Injecting Accountability into the Credit Crisis

The current crisis in the credit markets is not going to be alleviated with conventional tools traditionally employed to address credit crises.

In the early 1980’s, the U.S. also faced stagflation as we recovered from the 1979 energy crisis. In May of 1980 the unemployment rate was 7.5%, inflation was at 13.5% and industry was facing a severe downturn that began in housing, steel and automobile production and spread to the broader economy. In an attempt to tackle the rampant inflation, Federal Reserve Chairman Paul Volcker took the federal funds rate from 11% to a June 1982 peak of 21.5% while slowing the growth of the money supply.

The effect of the tightened monetary policy was an intentional steeping of the recession. Banks began to fail: in 1982 alone 42 banks failed and the federal government, through the FDIC, had spent in excess of $870 million in order to purchase bad loans and bail out financial institutions. In 1984 an additional 49 banks failed, marking the year as the highest in the history of our banking system. Unemployment reached a 1982 peak of 10.8%.

A catastrophic result of the tightening in monetary policy, along with the loose lending practices that preceded the tightening, was the meltdown in the Savings and Loan industry (ala subprime). While there are a lot of similarities between the collapse of that industry and our current subprime crisis, that is the subject of another article. In brief, the S&L crisis, begun by the tightening of monetary policy, the resulting recession, and loose lending standards lasted long beyond the end of the recession, costing an estimated $150 billion.

While $150 billion was catastrophic, it pales in comparison to the fallout from the current subprime debacle and the resulting meltdown in the credit markets. In terms of wealth lost directly from correction in the housing market alone the numbers are staggering. If we conservatively estimate the total value of residential real-estate in the U.S. to be $22 trillion, then with just a ten percent correction we are talking about $2.2 trillion in wealth removed from our economy. Many forecasts are now calling for as large as a 30%, or $6.6 trillion, correction, which directly impacts the wealth of individual homeowners.

Front line in the deterioration of the credit markets are the lenders, financial institutions and insurance companies. Financial institutions alone have collectively written down in excess of $96 billion in bad debt with more expected to come. Municipalities are finding no markets for the auction of their bonds resulting in higher interest rates on their debts and subsequent pressure on their already strained budgets. Duo-line insurers such as Ambac (ABK) and MBIA (MBI) are faced with imminent downgrades in their credit ratings which will trigger an avalanche of forced selling, flooding the market with already devalued assets. Banks are struggling to capitalize as they are now unable to move performing loans from their books. Currently we do not have the credit market of a developed and industrialized nation.

In response, the Federal Reserve has slashed 225 basis points from the Federal Funds rate while increasing monetary supply. President Bush has enacted a fiscal stimulus package that will put $600 to $1200 in the hands of every tax-paying American. There are proposed moratoriums on foreclosures, proposed five year freezing of interest rates on home loans, and increased consumer education. There have been numerous proposals for bailing out everyone along the way from the lenders to the hedge funds. There has been pretty much everything but accountability, common sense and a no nonsense approach to solving this problem.

The Fed’s attempts to rescue the financial markets and get capital flowing, while predictable, are not the answer. Unlike the crises in the credit markets that have preceded this one, tight monetary policy and expensive capital are not factors in the origination of the current problem. In fact, many would argue that Alan Greenspan, in his days as Chairman, directly contributed to the current crisis by making the cost of capital too low for too long. In fact, this misguided attempt at a short term solution may cause long lasting effects to our economy's detriment. The further rising inflation and the beginnings of a global crisis in both commodities and energy could be more adeptly navigated with a strong dollar.

While well intentioned, the fiscal stimulus package championed by President Bush and pushed through in a bipartisan attempt to help is not even a band-aid for what ails us. With home values falling precipitously, inflation at the pump, and rising food and utility prices, consumers are much more likely to spend the money on necessities than on a frivolous purchase. However, let us suspend rationality for a moment and say 100% of the fiscal stimulus is spent on discretionary items. Of that, .65 of every dollar will be going out of the U.S. providing no aid at all.

