Freefall Fed Policies?

Last week, the credit markets again seized up culminating in across-the-board sell-offs of mortgage-backed security holding entities. Thornburg Mortgage (TMA) reportedly was forced to liquidate some high quality mortgages at 70 cents on the dollar to meet margin calls. Soon thereafter, Carlyle Capital, a subsidiary of private equity firm Carlyle Group, reported receiving substantial margin calls that they did not have capital to meet, and began liquidating its 21 billion + morgaged-backed secuirities portfolio. As of the close Thursday, Thornburg's various preferred series had lost 50%-58% of their value while Carlyle Capital's bond fund closed off 60%.

In response to this malaise, and on top of the pending news of an inevitable, declining US jobs report, the Fed vowed to increase its Short Term Auction Facility size and extend the range of eligible securities banks may offer for collateral. The Fed also said it would pump additional funds into the credit markets by boosting repurchase agreement amounts to a total of $200 billion.

Meanwhile, at fixed income trading desks, AAA rated mortgaged-backed agency issues (GNMAs) are beginning to catch the hex. Astute investors are calculating that there's no need to pay 100 cents on the dollar when forced liquidation is occurring. Soon this astuteness (duh!) will surely cause them to ponder if GNMAs, though backed by the full faith and credit of the US, should not be discounted with a risk premium since the market inventory is quite large and getting larger as margin calls force greater liquidations, and because, after all, GNMAs are really subprime paper dressed up like an insured Ambac (ABK) or MBIA (MBI) guaranteed bond. That is, although the US Government backs them by tax dollars, it has backed a factor of two, or three, or twenty+, times its ability to pay, and additionally faces a $9 trillion budget deficit, has considerably greater liability to its citizens in Social Security and Medicare payments, and has yet to fund pension liabilities for its growing work force--all reflected, you might say in the US dollar's value.

The problem is reactionary policy instead of pre-emptive policy and the failure to fully assess and address the magnitude to the current financial crisis because of vested interests of all involved. These failures are largely perpetuated by the same people who created the problem who are now trying to fix the problem, albeit without Greenspan. The inherent problem is that they have a vested interest in backpedaling and denying that something so bad happened with them on the watch. But the fact of the matter is, the Federal Reserve, the FDIC, and the Comptroller all failed to exercise sound judgement and act to curtail the abuses of excess leverage and exotica in lending. Their constant state of denial (or hiding) has them dipping water out of a bucket to put out the flames when a fire is raging out of control just over the hill.

Let's dissect the seriousness of the problem at hand. First, there is too much leverage in the financial system. Second, there are inflated collateral values and therefore a lack of underlying loan and deposit collateral. Third, there are exotic securities with trigger events of enormous potential sufficient to wreck the world's financial system.

While it is apparent that a massive 'deleveraging' must take place, pumping out trinkets of rate cuts does not adequately address the issue of inflated collateral value and ensuing insolvency of lenders and their borrowers. Furthermore, banks hoarding the benefits of rate cuts to shore up their profits instead of passing the benefits down line to consumers to lower mortgage rates does nothing to forestall additional foreclosure, much less to extend consumer spending, which is our best shot at averting even greater, spiraling, economic woes. Moreover, the uncertainty surrounding the tranches of securitized debt and credit swaps all financed with high impact leverage destabilizes traditional credit markets--that's why they need to be regulated (ditto duh! Hello, Dr. Greenspan).

So what should the Federal Reserve do instead? To address leverage and inadequate capital reserves, the Fed should cut the discount rate, but at the same time increase capital reserve requirements at banks holding mortgages and high risk loans. Focus should be placed in two key areas: Government sponsored entities (including Ginnie Mae) and sun-belt banks where housing values climbed the most. Security portfolios should be evaluated and a calculation of adequate, excess reserves made. Equity of senior management should be seized, sold, and held in escrow, presuming that the judgement is made that a workout is probable. If not, the bank, lender, broker, or insurer, should be placed in trusteeship with all equity cancelled. A court should appoint a successor management group and the assets auctioned if the failed entity is deemed beyond salvage. The Justice Department should then pursue cases of fraud which underscore why entrenched players, particularly at the Treasury, FDIC, the Federal Reserve, and Comptroller, should not solve this problem with the same people or those conflicted because of past affiliations (think Paulson, Goldman, China, GNMA).

Because consumer spending drives trade and the US economy, Federal funds rate cuts must be mandatorily passed down. In addition to these normal rate cuts, interest rates on credit cards should be capped at no more than 12-15% for an indefinite period of time. Doing this would have 12-15 times the impact of a 1% interest rate cut. Lowering consumer interest rates is not only fair, but also stimulative to the economy and jobs and serves to reduce the impact of less consumer spending.

As far as the exotic mortgages and derivative securities are concerned, the government must regulate bank, brokerage, and lending entities operating under statutory capital reserve requirements to liquidate and unwind derivative contracts in excess of a 1:1 ratio, not of capital reserves, but of capital on hand in excess of capital reserves. Banks and government licensed-to-leverage entities should not gamble with depositor money. They should speculate only with shareholder equity capital without recourse to deposit collateral securities and probably in an entity legally separate from the regulated entity.

