Credit Stabilization

I try not to write often on the condition of the global markets as it is rather off topic for this blog. Of course, being a student of the markets for decades, I do have opinions and ideas that sometimes need to be shared.

Friday saw our first true bank run since the depression. It appears to be essentially averted and stabilized. More importantly, the institution will not liquidate. In the depression, institutions failed and this destruction of infrastructure aborted an early recovery.

Several years ago when a number of new debt instruments came into vogue, I was very disturbed. I know that there is no set of rules and ironclad guidelines able to resist a rising market and the enthusiastic participants. And so we have the sub prime collapse and other related inventories of debt instruments reeling into the market.

What few folks realize is that mortgage contracts are long term contracts between the borrower and the lender. They simply cannot be either unwound or liquidated on a whim or for that matter dire necessity. They are also very difficult to resell.

Over the past several years, a vast amount of fresh debt was promoted and created that with falling property prices are under water already, with worse to come. The good news is that this type of dodgey lending has ended. The bad news is that the bulk of the outstanding inventory needs to be refinanced as good paper. This is not going to happen with current lending rules and products.

However, if we fail to in fact refinance this idiotic disaster, we will have an unavoidable shrinkage in the money supply, to say nothing of a restructuring of equity. It will be a real depression. That is why the fed is jumping through hoops these days trying to keep the system turning over. Almost certainly, the velocity of the money supply is declining.

The one sector that will and is having a massive effect on the citizenry is the housing market. It is already a disaster and can slide into free fall. I can suggest a fix or at least a patch that could restore confidence and speed the turn around.

That is to unilaterally mark maturing mortgages to market and impose a new contract structured as follows:

A 75% to current value forty year mortgage provided the borrower qualifies (it gets real easy with dropping prices).

A swap of the remaining old loan principal in exchange for a fifty percent participation in the equity of the house over the current mortgage value established for lending.

Lenders have been statute barred from equity participation in such housing equity. Unfortunately, their own folly has made them the only buyers for the time been. So we must make a temporary fix.

The benefits are obvious. The borrower has a mortgage that is feasible in the current lending environment based on the present value of the property. His credit is also healed or soon will be. Disruption is largely avoided.

The lender swaps a current write down against capital for a fifty percent equity interest that could and should at a later date recover part or all the loss. What the lender loses is the cash that they were not going to get anyway, while restoring a customer to good standing.

The lenders will still have to recapitalize to make up the inevitable shortfall, but they will be able to do this in a stable environment in which everyone knows the rules. And millions of Americans will have a new lease on life.

Of course, some will argue that the reckless are been rewarded in some manner. That will not be true, but that is still preferable to a massive reduction in pension payouts. A true lasting depression will reduce and stifle everyone. On the current road, millions of Americans are having their credit wiped out for years. That is not healthy for the economy, particularly when the root of their failure lies in the recklessness of the lenders.

Example:

1 Original $400,000 property carrying a current principal mortgage of $375,000

2 Current market value of $240,000

3 75% mortgage granted at $180,000

4 $195,000 losses exchanged for a fifty percent equity stake in the property over the $180,000 level.

Thus by paying off the mortgage the borrower rebuilds his own equity and becomes a solid partner of the lender. At some point the borrower should be strong enough to buy out the lender at current market value.

The real point of this exercise is that the borrower now has no reason to abandon the property and the lender has no reason to add the property to a disastrous housing market. This stabilizes the situation and makes it very attractive for new buyers to enter the housing market since inventory will quickly dry up at current depressed prices.