The Unpleasant Coming Solution to Our Problems

The massive deleveraging of the banks, hedge fund deleveraging, and panic sales on the stock market has already affected tens of millions of people…and will soon affect everyone.

The results will be ugly, but are likely to solve the root of our current problems—which is the overevaluation of real estate. (To understand how the latter happened, please see my previous post.)

Most adult Americans own equities, either indirectly via employer sponsored plans or via directly purchased individual stocks. So the plummeting market will mean a lot less money available to tens of millions of people.

Further, unless the credit market is unfrozen, many businesses will need to stop hiring and/or lay off employees.

Some people will be able  to ride this out until the market turns bullish again in, say, three to five years.

However, a significant number of people will be faced with expenses they can no longer pay for by simply cashing in stocks. In such cases, they’ll be forced to sell their homes; and not at the inflated prices of recent years, but at firesale prices.

At the same time, banks will be forced to accept the losses represented by the bad paper they’re holding and sell off foreclosed homes cheaply.

Over several years, this painful phenomenon will drive real estate prices down to appropriate levels.

In addition, it will allow banks to know the real size of the hit they need to take, and to form realistic valuations of their debt to equity ratios.

How Did This Financial Mess Happen?

The truth is, there are always going to be recessions.

It’s inevitable that supply will periodically outgrow demand, and the economy will slow down until balance is reestablished.

However, this is something most Americans are very reluctant to accept.

In fact, it’s a bitter irony that our current problems are the result of efforts to avoid a recession eight years ago.

After the NASDAQ bubble burst in March 2000, the money that investors had pulled out of the stock market was redirected into buying something more tangible: real estate.

At the same time, the financial firms didn’t want to give up on the growth they’d experienced via tech stocks. And so they decided to pump up the real estate market.

These firms poured billions into subprime mortgages. Instead of dealing with only solid risks, financial companies expanded their lending reach by offering  cash for houses almost indiscriminantly.  As a result, lots of money went to people who couldn’t possibly afford their mortgage payments. In some cases, these new homeowners couldn’t even afford their monthly electric bills.

The seriousness of the problem wasn’t immediately apparent, because these lending companies passed their risk along to other companies in the form of synthetic products. For example, a company could have a loan that was a “D” risk but group it with four other loans and call the new package an “A” risk. No one was policing such activities, and so this bad behavior escalated over time.

Taking on high risks was tempting, because the payoffs could be enormous. But it turned conservative financial firms into casinos.

How do we repair the awful results of all this recklessness—particularly the underlying cause of the inflation of real estate assets, for which interest rate derivatives and credit rate swaps were just the icing on the poisonous cake?

First, the Fed will have to use part of the $800 billion bailout to flush these bad loans out of our economic system. Second, real estate prices will have to come way down–this is, back to levels not propped up by artificial means. (More on this in my next post.) And third, from now on each financial institution should be required to retain at least one-third of the risk for any loan it makes—because that’s bound to lead to more responsible lending practices.

Getting Our Cash Supply Flowing Again

I certainly picked an interesting time to start a financial blog.

While the market seems frightening right now, we aren’t going to have another Great Depression. On our side is something that didn’t exist in the 1930s—Milton Friedman’s Theory of Money Supply.

It was the acceleration of the money supply, caused by massive government spending for World War II, that got the US back on track financially in the 1940s. And our government is taking steps to pump cash into the system now as well.

Our biggest risk is that the Fed doesn’t move quickly enough, or strategically enough, to effectively deploy the $800 billion bailout approved by Congress before the current loss of confidence cascades into sheer panic.

One of the biggest problems of this crisis is that each bank can’t be sure of how much capital it actually has, let alone how much capital other banks have. This makes banks unwilling to lend to each other.

The Fed’s plan of throwing a bunch of money at select banks isn’t going to fix this cash freeze. Trust between the banks won’t be reestablished until the worth of the assets they are holding are better defined.

The solution is our government guaranteeing loans.

If a government window is created that directly lends to banks, this will remove the risk of one bank lending to another.

Banks will then stop being scared…and our economy can start moving again.

Perspective on the Bailouts

The recent government bailout of AIG could become a boondoggle; but it could alternatively turn a nice profit for taxpayers if structured correctly. So far, our politicians haven’t made this sufficiently clear.

The Fed paid $85 billion to rescue AIG, but in return got 80 percent of the company.

The Fed can now take its time selling off the various components of AIG. Because our government doesn’t have cash flow issues, it doesn’t have to rush and conduct fire sales, but wait for good offers that bring in more money overall than was spent for the AIG rescue.

Also, because our tax money was used, we’re effectively now all part owners of AIG. The government could formally acknowledge this—for example, by assigning shares of the company to each taxpayer based on how much he or she paid in taxes.

Along the same lines, when a profit was made from AIG, taxpayers could receive a portion of those profits.

If the government structured the buyout this way—and took a similar tack with the $700 billion bailout—Americans would be a lot more positive about these rescue efforts.

That’s not to say I’m personally thrilled about these actions.  I’m not sure where they’ll end, and I don’t want to live in a socialist country.

But if they’re going to happen, such rescues should at least be structured in a way that’s smartly implemented and fair to taxpayers; and this should be clearly articulated and communicated to taxpayers.