The effect of these initiatives would extend Federal interest rate benefits to the consumer greatly offsetting their higher cost cost of living while diminishing uncertainty and rebuilding confidence in the financial system--something just adding liquidity will not do. Surely numerous banks would downsize and others go out of business, but the government and the taxpayer would ultimately not be stuck with the entire tab for the mounting losses as equity would be escrowed, assets would be auctioned, and financial institutions would be required to again manage conservatively when using the public's money.

Comments

[Regulate]

The best advise, among many, listed is the cap on interest rates. The usury laws should not have been dismantled in the first place. That may have been the beginning of various abuses of the financial markets that have gotten us into the present mess.

[Paula Rush]

Finally, someone who actually does understand this entire debacle and the road we need to take to recovery. Can you call Bernie or Paulson, they really need a hand. At the last meeting, under grilling from the Senators, Paulson said, "If you've got any creative ideas, I'd be glad to hear them." Problem is, when you call them, write them, fax them, they ignore you. Believe me, I've tried. Our government doesn't seem to have the backbone to hold the players accountable, and dare we say, the criminals who ran off with all the money. The plan, as it stands now, and you so eloquently stated, is to give BANKS more money (liquidity) and lower their cost of borrowing (fed rate), which is not being passed on to consumers. It's a "BANK BAILOUT PLAN." Everyone's running around saying don't bail out the borrowers, but no one is realizing, they ARE BAILING OUT THE BANKS. The worst part is the banks have no intention of helping the borrowers and are all in save ourselves mode. A strategy ultimately doomed to backfire and fail. Players like Wells Fargo, Deutsche Bank, and Bank of America are using the bankrupt entities to hide behind while all the while they own the loans. Borrowers CAN ASK for the true owner of the note under TILA 1641(f)(2) and the servicer refuses to comply. See Kratz v. Countrywide case in Philly, and read the transcript from the hearing. Go on EPIQ and read the transcripts from the American Home Mortgage hearings on Oct. 31, 2007, and Feb. 1, 2008. The "servicer front" just refuses this information. In June, I attended the HOEPA meeting at the Federal Reserve Board, and I stated at that time the financial markets would collapse. All of the financial types looked at me as if I had five heads and dismissed me as irrelevant. Just weeks later the first two Bear Stearns hedge funds collapsed. I like to say I told you so, and normally it would be fun to do that, but not when millions of families are losing their homes due to this systemic failure in our government to prevent this debacle, failure to enforce the laws on the books, and lack of adequate response to what is argueably their failure. The biggest dirty secret is, they are selling off assets at fire sale prices to each other, pennies on the dollar in some cases (New Century (30Cents), American Home Mortgage(50Cents), but if you're a consumer asking for a loan modification, FORGET IT. So instead of accepting a reduced payment over a period of years which might cost a bank a few thousand dollars over a long period of time, to be made up later from interest paid over time, they prefer to fire sale assets, to other financial players who then turn around and foreclose enforcing those same loans for 100 cents on the dollar and profiting. Due to the incestuous relationships, ultimately they will all profit again. So it's, you help me, and I'll help you. Who's losing is the person whose retirement funds were invested in the fire sale assets, the taxpayers who will pay for all the losses the government is covering, and the taxpayers who will pay for all the social services the bankrupt and homeless will need. But also, don't forget these criminals stole the retirement funds of millions of elderly people, both in the stock market investments, and also in equity in their homes. The ripple will be so severe, it will be felt for years to come. I was sick to learn how many seniors who could have obtained safe reverse mortgages, were put in Pay Option Arms, and lost their home because of it. I, for one, am outraged. I petitioned the bankruptcy court of American Home to offer the same opportunity to bid for borrowers to bid for their loan as the FORMER financing partners get (the ones holding the fruits of fraud, hiding the involvment) and it was denied. Even though the bankruptcy laws clearly state, at an auction free and clear, ANY ENTITY WITH ANY INTEREST CAN BID. I also demanded certain protections be added to the loan agreements which were absent before. 363(O) states if you buy an interest in a consumer loan, you are liable for all remedies which could be asserted against the original holder. That I was successful on. Now if anyone can just find force them to tell who owns the loan, we can all enforce our rights! Who has more of an interest in buying the loan for 30 cents on the dollar then the homeowner! As long as our government allows this sort of illogical and self-serving behaviors to continue, there is no hope for the consumer.

[the finalhorseman]

nice commentary, rush. no politician, bureaucrat, fiduciary big shot, fed type or anyone else involved will ever respond properly.

there is no problem. so many of these types are probably on the take, nothing will ever matter, change or get resolved properly.

where is western justice when we need it? our beloved legislators buried it along with the western, the old west and america. they figure the american 'sheeple' will simply forget.

i cant seem to find my companions: confusion, famine and war. anyone who knows of their whereabouts, pls drop me a line. i dont want to be late for the big fireworks display...coming sooner then you think to your local neighborhood.

