Monday, January 26, 2009

Fixing the Economy Now

This item describes the structural nature of the next and final wave of the credit disaster. I would like to say something that was reassuring, but how? Low interest rates will salvage some of this paper. But even if a lot is salvaged, a lot will not be salvaged. And it certainly cannot be rescued by further foreclosure sales. The resale market has totally failed and prices now are mostly underwater.

If foreclosure is impossible and millions of Americans will be deemed bankrupts, how do we imagine that the economy will rebound? We are losing a real percentage of the middle class consumer in the next wave. This is about millions of families. This will result in a substantial reduction in US tax revenue. All because our politicians could not resist the idea that they could gamble on the nations future by throwing of the governors of the credit system. Do not blame the brokers or the banks. They already proved that they were drunken sailors back in the great depression. We have actually had a repeat of the roaring twenties.

Throwing money at the problem is not restoring personal credit or inflating the price of homes back to where the owners become whole. All it is doing is replacing the money lost on the bad loans already made. This is not inflationary because we have already absorbed all that red hot cash – ask China.

We must restore personal credit and turn all the housing stock back into earning assets for the lenders. If we could do that at a stroke of a pen, the economy would be on a roll tomorrow morning.

I have already posted on the how in an earlier article, but it is timely to do so again. Maybe this can be circulated to politicians and other opinion makers who might be able to do some good with it.

Firstly, I spent two decades working in my own private market laboratory known then as the Vancouver Stock Exchange. I understand and know what happens from hands on experience. There is nothing harder to recover from and repair than a credit bubble of any kind but it can be done. All aspects of that laboratory passed through my hands sooner or later.

Our only way forward is to acknowledge that these losses are real and may never be recovered. We have to recover the customers first because their recovery and success will rebuild the whole credit business and from there our business.

All the losses stem from the housing credit bubble. Solve that, and the rest will in time sort itself out. If we do not solve that then the automobile industry becomes a money vacuum for years as everyone scrambles after a slice of a shrinking market. This will be known as a second great depression.

We start by setting a date such as the beginning of this presidential term as the mark to market date. We use a date in the past because it prevents nimble manipulation by anyone. We have had enough of that already.

We pass legislation that provides for a new rule kit for mortgage foreclosure from that date. We establish a rule, that if a property falls into default, the property is appraised as of the mark to market date. Once the emergency is over, this will be set at some other date such as year end.

That figure is used to complete the following transaction. Fifty percent of the title in the property is transferred to the lender in exchange for the write down he is about to incur. The original mortgage is replaced by a mortgage on the basis of eighty percent of mark to market price of the fifty percent held by the borrower.

As an example, a property carrying a $400,000 mortgage in foreclosure and presently appraised at $$250,000 gives up fifty percent of the ownership to the lender and the new mortgage is based on $125,000 and is $100,000. The lender immediately writes down $300,000 in exchange for an asset presently appraised at $125,000. The mortgage is a ten years mortgage at current rates, renewable every five years.

This is likely a worse case scenario, or at least should be. The borrower is paying off a mortgage that he should be able to afford. During the next few years, he will also easily clean up his credit and possibly pay off the mortgage.

When he pays off the mortgage, he then has the right to purchase the remaining fifty percent from the borrower at normal terms. He has been and continues to be a good bank customer.

How has the bank fared? The situation was taking a $200,000 loss if the property could even be sold. If everyone was also selling, then the price could easily decline to $100.000 to $150.000 leaving the bank with a fully realized loss of $250,000.

In our scenario, the bank writes off $300,000 now but retains an interest worth $125,000 for a realized loss of $175,000. However, they retain a customer holding a high quality mortgage in terms of income coverage and asset coverage. In ten years this mortgage is paid off.

Now the bank sells the fifty percent that it retains back to the borrower at current market price. Their customer owns fifty percent clear. He easily qualifies for a new mortgage and completes the purchase and the bank has another high quality earning asset.

Suppose the price has recovered from $250,000 to $350,000. That fifty percent is worth $175.000. That is the new mortgage supported by the entire property. In other words at the end of ten years the bank has recovered $275,000 while earning some income. The capital loss is still $125,000 but the this has been offset in part at least with good quality mortgage interest from a customer whose ability to borrow is improving every year.

This formula can also be used to sell off the entire present inventory as well. This means that in as little as twelve months the housing market runs out of supply. It can be that quick.

It is all financeable with cheap government financing which is what we are doing anyway, but not nearly as effectively.

This new rule applied in the normal course of business once this crisis settles down, will be quickly integrated into normal bank lending practice and properly priced. You can see that the loss is reduced for any defaulting mortgage and that the customer survives to fight another day. Please note that in a stable market, giving up half of your ownership is a loss to the owner and a gain to the bank.

It will require a change in banking rules to allow such equity to contribute to the bank’s capital base properly. This is the one case that will be hard for the banks to cook the books on, so it will be safe to allow.

The Second Half of the Credit Crisis

By Ian Cooper Saturday, January 24th, 2009

Could it be we've just entered the second half of the credit crisis?

Just as 2008 was the year of subprime woes, this one will go down as the year of Option ARM resets (or adjustable rate mortgage resets). With billions in Option ARMs resets in 2009 and 2010, this crisis is about to unleash a fury no one's prepared for.

It won't be as bad as subprime, of course. It'll be worse.

That's because lenders created these ARMs with "teaser" features to borrowers, which included making lower minimal payments for the first few years before the loan reset to a higher payment schedule. And if that weren't bad enough, there's another feature called "negative amortization," which means you're not paying back any principal.

In fact, with negative amortization loans, your loan balance increases over time. Incredulously, every time you make a payment, you owe the bank even more. These are the loans that allow consumers to buy a house they can't otherwise afford.

As for speculators, they may use negative amortization loans if they believe prices will increase at a fast pace. But with the opposite happening, they're out of luck.

And the banks will be left holding the bag.

So when your financial advisor tells you the financial crisis is well behind us, you'll know better.

Housing aside, despite repeated injections of taxpayer money, the financial system continues to teeter on the brink of disaster. And while hope abounds for Obama's new approach, described as a "fundamental reform of the $700 billion rescue plan," it may still require trillions more dollars, putting added pressure on our unstable economy.

And if you thought we were in bad shape... look no further than across the pond.

The UK, just like the U.S., consumed more than it could pay for in what's amounted to one massive liquidity bubble. The UK economy shrank 1.5% (vs. 1.2% estimates) in Q4, and the government announced it was in recession.

A House of Cards.

It was in February 2008 that British consumers owed $2.7 trillion on credit cards... when debt per capita was at a higher level even than for U.S. households... when British household debt stood at 164% of disposable income, as compared to 138% in the U.S... and when research suggested that one in four people were either struggling with debt or felt their debt was unmanageable.

Here in America, we're still wondering how it is that no one sounded the bell. Will we actually learn from our mistakes?

As the "sage of Baltimore" H.L. Mencken once said... "... the common people know what they want, and deserve to get it good and hard."

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