Friday, March 14, 2008

Wall Street’s Katrina Moment

If we are not there yet, we soon will be…I believe that unless something is done, we are watching the slow motion collapse of our credit/debt driven economy.

Today’s Bear Stearns mess is giving me flashbacks of the camera crews filming the bodies floating in the water in New Orleans following Katrina. The flood of bad debt has been washing over Wall Street for months, last summer the credit crunch officially spread beyond sub prime when a couple Bear Stearns funds imploded and a Goldman Sachs fund needed a major cash infusion. Like New Orleans after Katrina, there is blame enough for all participants, but it is well past time for the government to step in and provide some support.

Now that the mortgage/re-fi market has come to a screeching halt, the Treasury Secretary (of an administration that believes regulation is wicked) thinks maybe we should draw up some regulations…you think? At least the “happy talk” about the strong economy seems like its being toned down. But just this week the president was talking about how the stimulus/rebate will fix any weakness/problems.

Mr. President, the problem with today’s markets will not be fixed with a $300 check, not even a $600 check in 6 weeks time. Please don't wait 3 months for this to be demonstrated as fact.

The problem is that all the existing market mechanisms for dealing with uncertainty about mortgage valuation and trading have broken down. Nobody can decide what they are worth so everybody is afraid to trade them. What was once a sub-prime debt problem has become a universal debt problem, as traders realize debt ratings are worthless and the firms that insure against defaults are on the ropes, indeed even the firms that simply trade mortgages are sinking.

What should be done? No less than the quagmire in Iraq or the Katrina (non?) clean-up there are no good options left. We must simply select the least bad option.

The government must step up and offer to purchase mortgages. It should start by offering to buy the best mortgages at a discount via Fannie Mae or Freddie Mac or an equivalent entity…indeed Fannie Mae and Freddie Mac were originally created to fix a credit/housing crisis. The discount should be steep, enough that “speculators” are not rewarded and that ordinary participants have to think hard about selling at that price. The steeper the discount the better in terms of limiting the amount of cash the feds would “tie-up” in the effort. I don’t know what the actual discount should be…maybe they should even let the market decide via reverse auction. The main idea is give all market participants a worst case value greater than zero. Depending on how that effort works the fed could then evaluate the need to buy lower rated mortgages at an even greater discount.

By establishing a floor value for the highest rated mortgages, the fed/treasury would encourage market participants to begin trading mortgages among themselves (if the felt the mortgages were worth more than the feds floor value) or allow them to exchange for ready cash mortgages they otherwise don’t want, which in turn would allow banks and market participants to get back to their real job of lending.

Call it a bailout or whatever you like, this action could easily cost a trillion dollars or more, although I would expect the feds to hold the mortgages long enough (3-5 years?) to break even or even make a modest profit from the transaction.

Eventually this will happen, because it always happens, the federal reserve and the treasury have to step in if the alternative is an economic collapse—some may laugh at this notion, but a year ago the “mortgage crisis” was a blip on the radar compared to the real problems our economy faces like energy security, runaway medicare spending (indeed health care in general), social security spending, rising inflation etc.

The question is will the “voluntary” administration wait so long that the rest of the world loses faith in the US economy, the dollar and our ability to manage either. With any other administration I believe we would be well on the way to solving this crisis, but with every passing day I’m reminded that the Bush administration is indeed unique in its incompetence and ideological opposition to government intervention (aside from war).


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