The Credit Crunch and The Insolvency Arena

Give me a wall and I will move the world...

To intervene or not to intervene. That is the raging debate on our satellites. That is the raging debate around our water coolers. ‘Let them fail!’ or “They are too big to fail.’ But it is far deeper and more subtle than that…

After the Great Crash of 1929, Hoover and the Fed did nothing. After our Great Credit Crash, we are doing everything. Both then, and now, we are finding that it is not working. Why? Because it is more about certainty than it is about circumstance. Most any reasonable plan, if it were consistent and solid, would be better than nothing at all (as in the case with Hoover) or everything changing daily (as in the case with Paulson). This is no longer a debate for the soul of the American Free Markets, which have been egregiously wounded, it is a debate for the survival of the economic machine itself.

A swimmer needs to have something against which to push. There is no speed without a stable backstop. There is no clear direction, no way to accelerate. There can be no predictable turns. There can be no start and no finish. The pool wall defines the environment and gives form and purpose to the race.

Our American economy is no different. Our global economy is no different. Investors need to be able to make reasonable assumptions as to likely outcomes. Paulson is swatting problems left and right like a man who wondered like a fool into a nest of hornets and has not the sense to move away. Will they let Citi fail? Some have been saved. Others were not. The message was perilous and mixed. Will they buy the toxic debt or not? Will they bail out the automakers or not? Today is one thing, tomorrow another. There is no wall for our push. No way to gain our speed. No way for us to make our turns.

The balance sheet of our nation is wrecked. But believe it or not, that is not the central problem. Give us a healthy market, a healthy recovery, a healthy consumer – and we could wipe that problem from the map. The problem is uncertainty. A crisis of confidence on the part of investors – and a crisis of confidence in the hearts of American consumers. If you are under the age of 40, you have never known the total fear of an economic crisis. This is nearly 1/3 of all consumers. They are truly scared for the first time ever. Don’t forget that regular people buying regular stuff make up more than 70% of our entire GDP.

As we have stated unwaveringly before, we need political courage now more than any time since World War II. We need someone to step into the breach and plant a flag. Someone to take a plan and say ‘This Shall Be.” That courage need not come from a President – though it might. It need not come from a Treasury Secretary – though it might. The courage must galvanize the markets into the confidence that a plan is at least in place. The race to recovery can begin.

Our recommendations for a recovery are well documented in this column. But here are out reactions to the most recent pieces of news:

1. The case of the failing automakers. As much as we dislike the idea, there is no way Congress will say no to the automakers. They will do something because it is the only way for them to save their political hides. We take that as axiomatic. Now, since we know we are going to end up giving them money anyway, let’s put the carrot to good use. Yes, you can have a loan. But first, we want you to show us your plan for bankruptcy. Show us who will take a haircut. Show us how you will restructure your ridiculous agreements with unions. Show us how you will solve your efficiency problems. Show us how you will shrink your bloated promises to everyone under the sun. Show us a plan to market to the new world of fuel efficiency minded consumers. Show us your new cars ideas. Jettison your diluted dealer network. Tell us how you plan to make money. Now, you must go into bankruptcy and do these things. You must cleanse and reorganize. You must use this bankruptcy process to make changes you have not had the courage to do in the past. During that time, we will set up a fund to guarantee warranty work so consumers will not be afraid. We will set up a fund to ensure suppliers will supply parts for the cars on the road. We will shore up your cash so you can emerge. Now go. And know that we will never help you again. Ever. No matter how bad it gets, we will let you fail.

2. The case of consumer debt. You gave too many credit cards to too many people. You had abysmal underwriting. You had draconian collection techniques. We know you are going to be an anchor around the neck of your parents, but we will not help you. We will buy preferred shares in your company with a predetermined plan to get out of your business quickly. We will use our preferred control of you to shore you up and restore confidence, but we will not bail out your losses on consumer debt. You will have to figure this out yourself. This is a free market and you messed up. Maybe you will change your methodologies moving forward. But if you choose not to, know that we will not bail you out ever. Not now, not in 10 years.