Further, if the federal government went directly to the institutions that are in trouble and gave them the money they are now trickling into the economy via a stimulus package, it would scarcely be noticed next to the enormity of the problem. In the end, it was a feel good way for elected officials to dupe the American taxpayer into thinking they were on the job.

Hilary Clinton, among others, is proposing a moratorium on foreclosures and freezing the interest rates on mortgages for the next five years. Again, well intentioned but like hunting bears with a sling shot. Many of these foreclosures aren’t because of resets in ARMs, they are because the underlying asset has deteriorated and they were speculative purchases intended to make a quick buck. As this class of homeowner/investor sees deterioration in the underlying asset, it no longer makes sense to service the loan.

I know some of you are rolling your eyes and saying you can’t just walk away…but before you do, look at the financial institutions and you’ll see that is exactly what they are doing right now. This particular sector of the loan market is not going to be salvaged by freezing the interest rate. On the other end of the spectrum, saving the honest homeowner who just can’t afford the increase in interest rate is not going to halt the free fall in price of the asset nor get the market moving again.

In a nutshell, for too long we’ve allowed a privileged few to eschew the tenets of supply side economics and create their own shady market off the books, to the detriment of our entire economy. On a global scale, a few people on Wall Street, some now moved on to Washington (Mr. Paulson) have defrauded the system with immunity. What’s worse, collectively we are now looking to these same people to fix the problem and it is not working. It is time to roll up our sleeves and get down to the business of fixing things.

First, for too long now builders have continued to build in formerly hot markets where there is now a glut of supply. In addition to this, financial institutions have bankrolled this additional supply to a market where this is rapidly diminishing demand. The natural progression of this scenario, as any 8th grade economics class can tell you, is a rapid decline in price. In order to address this fundamental issue, there needs to be an immediate moratorium on building spec homes nationwide. In order for a builder to obtain a construction loan, he must have a contract in hand for the home. This will directly lead to a much needed consolidation in this sector, the effects of which will be to govern capacity initially once the moratorium is lifted. As part of a national stimulus, or revitalization program, many of the builders that fall victim to the industry consolidation may be utilized renovating existing public housing and federal buildings among other projects that would be of direct value to our nation.

Halting the addition of new product is not going to be enough however. There has got to be a solution that will get existing inventories moving again and begin driving demand. In order to do this, we are going to need a new financial product. This financial product will allow first time buyers and those without large down payments to begin participating in the market again. It will be higher interest, longer term and have strong protections in place for the lenders such as not being able to clear obligation through bankruptcy.

In effect, we are looking at something like a 40 – 45 year loan at 9% or higher, with periodic opportunities to refinance at better rates for shorter terms. These same products would also be made available to those currently in distressed mortgage situations, including those speculators who would rather declare bankruptcy and walk away. In effect, this will have a meaningful impact on default rates, home price decline and demand in the market while providing protections for lenders from the continued downward spiral.

Some of the benefits of this approach are:

1. Immediately stemming the flow of foreclosures with protection in place for the lenders.
2. Terms attractive and profitable for the lenders, yet still favorable for the individual on a per month basis.
3. Immediate impact on inventories as product begins to move again.
4. Increased demand and a new customer base will prop up prices and in much shorter time period begin to appreciate.
5. Rather than revert to a renter nation we can expand home ownership.
6. We create a culture of buy and hold, much like we had in our nation until the late 1980’s. This will directly lend itself to the creation of a sense of community and real ownership in our neighborhoods, school districts, and cities.

Rather than a fiscal stimulus package, our government should focus their energy on a revitalization plan by rebuilding our aging infrastructure, keeping inflation under control and supporting our dollar. In order to pay for our plan, we first begin financing ongoing operations in Iraq directly from proceeds from the oil we now control there. As we set a plan for withdrawal, we include benchmarks in that plan that will include the repayment of our expenditures to liberate their nation along with favorable future trade terms for a finite period as a premium for the sacrifices we’ve made as a nation on their behalf.

