Market Commentary: September 30, 2008

Dr. Barton Smith from the University of Houston’s Regional Forecasting department is well known for his local and Texas economic symposiums.

Dr. Smith is one of my personal favorites and I feel his commentary below is a good read given the status of the banking industry and the possible implications to you and I on a daily basis.

DIRECTOR’S COMMENTARY - September 29, 2008

Solutions to The Banking Crisis

The world’s financial markets were stunned on Monday when the U.S. House of Representatives voted down the Paulson/Bernanke bailout plan for American banks and financial institutions.

However, this vote was not quite as unexpected as some claim.

The problem was that the deal was sold as a “Wall Street” bailout plan and in fact did seem geared towards bailing out those that got us into this mess in the first place.

If we are going to find a way to resolve the current crisis, it is not the maverick Republicans and Democrats in the House that will have to be convinced, but the American public who urged them to vote “No”.

What the public doesn’t understand is that absent a solution to this crises, they will ultimately find themselves suffering pain not seen since the Great Depression. What the leaders of Congress must come up with is a bailout program for the public at large and sell it as such, a program that properly punishes the guilty, while restoring health to the economy.

Here’s what I suggest. First we need to abandon all rules and pressures for banks to evaluate assets at mark-to-market fair value for the purpose of establishing capitalization requirements.

Instead, banks should be required to evaluate illiquid assets as an estimate of their present discounted value to maturity after accounting for realistic expected default losses that are defensible and transparent and fully open to quarterly regulator review that could require revisions.

This would reduce to some degree the size of the “bailout” and remove the irrational practice of forcing institutions to evaluate assets that have become illiquid in a panic at the lowest of fire sale prices.

The new accounting rules that went into effect in 2007 are, indeed, a part of the current problem, virtually guaranteeing that any small slide turns into a full scale avalanche. Panic prices have never been a good measure of “value”, yet that’s what we’re requiring banks to use in evaluating their assets.

Based on the expected present discounted evaluation of assets, banks should then be required to provide additional capitalization if they fall short by borrowing or by selling stock in the market place.

Because this might be quite difficult in the current environment, the Federal Government should commit to act as a “buyer of last resort” of any new stock issuance sufficient to provide them adequate capitalization.

This would punish the executives and owners of banks stocks by diluting their ownership and at the same time would give the American tax payer a stake in the bailout. In doing this, the federal government could create a government owned holding company that would own the stocks and participate in bank governance.

The stock purchases would come with a buy-back guarantee that would allow the banks to buy back all or some of the stock in the future as they get their financial house in order at a price equal to the government purchase price plus 10% annual interest.

As a stak eholder in the bank, the Federal Government would be allowed to vote on many of the banks’ operational decisions, such as executive compensations and payment of dividends. The federal government could also vote along with other stock holders to liquidate portions of the bank’s operations or assets if that were in the best interests of the stock holders, many of whom would be taxpayers..

While the markets begin to calm, the new Congress and the administration should immediately get to work to establish reasonable, but not excessive, rules for lending that make the quality of loans and their repackaging transparent and all asset packages easy to evaluate.

Out of control leverage of all financial assets should be restricted. The plethora of quasi banks under whatever name need to be brought under a common umbrella of regulation.

In addition, because of the enormous amount of debt that the Treasury will have to issue over the next 12 to 24 months, I propose that the FED make a rather bold one time move by increasing the reserve requirements for all banks within the FED’s control while simultaneously providing ample liquidity in the banking system to mitigate its consequences.

In other words, the FED would bring in treasury debt off the market (through open market operations) for the purpose of increasing bank reserves. Such a move would be money supply and interest rate neutral.

It would just increase the FED’s share of treasury debt ownership, thus taking some pressure off international financial markets that are currently awash in dollar denominated debt. This wouldn’t constrain the FED to keep monetary policy constant. They would be free to reduce the Federal Funds rate further if necessary and if they felt they could do so without inflationary consequences.

Policy reform shouldn’t hold financial institutions accountable without also holding home buyers accountable for their actions as well. Too many households got caught up in the greedy game of double digit home price appreciation with little down and credentials that weren’t credible.

Blanket bailouts of these individuals should also be avoided. To bailout irresponsible and often dishonest buyers rewards them at the expense of the millions of Americans who didn’t participate in shady games of home investment leverage that weren’t much different than the wheeler dealer behavior observed in the financial markets.

Government backed refinancing for those who qualify should be accelerated. Congress could consider allowing the refinance of loans where contributions of interest and principle are based upon current market values with an end of mortgage balloon covering the remaining principle from the original mortgage. The borrowers would be qualified using traditional HUD criteria, and the mortgages would be insured with standard FHA mortgage insurance and place back into the pool of mortgages held by the private sector with the help of a reconstituted Fannie Mae and Freddie Mac.

Households that could not qualify for such a loan under such favorable conditions would simply be required to vacate their home and relinquish their ownership rights, but because of the uniqueness of this market crash would be fully freed from any remaining housing debt obligations.

Furthermore, these households would be given the option of purchasing, without stigma, another house which they could afford (qualify for) by applying all down payment and closing costs made on the first home.

The new loan would also be insured by the federal government. Thus, the government would not be giving the borrower any major windfall gain which in typical plans rewards the foolish at the sacrifice of the prudent, yet would recognize the usual circumstances in which many American families got lured into ho using consumption beyond their means.

Those Americans who encouraged their Congressman to vote against the bailout plan had a legitimate complaint about the uneven treatment associated with the proposed Paulson bailout plan.

Some find the word “bailout” itself repugnant. I have no argument with them. But, they must also understand that a focus on who’s to blame for the current mess we find ourselves in will prove to be unproductive because the blame is far more wide spread than most would care to admit and because failing to focus on the future could leave all Americans in a most precarious position.

This generation grew up to believe that a Great Depression would never happen again. Our stubbornness in refusing to work together now to resolve the current crisis could put that myth to bed quickly.

Dr. Barton Smith

Director, Institute for Regional Forecasting