Like everybody who isn’t living under a rock, I’ve been scouring the financial news and blogosphere in complete astonishment on the financial debacle in the making. Everything I’ve read has missed what I believe are the fundamental problems that caused this mess, and thus are missing the solutions that will get us out of it (if it’s not already too late). There are two major reasons why the U.S. financial system is in the toilet and taking the rest of the world down with it, and there’s a straight-forward solution to the problem IMHO.
The REAL problems that seem to be getting overlooked:
1) Short term notes were used to finance long-term mortgages
Yes, there are foreclosures. Yes, that hurts business, but so far we’re talking about foreclosure rates going from say 4% of all homes to 6% (. The problem is that once a market was established for your mortgage’s cash flows, the mortgage industry said “Awesome! We can sign mortgages with consumers, and then package and sell the mortgage and make our profit quick instead of over the 30 years it will take for the mortgage to be paid off.”
The problem is that these mortgage co’s then took out a short-term loan themselves, then lended that money to the home-owner (you got your mortgage), and sold the expected cash-flows (i.e. your mortgage payments) in this new marketplace. When the marketplace lost confidence in the value of the assets being sold (partially due to foreclosure rates climbing, partially because of the lack of transparency), then the mortgage brokers couldn’t sell their mortgages off anymore. . . .BUT THEIR SHORT-TERM DEBT WAS STILL COMING DUE!!! They had all these assets (mortgage cash flows) on the books but the only way to get them is to sit around and collect those payments over 30 years, but they have to pay off their short-term Loan RIGHT NOW. This is the fundamental component of the credit crunch. . . Short-term debt that was financing long-term cash-flows.
2) In the face of a potential run on the bank, the bank president (i.e. Bush and Paulson) yelled “We’re headed for disaster!!!”
The Daily Show nailed this. . .Take a look at: Bush deja vu
The government was bailing some big boys out and saw that if things continue, there is going to be a need to do some institutionalized bailing out (i.e. no more one-offs, got to do these bailouts at scale). So i think it can be useful for the government to bring confidence into markets to stem the possibility of a panic, or what is called a run on the bank. There were a number of “runs on the bank” or market panics in the U.S. in the 1800’s and there eventually became an understood play book for how local bankowners should handle the occasional rumor or initial run on the bank.
I won’t go into the thick of the playbook, but the first rule, in the midst of a rumor, or run was always for the bank owner to get in front of all of their panicking customers and say,
“We’ve heard the rumors that have been circulating, they are without basis, we are a strong institution, and we know that is not proof enough for some of you, but to show this commitment to our customers and display our upstanding liquidity, we have implemented streamlined processes for people to pull their money out”
Basically, the theory behind stemming a panic is to make it incredibly clear to the most panicked, that they will get their money, and they will get it fast. They would go home with their cash in hands and tell everybody, that it was really easy to get their money, and that there’s probably nothing really to worry about. This stops most of the panics or runs on the bank in its tracks.
Furthermore, it would be UNHEARD of for the bank owner to get in front of his customers on the first day of the panic, and say
“We’re ALL SCREWED, we’re so screwed that its possible that our financial system could completely collapse”
Guess what, it is ALWAYS possible for the financial system to completely collapse. .. given an extreme lack of confidence. The key is for the leaders/bank owners to stem the problem at its root with strong messaging backed with a strong, reasonable solution.
So now we get to the solution:
We need to start over on the solution. First, I believe we can fix the fundamental short term debt issue . . . that has caused the lack of confidence in the financial institutions that has led to the “lending lock”. Second, we need to do a reset on our messaging.
The U.S. Gov’t needs to make long-term loans to financial institutions where the cash goes directly to paying off the financial institutions’ short-term debt. Financial institutions then go back to what they used to do with long-term mortgages. .. . collect the payments one at a time over 30 years, and pay their debt off over the same period of time. So what if the mortgage market is gone, the financial institutions will collect their payments (well most of the payments) from the homeowners, and pay their debt off over the same period of time. My guess is that the minute trust that these financial institutions are not going out of business any time soon, that this entire crisis starts to turn around. . .
Now there are a ton of other things that could/should be done to deal with this crisis, changes to mark-to-market, transparency regulations for these markets, constraints on short-term debt for long-term assets and a bunch of others, but the core problem is the short term debt issue, and any solution that’s going to work, must address that problem.
Here’s the Step-by-Step quick draft for Paulson:
Step 1 – Come up with a comprehensive solution on the issue of short-term debt. Size the short-term debt problem and put out a proposal that would bring confidence that the long-term problems go away. I would propose XXX or XXXX billions of dollars in long-term loans to banks and the US gov’t takes over the short-term debt. Put transparency and mark-to-market rules that let some steam out of the uncertainty and panic. Do not come up with half-measures, ad-hoc instruments that get brought out in an ad-hoc, seemingly reactive way. Bring a real solution, and a real roadmap, a real plan.
Step 2 – Bring in a dream team of professionals to implement the plan. Assign a long-term “CEO” of the initiative, and make the oversight committee a group of dedicated, non-partisan professionals, instead of a figure-head congressional committee that meets once every few months.
Step 3 – Start Over on messaging. Be the stand-up “bankowner” and be a real leader. Apologize for mistakes, present the plan to the American people (show us some charts–Ross Perot style). Establish a set of values that are guiding the efforts, calm the fears, and start over with a better solution, and the confidence of the American people, and the international community.
What do you all think??