In conclusion, this is not a comprehensive solution to the problems facing our economy. This is a no nonsense beginning that will have an immediate and measurable impact which is much more than we see coming out of Washington or the campaign trail today. We are in a crisis that can have a galvanizing effect on our economy as we bring solid solutions to bear or can be catastrophic if we keep on our current path. I for one have watched the bumbling attempts of our financial institutions, and now our government, to stick their collective finger in the proverbial dike. These are the same people who last March were telling us the housing crisis was contained and would not spill over into the broader economy. If we continue to allow these same people to attempt to solve the mess they’ve created without oversight and a new direction, then we are in for something far worse than what we are currently looking at. If you don’t agree with my approach, then at least I hope I’ve made you contemplate one that is better.

If you do, then act. For my part, I’m having dinner with someone well connected later this month and will pitch my ideas. I encourage each of you to do the same. We have got to have a different approach to this housing crisis; an approach that will preserve my home value and yours while getting this market moving again.

Happy Hunting.

Comments

[RichardSchweitzer]

This article is certainly in line with much of the accepted "wisdom" in the current media forms today.

However, the views taken of what comprises "wealth" in a Nation (or in an economic perimeter) are somewhat limited to a "pricing" or relative prices perspective.

The true rate of increase of "wealth" is probably better measured in terms of the accretion of durable, transferable assets.

In the cases cited, despite the "drop" in prices of specific assets (accompanied indeed by the rise in prices of consumables) has not changed the existence of of those assets. The housing stocks still exist; the manufacturing assets (palnts & equipment) continue to exist. The Phoenician, an asset whose price drop led to an S&L failure and criminal charges against Keating, came to realize its full costs in terms of price.

So, should we really say that "wealth" is "lost" because of pricing? What has changed is the ease of transferability. An argument may be made that the costs of transfers has risen, which is always plausible when dealing with the uncertainties of future relative prices. What changes are the classic "rational expectations," not absolute wealth in terms of existing and continuously regenerating durable assets.

[fjd10595]

This article is pretty much right on target. Especially where it states that the "economy as a whole has suffered to the benefit of the few", i.e. Paulson and wall street. Does anyone ever listen to Paulson speak? Reminds me of George Bush. Very poor speaker. Nothing is explained well. Paulson is way overrated as a fiscal expert. Anyway, the legacy of George Bush and company is the enrichment of their friends (tax cuts, increased spending, lax regulation, asset bubbles) and then pass the bill to our kids who will be crushed.

[Enough withthebuffoonery]

"As we set a plan for withdrawal, we include benchmarks in that plan that will include the repayment of our expenditures to liberate their nation along with favorable future trade terms for a finite period as a premium for the sacrifices we’ve made as a nation on their behalf."


*Whistles nonchalantly*

[Pent updemand]

"Nationwide moratorium on spec homes"? Shall we address you as Der Fuhrer as well? More liberal fascism. Golly Mister, I'm filled with patriotic ardor for the chance to sacrifice my financial future to preserve the value of your home. I'll remember that we're all in this together when I'm still stuck living in a rental 10 years from now. So a 40-50 year loan at 9% will make a home affordable for me? No thanks. Isn't that better known as "indentured servitude"?

This article is full of yet more bandaids. You want a solution? Mark it to market. That is the cure for what ails the financial system. There are going to be failures a-plenty, but no sane investor is going to risk his capital with a bank until we've excavated the banker's backyards to find out where all the bodies are buried.

If you are an owner in a formerly hot market, much of your home's value is completely imaginary. Yes, it makes you sad. But that is reality. Get over it.

[BlueFire]

Some great nuggets in this article, but here is another angle. At the local, state and fed level, government should immediately condemn as much vacant property as possible. The bailout funding should go to a massive demolition enterprise to clear out as much dead wood as humanly possible in urban, suburban and ex-urban regions. Builders will keep building based on the tastes of consumers. But there is so much dead wood to be cleared out which would bring builders back into blighted regions. Yes, it will create gentrification. So what? It's not like these neighborhoods are actually going to pull themselves up by their bootstraps.

