By October of 2007, I was truly puzzled. Any businessman worth his salt, given a serious inventory deficiency problem, would institute an audit, physical inventory, whatever it took to identify the magnitude of the problem. He would hope in that process to determine the cause but, first and foremost, how big was the problem? The only thing I heard or read was someone saying the CDOs et al, couldn't be valued (inventoried?) as the means by which they historically were valued had failed (mark-to-market). To me that sounded like someone saying they lost directions to the warehouse or they needed a new adding machine.
Time has gone by, accompanied by hand-wringing, tons of taxpayer money down the drain, repetition of all those issues readers of Seeking Alpha are steeped in daily, and nothing got done. Government threw money at a problem whose size or value they hadn't determined, the last thing a businessman would do. No one seemed to know what to do. Some said, "Change the rules, eliminate this failed valuation method."; no businessman would do this as he would know the method may have flaws, but isn't the problem - after all, without the so-called defective method, we might still not know the depth of the problem.
In any case, that threat was a form of the last straw to me, so I thought a while and developed a solution, one I applied 20+ years ago to a shortage where the numbers were gone and the values were suspect. As modified, it absolutely should take care of this problem. I am thinking of it as a solution to the issues at what we now call banks; it may have other solutions, but this is solely for the bank/financial institution issue.
1. Whether one speaks of an individual mortgage or a CDO, it must have a face value, otherwise some couldn't benefit from taking write-downs for credibility while others pumped up their balance sheets by "holding to maturity".
2. Speaking from this point forward about CDOs or whatever investment instruments are similar, it is reasonably evident that many believe these instruments don't contain what they are supposed to, some allegedly are a full barrel of rotten apples, others containing only one or a few, some even containing no bad apples. Two points must now be made:
a. Only Wall Street types think these one or two bad apples spoil the barrel; thus, probably eventually to their trading benefit, they allege all barrels are spoiled or nearly so - however, as I see it, in this case Wall Street only represents one day, today's, market.
b.The businessman knows there are some very bad barrels, some with bad apples that miraculously don't affect their neighboring apples, and some with pristine apples that may actually be coated in honest AAA (Wall Street's equivalent of ALAR.)
3. Wall Street is busy putting everyone it can out of business, or at least driving the value of anyone suspected of holding these instruments as low as possible. Everyone is going along like sheep; however, this businessman knows that Wall Street doesn't know what is in the barrels either. Thus, the first step of the answer.
4. A trio should be formed Monday. I would suggest Paul Volcker, Lawrence Fine and Mohamed El-Arian only because their candor/experience/plain sense stood out, for this writer, far above the din since August 2007. They should be asked to set a value - one price expressed as a percentage discount from face value - on all of these instruments! It may be necessary to group very broadly some different types of these vilified instruments to do so. Hereafter I will call them all CDOs.
5. These august and, to me, brilliant gentlemen know three things, I am sure. They are all positive that each barrel is worth face value, zero, or something in between; being super intelligent business men knowledgeable about these arcane barrels baffling the world, they also are reasonably sure the average value is probably between 40% of face value and 65% of face value. (I will not steal their thunder by attempting to be more accurate.)
6. Like doctors, these gentlemen would like to heal those inflicted with barrelitis, but also want to "do no harm"; this is where the government comes in. We must not forget that, in addition to the three values above, some barrel owners - in an attempt to be more honest or, in some cases attract more government money, have absorbed financial write-downs on the face value of some or all of their barrels. It must be noted, that these actions, applauded by shareholders and others, DID NOT CHANGE THE VALUE IN ANY GIVEN BARREL. Rather, it put the barrel holder at less risk of dying if his barrels were saturated with rotten apples while giving it a future profit if they were wrong. In some ways, this was the first thing the businessman could applaud - tax deduction today, profit deferral to help future years.
7. Thus, we tell the Titanium Trio to value ALL barrels that exist at that ONE number (a % of the face value) at which no barrel holder, hopefully, or only a tiny number would be forever insolvent. Why? We'll ask our wise men to value them - obviously - on the lowest side possible without having to instantly wrestle with insolvency. They, in their wisdom, may select a slightly higher value, which I would also understand. However, I would totally trust them to make this decision.