3. The case of Mortgage Backed Securities. A market must be made here and the move of the Fed in late November was a good one. We made a huge mistake in not exploiting the moment back when Fannie and Freddie were teetering. We should have used our bailout promise to them as a way to force them into the private sector more quickly. But, the mistake having been made, the liquid market for MBS’s was a good idea. Next step is debt forgiveness and renegotiation using private sector methods. Yes, forgiving someone’s debt who acted like a fool is horrible to consider. We have documented thoroughly out objection to this most perilous of moral hazards. But if we do not arrest the slide of home values, we will not pull out of our dive. This can not be done with loan modifications alone. Debt forgiveness must be a part of the equation. Our math would give almost 1/3 of all mortgage holders on Owner Occupied homes a whopping 35% forgiveness and a brand new loan. And for the other 2/3’s? The ones who pay their bills and behaved sensibly? They all get a tax credit. A large percentage of their lost equity will be taken as a tax credit. Even more could be claimed under certain refinance scenarios. These credits would be partially recouped by the government if the home were to sell in the first 5 years. Then descending to zero by the 10th year. We are in the sinking boat together. We can not refuse to help out neighbor bail or we will all slip under the waves.

4. The case of the failed banking system. FDIC insurance made sense in the 30’s. In fact, it was brilliant. But a new plan to insure deposits must be constructed. A career banker in Tennessee named Jim Rieniets came up with a plan whereby depositors and banks share some of the risk. It is a brilliant and simple way to modify the FDIC plan for a modern era. It would keep bad banks from sucking up all the deposits as they die. It would keep bad banks from pulling good banks into their slough. We should also make bank regulators look at the right things. Currently, they oversee banks by browbeating them into submitting to things that don’t matter in a way that is inefficient, paternal, and obscene. Regulators should definitely be hard on banks – but at least they should be reasonable. I had a teacher in 6th grade who was tough as nails on chewing gum but never noticed the fights on the playground. Surely we can do better than him.

5. Lastly, the case of the broken Hedge Funds. Just give it some structure. Don’t kill it. Don’t hate it. Don’t blame it for our universal woes. The Hedge Fund market grew too fast and did so under the radar. That is okay. We missed it. Now fix it. They would probably accept a certain degree of regulated transparency. While we are at it, make a market for Credit Default Swaps. They are, like Warren Buffett said, ticking time bombs. But they are not going away. Derivatives will be around as long as there are computers to calculate their mathematical complexities. Let’s find them a place to play. Bring them in off the streets. The monster in the closet is always more frightening than the one in the room. They have a role to play in our financial future. Like Gollum in the Lord of the Rings. Don’t kill them yet. They can enhance credit quality. They can give us a barometer of perceived risk. They can democratize the risk IF they are given some rules by which to play.

Starts with sh and ryhmes with Citi Group

There is a new drugstore test called the E.G.T. (Early Government Test). You pee on a stick. If the lines appear, you are no longer living in a free market.

Of course, it may be a temporary condition. A few months of gestation, a painful birth, and about 18 years before you are back to your old self. But I suspect it is a little more permanent.

Most takers of the test this week will find that they are no longer living in a dot com country – welcome to dot gov.

It is not difficult to track the arc of the free markets. As an engine of social change, the Industrial Revolution celebrated capitalism with a religious fervor. By the turn of the century, the fits and sputters of market had to have some monopoly busting, but by the 1920’s, American markets were the wonder of the western world.

With the pain of the Great Crash came silence from Washington. Adam Smith’s hand was nowhere in sight. In that moment of confusion, New Dealers found an audience. Government intervention and regulation was the new world order.

And so it has been. The prosperity and pain of the free markets have grappled with the prosperity and pain of the regulators for most of our American history.

The debate is not between a totally free market and a totally regulated market. Rather, like so many other things, it is a matter of degrees. I am just a little nearer to the free market side than our modern day New Dealers.

The news about Citi today brings the issue into sharp relief. After falling an appalling 60% last week to $3.77, the board of directors is said to be talking to the Treasury about creating a separate bank to hold all the bad stuff that is dragging Citi down. The new entity would of course have some sort of federal backing to share in the losses beyond a certain tolerance.

An idea? This proposed other bank should probably be called something that rhymes with Citi Group but starts with an ‘sh.’

None of it should be a surprise. The stick had lines. The dot com was dropped for a dot gov. We are in a season of extraordinary things. I know the markets need more transparency. I know areas of the market need more regulation. But is it so hard to recognize that nothing good has ever some from over reaction?