Dedicated to the writings of Saint Luke.

Saturday, September 27, 2008

A Manufactured Crisis

The bailout is a bad idea. When a solution is proposed that gives dictatorial power without accountability to a Bush appointee near the end of his ignominious presidential reign, it becomes obvious that Bush would like to rule from the dead. The liquidity crisis has been caused by the promise of a government bailout. This crisis is now being cited as the reason why the bailout is necessary. Yet the idea is doomed to failure because it does not address the fundamental problem.

The subprime mortgage debt is the fundamental problem. It was created by Wall Street. Until we recognize that the Wall Street created debt instruments are toxic, no proposal that does not detoxify these instruments will succeed. These instruments have no value because there is no market for them. The bailout solution is to purchase all of these toxic instruments thus creating value. The reality is that because only the government will purchase these toxic instruments, the purchase by the government does not change the fundamental reality that no one else will purchase them.

The very provisions initially designed to provide security and safety for investors made the instruments toxic and worthless when Wall Street included a few subprime mortgages and continued to create more packages each one of which included a few more subprime mortgages. It would seem to be a simple solution to separate the subprimes from the non-subprimes to create a market for these instruments. This can not be done because the trust instruments contain clauses that effectively preclude any modification of the package. These “thou shalt not modify” provisions contained in all of the packages is problem one.

Strangely there has been no public discussion of this problem. The first step is to provide legislative and judicial authority to un-bundle these packages. Furthermore, no relief should be provided to any entity holding a toxic package unless the entity and the trustees of the instruments agree to allow the package to be unbundled. Once these packages have been dis-assembled, there will be a ready market for a large portion of these mortgages. This one change will substantially reduce the cost of the bailout.

We need to provide relief for the homeowners who are under water because their outstanding mortgage balances exceeds the fair market value of their residences. The bankruptcy courts traditionally have had the power to modify mortgages. The bankruptcy reforms acts have removed this power from the courts with respect to residential mortgages only.

Wall Street would like us to modify their debt but not modify the debt of the homeowners whose residential mortgages were used to create the toxic instruments Wall Street peddled. As the bankruptcy bar has noted, a slight modification of these mortgages would provide the economic incentives for homeowners not to walk away from their properties. This modification would reduce their mortgage indebtedness to the amount equal to the fair market value of the residence and would stabilize the housing market.

All economic studies have shown that the way out of a debt crisis is forgive some of the indebtedness. In our greed, we have forgotten Economics 101 and more importantly, we have forgotten that the prayer we used to say that included these words: “forgive us our debts, as we forgive our debtors.”

Copyrighted 2008


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