OK, the bailout plan went down in flames.

Let me get one big misconception out of the way: the proposed bailout would NOT have allowed people to live in their houses and pay no mortgage payments. (I heard that gem in Ri Ra) It was NOT the people who were being bailed out.

As I explained in my blog post on Friday, the plan dealt with bailing out banks, mostly New York and foreign banks with branches in the US that had the poor judgment to buy mortgage derivates. These banks bought lots of this stuff, but their smart MBA trainees could have told them that:

1) Housing prices in certain parts of the US cannot go up at 15%-25% a year without retreating someday, leaving people with a house worth much less than their mortgage

2) If you give people 100% mortgages with no credit check, many of those mortgages will fail

So, how many of those Trillion dollars of derivatives are bad?

Absolutely no one has any idea.

Our Portland mortgage is probably in a derivative package because we refinanced in 2004, and since we have never missed a payment, it may be classified as good; the so-so mortgage in the package is thus called because several payments have been late, but does the existence of a weak or failed mortgage with a good and a so-so mortgage make this derivative without value? Hardly.

Banks hold these derivatives as assets and collateral against which to borrow and then lend massive amounts of money. Seemingly to down play the credit crisis, the Press Herald ran an article Saturday proclaiming that people still were getting car loans; the credit crisis is not YET about car loans (but WILL be if not contained).

The crisis right NOW is about massive loans called commercial paper and lines of credit that make the American economy function.

Last week, Maine DOT was unable to auction $50 million in transportation bonds because no one was lending that much at a normal rate. Maine was offered 9% on the bonds instead of the normal 3.9%. There is talk on the web about large corporations that cannot buy supplies and make their payrolls because many depend on short term loans to tide them when they have cash flow problems such as when customers pay slowly.

Derivatives are structures meant to reduce risk. If the "bad" mortgage in the package fails, the so-so and good mortgages would still give the derivative value. The banks bought derivatives knowing THIS risk. Thus, the banks should NOT be rewarded for their folly for failing to see the weakness of the housing market. Banks should act like any other player in the stock market, and, since they cannot sell these derivatives, the banks should hold this paper to maturity.

The true crisis in the economy is liquidity -- the banks holding the derivatives cannot use the derivatives as assets and collateral to make the economy run.

Secretary Paulson originally framed the liquidity crisis by proposing a buyout of the derivatives, and the Congress walked in lockstep with that concept. The result was a public uprising on both the right and the left.

Congress needs to do what it failed to do over the last 10 days; it needs to consult the top economics in the US and the World -- no economists were consulted as of Sunday -- and Congress needs to THINK OUTSIDE THE BOX.

LIQUIDITY CAN BE RETURNED TO THE MARKET WITHOUT

BUYING THESE VOODOO INSTRUMENTS AND WITHOUT

THE GOVERNMENT REWARDING THE BANKS' INVESTORS

My solution: the Federal government should authorize the Federal Reserve Bank to LEND up to $700 billion to banks IN THE US holding these derivatives at an interest rate that is slightly higher than the normal rate. Banks would be required to use the mortgage derivatives as collateral for this loan. They would have to hold these derivatives to maturity or replace them with an asset of equal value.

This simple action is guaranteed to instantly return much of the needed liquidity to the US market with no complicated Federal ownership of mortgages, banks, etc. There would be no smell of socialism.

Finally, two things:

1) The Federal government needs to return to the problem of the sub-prime crisis by dealing with people who bought houses to LIVE IN and freeze their resetting Adjustable Rate Mortgages (ARMs) for 12 months. This will allow the homeowners the time to change to a traditional 30 year mortgage. The Feds should not rescue people who bought houses, condos, etc. to flip.

2) The stock market must be re-regulated. Banning naked short selling in any stock is absolutely essential; continuing the current ban on all short selling of the basket of financial institutions and troubled institutions is also essential.

3) The mortgage market must be re-regulated. The transparency of financial statements that resulted from the enforcement of Sarbanes-Oxley must be extended to complicated financial instruments such as derivatives and the more than $45 trillion of credit default swaps.

Peter B. Hayward

Copyright © 2008 Peter B. Hayward. All Rights Reserved

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