[maynardgkeynes]

To the extent that you are suggesting that the US government would default on its EXPLICIT guarantee of GNMA paper, you are a complete lunatic. I leave it to others to assess the wisdom of other advice you dispense in light of this observation.

[john haskell]

this York piece is so error-riddled and ill thought out that he should just be removed from the Seeking Alpha website. Anyone who thinks the Federal government is running a $9 trillion deficit has no business attempting to comment on market trends.

[tramp]

Rush.. your comments seem well thought out, but one point concerns me. Allowing the defaulting debtor to bid on the "30 cent" paper will encourage the mass psychology of "profiting by default". A huge mistake was made when the "Cancellation of Debt" (COD) income rules were amended. COD had applied from the inception of the income tax laws, as the theory is indisputable. I no longer expect "moral" reasons to encourage people to pay their debts. But the law should encourage it. Once COD no longer was taxable income, one of the BIG reasons to continue making payments was abandoned. The "profiting defaulter" no longer worries about COD. If you're in a home that's upside down, the "Jim Cramer" mentality of ignoring the monthly payment until the bank "makes me a deal" becomes "acceptable" nationwide. The LAST person that should profit from his own default is the defaulter. If you pay people to default, they will default. The debtor has his chance to acquire the property at the "fair market value" in the foreclosure process. To provide him with other less "embarrasing"... means to make a buck on his own decision to not honor his contract will simply encourage it via the "law"; which condones the "Jim Cramer" mindset.

[tramp]

The COD rules in IRC Section 108 did not, prior to amendment, cause income to people who were technically bankrupt after the cancellation. THUS, the only people who benefitted from the amendment were people who had wealth AFTER their foreclosure.

[cheesecake]

i must say, a pretty stupid article.
For eg, the Fed should increase the reserve requirements for banks based on their loan portfolio...isn't that the bank's job ? Why the hell should the Fed check banks books or increase current reserve requirements, when we are having a credit liquidity problem.

[swaps]

Actually, the long statements by Rush and York pretty much demolish the short opposing statements which offer little substantive counter argument, just emotion.

[pharma]

The fact are quite simple and speaking for themselves:
- The present financial situation is out of control. So far, actions undertaking by the Feds and the Treasury have failed to even address the present situation and, to a large degree, were outright counterproductive;
- The Federal Reserve, Treasury, FDIC, and the Comptroller non-action and/or misguided actions have allowed the abuses of excess leverage and exotica in lending;
- The people directly responsible for the present financial and economic catastrophe [specifically sr. executives of major banks, investment and lending institutions, and security rating agencies are all allowed to keep their loot at the time when the entire country is suffering.

Conclusion
- The most serious issue is not a credit liquidity problem. Contrary to this notion, it was uncontrolled liquidity that was/is responsible for the present situation. The lending process that brought us to the present situation was nothing more than another financial pyramid. Consequently, just pouring more liquidity [gasoline] will ignite an inferno.

The major issues responsible for the present terrible crisis are the trust and integrity of the entire financial system!

PS
Unfortunately, the present political situation in the USA does not offer any hope for properly & honestly addressing and solving the runaway catastrophe.

Some repliers to this article went so far as to suggest a censorship of views and/or ideas they do not like or agree with. It is outright disgusting!

[helplessobserver]

pharma,
Your distillation of the facts is right on target.
observer

[Amidwesternneighbor]

Absolutely spot on, regarding banks hoarding the effects of the spread increases. And pretty short-sighted of them to do so.

[farmerfloyd]

I a private investor with no loans and 2 million to invest, where do I go to buy some of these 30-50 % loans?? SEE you cant,
just banks selling to each other. Very closed or hundreds of millions to buy. Small person is locked out

[iThinkBig]

Spot on Pharma. And what is so disturbing is that these people will get away with it. When the house of cards falls, depression occurs and people want to overrun Washington, these people will be long gone.

We the People (the responsible amoungst us) will have the heavy burden of ridding the turds in our nation while fighting Islamic terror and a ressurgent Russia with our hands tied behind our backs. We shall win in the end but the next several years are going to be very, very difficult.

I am buying some land up north away from the population centers. I will give a map to my family and colleagues. If it all works out, great I will have a nice excuse to get away from the wife with the buds. If not, I will be prepared and lots of ammo and advanced computer equipment is part of my preparations.

Also add that those who say I am emotional, they are right! My friggin countrymen are going to suffer in the millions, liberalism is touted as the new savior of our nation and I hear whining every day by irresponsible people who had it easy and now expect hand outs from the taxpayer (us). I will not reach true fiscal reward for being bright and responsible, my timing sux and I am pissed! But I know how to read data and back in June I began preparing the company and family to ride out the storm. I was scoffed at then when I told colleagues chance of recession was 100%. Now I am scoffed at when I tell people chance of depression is 100% UNLESS the new Administration builds the Manhatten Project of energy and can create a few million jobs in a mere couple of years. We're Americans and it's possible but I don't think it is probable.