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How to Stop the Credit Crunch and save the Financial System

The Weekly Report

Welcome to the Weekly Report. This week we look at the withdrawal of the US from the capitalist system and why my Moral Hazard Outrage Indicator has melted into a lump of molten plastic.

More importantly The Collection Agency comes up with a viable plan on how we stop the credit crunch, depression and the end of the Western World.

Notice the time is outside market hours

Whilst the US Fed and Treasury go begging to Congress for funds to bailout nearly everything except the 99% of the US population that is not in the top 1% of the wealth bracket we are told that the cost of not doing this might be higher than doing it, for the taxpayer that is.

In other words you, the taxpayer are going to pay for the mistakes, the pitiful delusions of those that thought they could overrule markets by thinking "innovative". It's obscene and worse it does not address the problem.

The problem remains because Paulson et al do not understand what has happened, how the system has been so abused that it no longer functions. Ben Bernanke knows why, he studied in depth what caused the last failure of the Keynesian dream. His attempts to bypass the inevitable outcome were summed up by this writer in a series called the Eggertsson Theory, available for free at An Occasional Letter. However the Monetarist approach adopted by the Fed is struggling to survive as a viable option as the whole financial system does what any Ponzi scheme does and collapses in on itself.

The latest plan is for a Government "Bad Bank" to be set up, funded by Treasury Debt converted to cash by the Fed and used to "buy" (without a pricing mechanism?) poorly performing or defaulted privately invented securitised assets. It is being touted as the cleansing of the financial world to achieve nothing more that the ability to re-create the same conditions that existed over the past 80 years. Again this is no surprise to this writer, I suggested some time ago that the moves made to shore up Fannie and Freddie would not mean the survival of these GSE's and that it was more likely that a new Institution would appear. All that Paulson has done is to revive the M-LEC idea, a Government held and controlled Super SIV, moving the debt of Banks and Nationalised Assets to an off balance investment vehicle. Although some in Congress are warning about the possible long term risks and damage such a scheme could cause, I expect Congress to do what it has always done after its members see the damage done to their own investment portfolios.

What happens to these asset back instruments once they have been placed under the control of the State Politburo, sorry, government is unclear. Is the debt forgiven, is it traded out in the future during the next boom and scramble for investment returns or is it encased in glass and dropped into the deepest part of the Atlantic to lay forgotten?

No wonder my Moral Hazard Outrage Indicator melted. The taxpayer sees an increase in debt that makes anything ever done by the US in the name of financial stability look like small change. This will cost over a Trillion dollars (where have we heard that figure before?) to bailout a failed Financial System. This has nothing to do with "keeping house prices high" it has no benefit for those already in or entering the process of default.

Let us be blunt, if you make money by ignoring risk and applying ridiculous modelling to financial assets you should suffer the losses too. For those who decry such a stance, saying that it would cause the financial system to implode, face facts - the system doesn't work.

If you allow the unfettered use of credit and leverage then without exception the unwinding will be catastrophic. Joe Public doesn't care anymore, his access to new credit has become restricted to non-existent and he is already suffering the fallout of this stupidity. We allowed the use of credit to build the economy which allowed failed business models to continue to function long after their natural life expectancy.

Still it hasn't stopped Paulson in his attempts to move beyond the law and spread the idea to the rest of the world:

  • Sept. 21 (Bloomberg) -- Treasury Secretary Henry Paulson said he's confident several countries will take steps comparable to the $700 billion plan he proposed to buy bad mortgage-related securities to address the global financial crisis.

  • "We are talking very aggressively with other countries around the world and encouraging them to do similar things, and I believe a number of them will," Paulson said on ABC News' "This Week" program.

And this:

  • By Alison Fitzgerald and John Brinsley

    Sept. 21 (Bloomberg) -- The Bush administration sought unchecked power from Congress to buy $700 billion in bad mortgage investments from financial companies in what would be an unprecedented government intrusion into the markets.

    Through his plan, Treasury Secretary Henry Paulson aims to avert a credit freeze that would bring the financial system and the world's largest economy to a standstill. The bill would prevent courts from reviewing actions taken under its authority.