[ThePhoenix]

Interesting article but really the solution is much more basic. First, FNMA/FHLMC need to have the true backing of the Federal government in the form of a guaranteed return on the bonds they issue. Right now, they are falling out of favor. In addition, a new entity with the same backing should be created for looser credit (but not subprime loose) to make more funds available to the market. Similar to FHA. Second, a tax credit of $10,000.00 for first time home buyers to buy in the next 2 years, and a tax credit of $5,000.00 for previous buyers who purchase in the next 2 years. The tax credit at the very least would create a bottom to a current freefalling market and easing of the availability and liquidity of credit will help that bottom stay or in the future reverse the freefall trend.

[Don Grant]

In the mid 1970's the energy crisis reaked havoc on the economy and homebuilding came to a complete halt. The problem was builders had lots of standing inventory thus building stopped making the economic picture worse than it already was. Alas, the government came up with a simple solution. Anyone who bought a new home that was standing or already under construction was given a $2,500 tax credit if they bought in the next 9 months. $2,500 does not sound like much but the average home price was probably around $45,000 back then. Like magic, after nine months there was barely a standing inventory home left and builders started building again which jump started the economy in 1976. The $2,500 was not only free money for the buyer but became a good part of the down payment many people were having trouble coming up with. My guess is this could be an important tool again, albeit the dollar amount of the tax credit will need to be substantially higher. We could turn the negative psychology around causing fear that a buyer now has, get money into the economy in a way that it gets spent and as we all know, housing is an engine that multiplies throughout the economy. Let's get on with it.

[Expat]

Bluefire: Great idea. And while we are working on ideas of Great Genius and Sophistication, why don't we help to bail out Ford and GM by systematically torching entire parking lots of cars are shopping malls and football games. Think of the boom in car buying! GM and Ford stock would soar!

Why stop there? Let's knock down skyscrapers. Let's sink the entire US fleet. Hey, we could even eliminate unemployment!

House prices bubbled up irrationally. Everyone thought they were rich. Too many people made bad bet based on this bubble. Now house prices are reverting to long-term levels and everyone is upset (except those who did not buy yet).

House prices have another 25-40% to go. It's reality. It might suck for you, but I love it.

[weedwacker]

The crisis of the 80's was the direct result of mortgage fraud, followed by a tightening of credit. This crisis occurred for the same reason. The states deliberately foster mortgage fraud and will continue to do so until control of the mortgage industry is taken away from them.

[coyoteyogi]

The problem is obvious. Right now all the deck chairs are lined up in straight rows. When people rest and stick their feet out, the waiters are unable to deliver their cocktails quickly. The solution is to arrange the chairs in a circle. Then the easy delivery of kool-aid will facilitate a recovery. Of course, this assumes a level playing field. If the playing field should begin to tilt then the solution is to stack the chairs at the upper end of the tilting field. Why people in government cannot see this perfectly obvious policy is a mystery to me.

[Mr Pasadena]

I agree with much of his article except for the 40-45 year loan. There are actually 50 year loans available today. They were created because the cost of housing is too high. As far as I am concern, let the Real Estate market work in America. Capitalism will take care of the excess. That means lower home prices or higher income to sustain the prices. And yes, l do own my house, not rent from a bank. That means my imaginary equity wealth will go down. Everyone wants to count equity as wealth but unless you sell, you have no wealth. Our government counts this $22 trillion dollars as wealth but from what? Not everyone will sell. The only other option is an equity loan. But don't you have to have income to pay it back. Now I know that some of our beloved law makers think that paying back a loan that you sign up for is bad business. Uh? Isn't that what credit is all about? I am waiting for the home prices to come down to what it should be. No gimmick loans. Then I want to buy a second bigger house. Using 40-45 year loans just put this country into more debt. Supply and demand. That is what America is about. Let Capitalism work. Do not keep home prices artificially high. That will stop me and a lot of other American from buying a house without being a slave to a mortgage. It will also prevent us from spending additional money to stimulate economy by furnishing the home.