Phil Anthropy

Entering the Endgame for Monetary Policy

The value of something is what people will pay for it. The stock market is like the Antiques Road Show. People buy things in hopes the value will go up, but business success isn't guaranteed. If people suddenly find the Blackberry to be less popular than the latest gizmo from someone else, then RIMM suffers. The wild fluctuations in everything from the bank stocks to the oil funds to the manufacturers to tech implies to me that traders are clueless about whether the Napoleonic breakfront of the day will be more valuable tomorrow or as worthless as yesterday's newspaper. I am oversimplifying, because companies do have a liquidation value, but that is usually far less than the current market price of the stock.

There is expectation, and then there is reality. If everybody was content to hock themselves to the hilt tomorrow in order to buy a house, because houses would increase in value, then the real estate decline would be over. In one day, everything could turn around. Unfortunately, real estate was a bubble, fueled by a change from banks holding mortgages to banks selling mortgages to Fannie Mae as fast as they could and passing the risk along to the greater fool in a CDO package.

The total value of derivatives and the leverage used to produce them doesn't matter. All that matters is the pricing, which may have no relation to reality, or may have a relation that can change abruptly. The Napoleonic breakfront suddenly becomes worth twice as much, because the government puts a bounty on breakfronts.

Let's talk about economic decline. Who would be the real losers in a depression? The Chinese and the Europeans, not us. Yet the Chinese are alleged to have ordered their banks not to make any more loans to U.S. banks. That seems odd. The Chinese have plenty of liquidity. They could bail us out easily if they chose to. They obviously must be continuing to buy our treasuries, because if that didn't happen, interest rates would soar overnight when demand fell. I don't believe the Fed has enough funny money remaining to "monetize the debt" by buying up the treasuries with our own (ink still wet) money without causing immediate inflation.

So how do we solve the problem? I have some suggestions.

Put a cap on interest rates for credit cards at some reasonable level, like 10%. Bankruptcy laws have already been changed, so that people can't get out of repaying their debts. The banks don't need 20+% interest to make money, when they are paying 1% at the Fed funds window and can leverage that amount by 12 to 1 on reserves. This will immediately give people in debt some relief.

For any adjustable mortgage that is resetting, have the lender ask the homeowner if he wants to stay in the house. For houses that are deep "under water," where the current value of the house is far less than the amount owed in the mortgage, foreclosure is inevitable. If the person wants to stay in the house, have the lender refinance to a fixed rate mortgage at prevailing 30 year fixed rates. Have the government then issue 30 year treasury bonds to fund and pay the difference between the current (before reset) amount and the new, fixed rate amount, in return for an equity interest in the house that is senior to all other notes (including the lender's mortgage), and that serves as a senior lien on any sequence of sales. This is not an original idea. It has already been discussed in the media.

Let me explain a little further. The government becomes a partner of both the homeowner and the lender. The homeowner continues to pay at the previous rate. The government pays the difference, in an "equity sharing" arrangement. If the house is ever sold, the government gets paid first, up to the cumulative amount invested in this equity sharing (plus a nominal interest amount, say 2% APR). The lien goes with the house, so that subsequent sales have the same deal until the government is paid back.

Meanwhile, the lender can sell the mortgage, which is now a fixed rate mortgage that is probably only a little less creditworthy than prime. Fannie Mae buys it and packages it into CDOs, as before, but this time the rating and insurance agencies are carefully monitored to ensure that they are not overly optimistic about the risk.

After 30 years the mortgage is paid off. The homeowner then refinances the home (or sells it) to pay back the government's share of the equity.

Since the funding is done through 30 year treasury bonds, no current money is required from the government, and there should not be an inflationary effect. Banks can use those bonds as assets on balance sheets and "mark to market" at full value the original mortgage, thereby immediately seeing a large increase in the balance sheet total. That has a 12 to 1 multiplier in terms of their ability to loan money, so credit is immediately available.

It is possible, despite moaning and groaning to the contrary, to bootstrap oneself into prosperity. Indeed, it is easy. If one person makes shovel handles and another person makes shovel blades, and nobody wants either one, the situation can change overnight if the two companies put those products together correctly and suddenly have a shovel that everybody wants and that is useful.

If toxic CDOs become nontoxic, then suddenly everybody wants them, the prices go up to reasonable levels, credit increases and everybody is happy. The antique dealer's Napoleonic breakfront is in demand again.

Saying we have to go through a "purging" or "long, deep recession" or other such process is simply untrue. We may end up there, but it is not necessary. We are in our current pickle due to certain excesses. If those excesses are curbed, we can ease our way back to prosperity.

First, there must be confidence in ratings of debt, based on accurate assessments of the likelihood of default. Second, counter party insurance against default, whether through credit default swaps or straight insurance, must be accurately evaluated for safety in terms of reserves held by the insurer. Third, leverage must be limited to reasonable levels. This will not be enforceable universally, because the markets are too complex and international, but enforcement domestically should be possible. Fourth, banks must not be allowed to conceal debt through alleged creation of Cayman Islands shell companies which buy toxic debt from the banks and shield it from view within the shell, while the risk of default remains the same. Fifth, the government, whether at federal or state levels, should auction off foreclosed and purchased properties at the retail level, property by property, to individual buyers, not just in large packages to the fat cats (as some allege was done during the days of the Resolution Trust Corporation). Sixth, those who have caused this crisis through negligence, fraud or malfeasance should face legal consequences. Seventh, some might advise the American public (I am neutral on this) to vote out of office any elected officials complicit in causing this crisis through their inaction, cronyism, ineptitude, or corruption.

Our economic markets are sensitive to large perturbations. If we can reduce the size of the perturbations, the markets will be far more resilient. We can absorb dozens of bank failures, as long as they do not happen simultaneously.

Once values begin to return to sane levels (which may be lower, but will not be zero), the economy can resume its functioning at a reasonable pace. Then we can slowly start cutting our spending (maybe reducing the number of wars we're fighting or moving towards energy independence might help save some money, although I won't second guess our foreign policy).