to ones they don't need access to right now.

The Problem with Palin

When liberals "attack Palin", they are not attacking Palin. Liberals are attacking McCain's judgment in selecting someone that, by the McCain campaign's own arguments, must be unqualified to be President.

It's possible for honest people to disagree on what qualifies a person to be President. The Constitution says only that one must be 35 years of age, born in America, and without a felony conviction.

Given two honest people, one can honestly believe Obama or McCain (or both) simply is not qualified to be President; the other can believe they both are. A person who believes that experience in government is important may believe that Obama does not have enough experience and McCain does; but an honest person cannot believe that Obama has enough experience and McCain does not. For someone for whom experience in government is the key qualifier for being President, McCain is obviously your choice.

People like me who support Obama do not disagree with the sentiment that McCain is more experienced than Obama. I believe that experience is overrated, that judgment and leadership are the critical qualifications for being President. I believe Obama has better judgment and leadership skills than McCain.

The problem with Palin is this:

Given that the primary qualification for being Vice President (in fact the only qualification) as stated in the Constitution is that you are qualified to be President, an honest person cannot hold that Obama should not be President because of his experience AND that Palin is a good selection for Vice President.

In other words, Palin's selection as Vice President does two things:

• It negates McCain's experience issue
• It re-enforces Obama's judgment issue
  

Put bluntly, selecting someone for Vice President who you do not think is qualified to be President shows monumentally bad judgment. If the McCain campaign honestly believes its own rhetoric about the importance of experience, it has done just that.