The 2008 Financial Meltdown

And how to resolve the situation...

The meltdown of the US financial system happened as expected. While saying "I told you so" might be satisfying, the collateral damage to everyone else in the world makes the satisfaction of being right rather moot. So the real question is what needs to be done to clean up the mess? Obviously, the markets are indicating that all of the steps taken by the Bush administration are inadequate; so here is my recommended plan of action.

The plan has two primary goals; keep people in their homes and eliminate the "junk bonk" asset backed securities. Achieving these goals will thaw the real estate and the commercial paper markets; by getting these markets functioning again, the rest of the financial system will be able to recover and function as normal.

The four step plan is:

1. US government guarantees mortgage payments to the banks;
2. US government rewrites mortgage terms;
3. Asset Back securities are split up into classes and reissued;
4. US government buys mortgaged homes.

Obviously, the plan needs some explanation; as things are not what they seem at first glance.

Step 1: Mortgage Guarantee

The US government guarantees the monthly payments on all first mortgages on primary residences for the next two years. The guarantee means that in the event of a default, the US government pays the bank the money owing.

The "Catch": the money paid out by US government is treated as a tax loan to the home owner, repayable in two years as part of the home owner's income tax.

The "Result": this removes the moral hazard of the US government bailing out home owners; home owners cannot walk away from their debt.

Step 2: New Mortgage Terms

The US government rewrites the mortgage terms on all first mortgages on primary residences. Rewriting a mortgage means invoking the "early cancellation" clause and issuing a new mortgage. An early cancellation triggers a penalty payment normally equivalent to 3 monthly payments; the US government will pay these penalties to the banks. The new mortgages would be issued by the same bank that issued the original mortgage.

The new mortgage terms would include:

• Term extended by 5 years; so if there is 2 years left, the new term would now be 7 years.
• Interest rate is now Prime + 2%.
• Mortgage is open; it can be paid off at any time without penalty.
• Mortgage is transferable; on sale of the property, the new owner can assume the mortgage.
• Principle amount of the mortgage stays the same.

The "Catch": the new terms apply to ALL mortgage holders, not just the people with onerous mortgage terms; people that made "good" financial decisions should benefit from the bail out as well.

The "Result": the cost of owning a home is reduced, which means fewer people will default. The banks get a quick shot of cash from the cancellation fees, but lose out on the reduced cash flow from the lower interest rates. The mortgage terms are Very attractive for home buyers.

Step 3: Junk the "Junk Bond" Securities

The existing Asset Backed securities need to be flushed out of the financial system. The first step is canceling the mortgages these securities are based on; once the mortgages are cancelled, any securities secured by those mortgages are also deemed to be cancelled. The second step is issuing new securities based on the new mortgages.

The new securities are split up into multiple asset classes in order to improve risk transparency. The current securities are designed to HIDE the underly risk and decieve the purchasers of these securities; thus allowing the issuer of the security to skim the risk premium. The new securities will eliminate the deception and the skimming. The interest on the new mortgage backed securities will be Prime + 2%; the payments made by the mortgage holder will pass through to the holder of the security, without any "sticky fingers" in the way. The interest rate on the rest of the new securities would remain the same as on the original securities.

The "Catch": the middle men between the borrowers and the lenders get cut out of the cash flow.

The "Result": the new securities will be split up into different risk classes; the risk classes can then be priced separately and traded separately; this resolves the primary problem with the trading of "assets" for which the market is currently frozen.

Step 4: Buy the Homes

The US government guarantees to buy a mortgaged home, provided that the home owner has purchased another home. The US government buys the home for the amount of the mortgage.

This guarantee provides the critical incentive for thawing out the real estate market. How this happens is...

• Homeowner has a mortgage they cannot afford, the mortgage value is higher than the house #1 value;
• Homeowner cant walk away (because Gov. will just add the amount to the homeowner's tax bill);
• Homeowner CAN afford a smaller mortgage on a lower priced house #2;
• Homeowner "sells" existing home #1 for the price of the mortgage (break s even)
• Homeowner "buys" home #2 (because that is the only reason the government bought house #1) and assumes existing mortgage (which the government previously arranged for)
• The person "selling" home #2 can now either leave the market or buy down into home #3
• etc.

The "Result": homeowners "buy down" in the market into homes they can afford; this means people staying in homes and paying mortgages.The "buy down" creates a demand and the "guarantee" sets a price floor which together thaws out the real estate market; this sets the stage for the market prices to recover.

The "Catch": the US government (aka tax payers) wind up owning a lot of expensive homes; however, that is not too bad, as these expensive homes will recover in value over the next 5 years.

Summary

The four step plan creates a feed back cycle that corrects the current meltdown. The plan forces home owners to "buy down" into homes that they can afford. The plan stabilizes the cash flow to the banks. The plan creates tradable securities.

The down side to the plan? The banks will hurt as cash flow goes down to Prime + 2%; the financial middle men will hurt as cash flow goes away; and the US government has to borrow a lot of money.

17-OCT-2008