The $700 Billion Falling Knife

OK, so the market fell 777 points, dove like a jumbo jet that ran out of fuel. Clearly Wall Street didn't like the news that Congress had demurred on the $700 million bailout package.

But what was to like about the plan in the first place? OK, if you are holding some funky real-estate based derivative assets that you cannot figure out how to price, then sure, you were looking forward to having a naive $700 billion buyer in the market to pay way too much for these assets. But how was that going to stabilize the markets, and more importantly get the US economy and financial markets moving the right way?

There are so many problems with this plan that it is hard to enumerate them all, but lets start with a problem that Bill Gross at PIMCO hit on: Who is making the decision of which assets to buy, and who is determining the appropriate / fair price? I got news for you, neither Paulson nor Bernanke have any clue how to price these assets. Bill Gross was recommending a price of roughly 65% of face value, but what about the derivative assets that do not have a face value? And why is 65% a magic number?

Is it possible that our government could purchase $700 billion in assets that are worth materially less? Is it a possibility that after our government purchases these securities that our markets will still drift downward? The answers are yes and yes.

A downward market absorbs capital. Lots of it. It creates a vortex that sucks everything in its path into the abyss. Just ask TPG. Those smart fellows learned a $1.7 billion lesson about the sharpness of a falling knife. Sure, $700 billion is a whole lot more than TPG threw into the pit, but arguably TPG threw their dough in a much shallower hole. We have no idea how big the entire real estate related market pit is, and certainly no conclusive evidence that $700 billion will plug it.

A smarter idea would be to stop, take a step back and review what put us in this predicament in the first place. Sure, there were lots of bad mortgages out there, and lots of dumb securities formed and derivatized (new word? Honk if you like it). But the problem wasn't that banks were making sub prime loans. The problem is that they stopped.

OK, take a deep breath, and stay with me on this.

Since 2001, the engine of our economy has been real estate. This has driven construction, which has driven commodities and labor. The average American was wealthier, and used his home as a blank check. New homes meant new furniture, new drapes, new paint, new dishes. Remodeled homes meant media rooms, new flat screen TVs and other electronic toys. New communities meant new shopping centers, new health clubs and preschools. And of course, new mortgages, second mortgages, and credit cards bills to finance all the purchases.

Say this with me: It was good. Very good.

So the problem wasn't the real estate lending based boom. The problem was it STOPPED.

Why did it stop? Well, thats is a complicated question, but basically, the market stopped purchasing loans because of all those scary, evil, and bad sub prime mortgages out there (we will come back to that in a second).

Who was the market? Basically Wall Street packagers, and a couple agencies you no doubt have heard a lot about, Fannie Mae and Freddie Mac. A couple of Bear Sterns hedge funds go "tits up" (to use the street's vernacular), and the market ran for the hills. Soon, all across the media we were hearing about the evils of these sub prime mortgages.

So these Wall Streeters and Agencies responded to pressure from the government and the media, and these folks stopped buying loans from banks. When they stopped buying, the banks couldn't make any more loans.

And so the real estate market ground to a halt. No more liquidity. Prices fell. People could not refinance. They were foreclosed upon. Prices fell some more. Banks were damaged and began to close. And so on. The vortex had been formed.

Wrong idea, wrong response.

Markets are based upon liquidity much more than underlying value. Value is a tenuous thing, its what the buyers agree to pay and sellers agree to receive. Its ephemeral, fleeting, and based on psyche. Primarily that psyche depends on: If I had to resell this thing, what could I get for it?

So were sub prime mortgages bad? How about so called liar's loans? In each case, a resounding "No." Really, who cares whether you leverage your home 50% or 100%, so long as you can afford the payments? If you can afford to make the payments, the fluctuation in the market prices for real estate do not really matter in the short term.

Were there problem loans? Of course there were. These were the loans that I classify as "designed to fail" loans: negative amortization, teaser rate, pick a payment, call them what you like. They all had one characteristic: The borrowers could not afford a traditional mortgage. These mortgages were relatively short term before they reset, and depended upon either 1) real estate prices increasing significantly so that the loans could be refinanced, or 2) that the buyer's cash flow would significantly increase. Or in some cases both!

Well, what happens to borrowers with negative amortization loans when prices don't go up but rather go down? Well friends, we are living it.

So what does that have to do with our $700 billion debate? The issue is this: Now that lending has ceased, and prices have dropped, piggy banks have gone dry, and the economy has faltered, will propping up the owners of these crazy derivatives make a damn difference to Joe and Jane homeowner? And by extension the economy? The answer is "NO."

A Better Idea: Take that same money, or even less, and create a new Fannie Mae or Freddie Mac to purchase MORE LOANS! We would have to call it something else; how about in honor of Bill Gross and me we call it Billie Mike. Whatever.

The point is to start buying new loans again. Lots of them. This will drive down the spread in mortgages, and create liquidity. Liquidity will support real estate prices. Construction will restart, and people will start buying furniture, etc..... you are seeing my point I think.

So how can we be sure that the same mistakes are not made? First, no neg am loans. They cannot be sold into pools. Also, require that borrowers sign a statement acknowledging the risk. Further, require that lenders segregate their portfolios so that they disclose exactly how many of their loans are this toxic waste. Perhaps require 100% capital against negative am loans that are more than 50% loan to value.

Also, on the intermediary side, its time to require much more capital against derivatives. How much? and won't this damage liquidity? Well, I don't know how much, that's a subject for a different blog. And certainly it will diminish liquidity. But remember the 1990s when Alan Greenspan developed the concept of "soft landing." Soft landings are ok. Hard stops are not. If liquidity is a bit less than 2005, that's ok. We just can't have the hard stop of 2008.

So there you have it - a simple, elegant, and aptly named (Billie Mike) solution to our economic woes. Messiers Bernanke and Paulson, you're welcome and you know where to reach me.