I have never lived in poverty. I have been cash poor, and I know commodity cheese when I taste it, but I have never lived 24/7 in destitute poverty. There has never been a single moment in my life when food, clothing and shelter were not readily available and affordable.
People who lived through the Great Depression knew a very different reality. Billmon's reference to "searing generational memories" is dead-on accurate. At some primordial level, I have morphed into my Grandmother. I stockpile staples, I can't throw anything away, and I spend precious hours learning how to do stuff by trial and error (with a lot of help from the internets), so that I won't have to pay someone else to do it for me. Self-sufficiency has become a bit of an obsession, actually.
Yes, I'm terrified of those searing generational memories, and they aren't even mine. The relative security that I have always taken for granted is now being threatened. It's not the vague, fight-them-over-there-instead-of-here kind of threat, either. No, this is the oh-shit-I-might-lose-my-life-savings-and-have-to-eat-catfood kind of threat.
I'm very angry. This is not my fault. I worked hard for what little I have, and somebody else has gone and fucked it all up. I want heads on pikes, and I want them now!
(/rant)
Ultimately, we have a choice. We can open a metaphorical vein, and slowly bleed to death by whatever escape mechanism suits us, or we can deal with the reality, accept the lemons, and make some lemonade.
The current recipe, as outlined in both the rejected Paulson Plan and Rep. DeFazio's slightly modified flavor, is to have the US taxpayer buy up distressed assets at a premium to recapitalize the banks. The liquidity boost will free up the credit markets and we'll all just move along, maybe find a better fix down the road.
I don't think that either of these plans will ultimately work. Basically, I don't believe that the rest of the world will loan the U.S. enough money to buy enough assets to ease the fears of insolvency that are causing the credit freeze. Even if they loaned it, I don't believe that we could make good on those debts, and a default by the U.S. Government is not a pleasant idea. As we speak, the IMF auditors are demanding a peek at our finances.
The alternative is that we simply print more money. That would almost certainly spark hyperinflation. Picture stacks of cash to buy a loaf of bread. See also, Argentina. Not good.
The problem that everyone knows about, but refuses to address directly, is the credit derivatives market. Because it is not regulated, no one knows exactly who holds how much bad paper. We do know that the estimated total value of the derivatives market is some $70 Trillion. That is a very scary number. Even to investment-banker types. Especially to investment-banker types.
By now, most of us have learned something about credit default swaps. The CDS contract serves a legitimate purpose - insuring the risk associated with holding any asset over time. But in the absence of regulation, there is no requirement that one actually own an asset to insure it with a CDS. Thus, the CDS became the preferred tool for gamblers everywhere.
Place your bets here.
Investment-banker types aren't stupid. They saw it coming, the collapse of the mortgage market ponzi scheme. It was only a question of when, not if. Because of the tiered, fractionated structure of mortgage-backed securities market, there are near endless positions for the gamblers to exploit, and there are fortunes to be made betting on who will get caught holding how much when the pyramid collapses. All made possible via the credit default swap. $70 Trillion is a very scary number.
Place your bets here.
Credit default swaps are term contracts. The buyer pays a "premium" to "insure" against a "credit event" for a period of time. If the credit event occurs within that period, the seller has to pay off on the contract.
Place your bets here.
The problem with the bailout proposals is that each bailout under the plan is a "credit event" in the derivatives market. Each bailout triggers the big insurance payoff on another raft of CDS instruments. Each bailout creates more of the insolvency that it is intended to cure. That additional risk of insolvency will maintain the credit freeze and more bailout money will be needed to try to unfreeze it. More bailout triggers more insolvency from derivatives, and the cycle continues until we reach the floor of the market where all bets are settled. No one knows where that point lies on the scale of 0-$70 Trillion.
It's a very scary number. How much of it is pure speculation on the crash? This is what Paulson meant about "price discovery." His idea was basically that if he had total control, he could out-master the masters of the universe. By controlling which assets to purchase and which banks to save, he would control the credit events in the derivatives market. He could control who profited, and who was rendered insolvent. With a lot of luck and by choosing carefully, he thought he could discover the extent of the speculation, and contain the damage before he ran out of taxpayer money. (That's the best spin I can put on it, although I could argue a much more sinister version).
The DeFazio plan seems to be the same approach only instead of bailing out banks with cash, it would recapitalize them with government issued bonds.
Under either plan, if the U.S. is unable to borrow enough money to purchase enough bad paper to find the floor of the $70 Trillion derivatives market, then the additional exposure triggered by the credit events will cause the credit freeze to continue and the economy will collapse.
Understand that it's all or nothing. If they start the bailout process, the only way it can work is if we spend enough to find the floor of the derivatives market. We have no idea whether $700 Billion would be enough, but to me it seems highly unlikely. Given the advance knowledge of the subprime crash and the unrestricted ability to place bets through the credit default swap, I have to believe that a relatively large portion of that $70 Trillion is tied to credit events in the mortgage crisis. Ten percent, which seems ultra-conservative, is a potential bailout of $7 Trillion. Discount that number a bit for effective damage control, but $5 Trillion is still a huge number. Who will loan us that kind of cash? Who can? How in the hell could we repay it? What if the numbers are really much higher?
Is there an alternative? I think so, yes.
The trick to unfreezing credit is to remove the existing insolvency without triggering credit events in the derivatives market. If the credit event never occurs, i.e, if the mortgage does not default, or we don't bailout Bank X, then that additional exposure is never triggered.
The only way I know to accomplish this is to prop up the value of the assets to erase the insolvency on the balance sheet and effectively recapitalize the bank. We can't buy the assets or the bank because either of those would be a "credit event." But we can make good on the monthly payments and guarantee the mortgage. If the U.S. makes the payments on the bad debt per existing loan terms, it is not a default, it is not a "credit event." It would not trigger that derivative exposure. Guaranteeing the mortgage income stream would remove the insolvency risk that is causing the credit freeze. It would make all the paper good again, including the nightmarish slice and dice CDOs. That, in turn, would save those pensions and 401K funds that invested in the ponzi scheme.
Over time, the speculative positions in the derivatives market will unwind and the threat of triggering that extreme exposure will evaporate. At that point, the government can address the issue of the actual mortgages, and decide whether to continue making the payments in a given market, refinance the terms and allow the home owners to keep the home (perhaps a cram down), or foreclose and payoff the mortgage. Even in a crappy market, the home has some value. It won't be a total loss.
This recipe would still have a substantial net cost to taxpayers, but it is a plan that would work and it would be one hell of a lot cheaper than $5 Trillion, and probably significantly less than $700 Billion. Experts have better numbers than I, but for the sake of argument, consider the following estimates which I think are very conservative:
Currently, outstanding mortgages total about $12-14 Trillion. The default rate is 6.5% and will no doubt rise when interest rates reset. If the default rate rises to 10%, there would be about $1.5 Trillion in bad debt to service. If PITI averages 1% of the debt (mine is .625%), the monthly payment would be $15 Billion. I don't know how long the CDS contract periods are, so I don't know how long we would need to carry that load, but $15 Billion a month is a whole lot better than $700 Billion upfront. Eventually, when the mortgages get liquidated or refinanced, we would have to payoff any deficiency from a loss in home value. Even with a 30% loss in value, that deficiency would only be $450 Billion.
Guarantee the mortgages, make the mortgage payments. That's my recipe for lemonade. Tell me why I'm wrong.