8. Now we get the government involved. All the barrel holders will be told that they are to use the ONE Titanium Trio number to value all CDOs REGARDLESS OF THEIR QUALITY (which no one knows,right?). They cannot book any profit should their prior actions have placed them below the TT# until they clear this CDO by selling it, trading it, or in some way removing it from the guarantee - even then, if they have other CD's under guarantee, they cannot take any differential into profit until all CD's are cleared from the guarantee. Should the TT# (face value minus the TT# percentage) be below their current carrying cost, they will have no worries. The US Government will guarantee the difference between face value and the face value minus the TT percentage. However, there will be a choice that these financial institutions (barrel holders) will have to make!
9. The government is going to begin removing, at the end of the first and subsequent 12 month periods, either 20% tranches over 5 years, meaning the bank must do something to replace or augment their capital to replace the 20% of the guarantee annually, OR the government will guarantee the difference for 10 years, meaning the bank must do something to replace or augment their capital to replace 10% of the guarantee that will be removed annually.
10. Why isn't everyone going to take the 10 year deal? Because the 10 year deal comes with all kinds of government meddling - no/low dividends, no/low bonuses, restricted salaries, goodness knows what Nancy and Barack will dream up with the eager assistance of Dodd, Rangel, Reid, Barney and goodness knows who else.
11. Those who take the 5 year deal have free hands to market, swap, make other money to cover their write-offs and take responsibility for and act to get rid of their so-called toxic assets now that such assets (many of which were never toxic) are allowed in sight long enough to determine their real value over time.
Why doesn't everybody fake it until they don't make it? Because those opting for the 5 year program will sign a document that says they do so knowing that at the end of the 5 years, if they haven't been successful, they acknowledge they cannot get either any taxpayer money or further government guarantees. If this means they end up insolvent, they can explain to the shareholders why they were so aggressive. For the first two years, banks will have the right to leave the 5 year program, accept the handcuffs of Washington, and have the balance of their CDO's guaranteed over either 9 or 8 years, shackles included.
I'm assuming that the Fed can put a number on the face value of the gross amount of CDO's each bank carries as it must be reported in some broken aggregates; if not, the bank has 30 days to get the number. I'm further assuming that, since taxpayer cash money is not required, this can be done by the Fed without waiting three months for Congress to fill it with earmarks. If these assumptions are close to correct, we could kick off the program on May 1 - though I know that most of the people responsible for getting this on the road are not businessmen or they wouldn't be in this mess. So let's assume that, in the absence of Teddy Roosevelt, we'll get going June 1, 2009.
Let's see what we have:
1. A program that rewards those institutions who didn't sell as many, buy as many or tried to write down and stay solvent at the same time instead of perpetuating the fiction that they''ll carry perfect apple barrels to maturity.
2. A program that rewards those institutions that are good marketers, good salesmen, good cost managers, and good bank business people so they are regularly replacing their shrinking guarantee with cash flow. Not only is it from selling their CDOs at what should now be somewhat higher prices that probably increase as this moves along, swapping CDOs for other forms of equity augmenting value, but it is also from running their businesses without Wall Street's destructive threat, from having stock that now begins to rise as their performance warrants, and for those who are the best operators and business-like bankers, from the extra profits and successes they will have without the cost and burdens of government meddling and interference. They may even get strong enough to acquire someone else who is foundering in this process.
3. But wait, there's more! Because one day, they'll have a balance sheet with all toxic assets guaranteed at face value - one might say 80% for a year - they can lend more, they can be more transparent in their accounting, they can be more aggressive in their efforts to deal with the foreclosures that can be avoided, they can lend small businesses and big businesses more money because they have a balance sheet and a definable way to the future - one that they must report on quarterly.
4. Wait, there's more! The government can quit wasting money on fixing a problem they can't fix, as these banks will have to work out the servicing, collection, re-financing of some of these or they won't make funds to balance the guarantee reduction. It will take a full court press, service to customers, competition on fees all sorts of things consumers will reward with more business to the winners.
There are more benefits but you'll figure them out. There are some caveats; this isn't an accounting exercise, where you produce the aggregate number and have the bank auditor sign off and get going. No politicians on the titanium three; no fiddling. If a bank can't solve this problem in the 10 group period, they deserve to go bankrupt, period.
One of the many things I've learned in life is the more complex the problem, the simpler the solution must and will be or the problem goes on and on. Keep Geithner's hands off this. Insist Bernanke lookw but doesn't touch. Get a manager who can manage, who can say no, who can fire if necessary but who will get this going and keep it on track. Frankly, if I had to hire him, I'd call Larry Bossidy and if he wouldn't do it, I'd hire the man Mr. Bossidy thought would get the job done.