    "He's asking for a huge amount of power," said Nouriel Roubini, an economist at New York University. "He's saying, `Trust me, I'm going to do it right if you give me absolute control.' This is not a monarchy."

    As congressional aides and officials scrutinized the proposal, the Treasury late yesterday clarified the types of assets it would purchase. Paulson would have authority to buy home loans, mortgage-backed securities, commercial mortgage- related assets and, after consultation with the Federal Reserve chairman, "other assets, as deemed necessary to effectively stabilize financial markets," the Treasury said in a statement.

    The Treasury would also have discretion, after discussions with the Fed, to make non-U.S. financial institutions eligible under the program.

These assets are toxic for a very good reason. Too much money was looking for a return and that allowed lending to happen at very lax standards. Then some bunch of merchant bankers decided whilst munching through a Chinese takeaway to bundle the debt into packages and sell it on, freeing up the capital to allow the process to continue. All that risk was introduced into the financial system without a single $ to back it up. If you wanted to insure yourself against loss you agreed a Credit Default Swap with a third party. They wrote the insurance for a fee and you got your cover. Unfortunately as we have seen with AIG and others, they didn't have the money to pay out when a triggering event happened, the insurance was worthless.

Now we have Paulson touting another insurance scam, where the Taxpayer has to allow a devaluation of the dollar without an increase in spending power. Worse still the Taxpayer now has to watch as the Treasury and the Fed securitize the debt and give cash to the very Institutions that caused this to happen, for the second time in less that 80 years! Does anyone not see what happens next? The new cash is used to start the same process all over again. This no cure, this is no bailout. This is a continuation of the same broken, corrupt and unworkable system that has been used since the inception of the Fed.

Its time for the system to change. The pain is already coming as the availability of credit for business and consumers comes to a halt. This new cash isn't going to help them, it'll just be directed to the next "big thing". So what can be done to alleviate the problems and set up a new way of running and living in an economy?

Firstly the new cash must not be given to the Institutions; they will only blow it again causing an even bigger mess. By all means take the liability away from the Institutions and transfer it to the Taxpayer, let the Institutions clear the books and purge the debt. Then place them in a regulatory hell which refuses them access to leverage or the ability to create money without very large reserves. They will think much more carefully about where to invest if their assets are rarer. The word "risk" will be the first thing anyone mentions when an investment plan is put forward. Limit their take on returns to a maximum of 4% a year, anything over this has to go back into the "Bad Bank" SIV without any relaxation of regulation. Place oversight into the back offices so that the Institutions cannot limit their gains to 4%. Increase the levels of taxation upon profits. In effect make the flash world of finance revert to the dull world of traditional banking.

Secondly, the new cash should be directly used to lessen the debt burden of the Taxpayer. Either the mortgages or loans should be reduced by a one off payment and/or the amount of interest paid should be subsidised. This has the bonus that a reduction in the amount owed allows a re-pricing of the debt within the Bad Bank SIV to a realistic level, it also allows a lower income stream to be feasible in servicing the toxic debt. As the new owners of the debt the Treasury can set the expected level of return, in effect quoting its own mortgage rate.

By reducing the amount owed and the interest paid the housing market can settle into a realistic pricing mechanism which will result in lower, achievable prices that can be attained by new buyers without resorting to financial innovation (lying and cheating about income). Those in possession of mortgages can see a worthwhile reason to continue servicing a lower debt burden, slowing and stopping the defaults and keeping the asset backed bundled debt viable.

This is not price inflationary for consumer goods. We already know consumers are tapped out and unable to purchase staple goods, let alone luxuries. The freeing up of a part of the previously non-disposable income to the disposal side of the accounts will not cause a buying frenzy, without access to free and cheap credit the consumer will have to save to buy goods.

Finally, we never allow the current form of economics to rule over the financial system and the people ever again. Get Congress to ban it.

The punishment will be served upon the Institutions who rightly deserve it; the relief will come to the Taxpayer that bailed them out.


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