Real Estate
How to fix a "Credibility Crisis"
By Dan Smith

How to Fix a “Credibility Crisis”

Last month I promised to provide you with my thoughts on fixing the current economic mess we are in. Hopefully, what stood out was that the root cause of this entire mess is widespread fraud, on a level never before seen in U.S. history. There is a 92-year-old woman named Anna Schwartz who lives in New York who provided important insight on this issue recently. Her view is telling not because she is old enough to remember the Great Depression, but because she has worked for the National Bureau of Economic Research since 1941 and co-authored A Monetary History of the United States with Milton Friedman. In a recent interview with the Wall Street Journal, she correctly identified (in my opinion) the issue as follows:

The reason credit markets are frozen and banks won’t lend to each other is “ ... not due to a lack of money available to lend, but to a lack of faith in the ability of the borrower (other bank) to repay the debt. The Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that (uncertainty) that the balance sheets of the financial firms are credible.”

This “Credibility Crisis” stems from two main sources of fraud. The first leg of credibility was broken by the fraudulent bond ratings provided (for enormous fees) by all of the major ratings companies (Standard & Poors, Moody’s and Fitch), which among other things have ruined jumbo mortgage rates for nearly two years now.  However, for our economy as a whole it has been even more devastating. Foreign investors, for instance, can’t trust any of these ratings now that they have been burned on such a large scale. Corporate paper (bonds) can’t find necessary funding either because the only ratings available come from these same crooks. The second broken leg came about as a result of the astronomical insurance fraud perpetrated by the use of un-capitalized, or grossly under-capitalized credit default swaps. Further, the leading reason good banks can’t believe the balance sheets of other banks is because many (if not most) of the “bad” banks hold these toxic credit swaps in off-shore holding companies, created for the sole purpose of preventing their disclosure on the company’s balance sheet. Hence, the frozen global credit markets, which are bringing down foreign economies around the world as I write.

In my opinion, the collective governmental effort worldwide has been putting the cart before the horse. The powers-that-be assume that they can throw billions of dollars at the problem as if it were a simple liquidity crisis and deal with the crooks later. But with hundreds of billions spent already, there has been no real improvement. Henry Paulson can tell us all that it would have been much worse by now without these historic bailout giveaways. However, it doesn’t take a rocket scientist to see that simply isn’t true. And it is going to get much worse.

The fix likewise doesn’t take a physicist to understand.

1.                  One of the very first things we need to do is require every company operating in the U.S. to be completely transparent in its financial reporting. Emergency legislation should be passed as soon as possible that forbids non-disclosure of liabilities and/or assets by use of this off-shore loophole, for instance. Accurate balance sheets under these new accounting requirements should be published within 30 days of passage. Only in this way will lenders collectively be able to know exactly what they are dealing with and be able to make prudent lending decisions. Mark my words, money in the credit markets will remain primarily frozen until that day comes. Some will argue that you can’t adequately value these toxic credit swaps because they have no market, then require they mark them to $0 and see where that leaves them. In essence, many of these bad players will be forced to enter into bankruptcy instantly. In this way, their assets can be liquidated in an orderly fashion, they can reorganize, or they can negotiate mergers with sound financial institutions at market terms.

2.                  We need to see arrests made and these crooks sent to jail—now. There are two reasons for this. First, until all investors can see that the U.S. has “cleaned house” at these rating companies, there is no reason for anyone to believe the ratings system at all. Second, until the general population can see these phony credit swap dealers led off to jail, there will be no perception of a conclusion to this mess. This is a key because the perception of the general population is paramount to any economic recovery. No one will “feel” like spending again until they “feel” like this is all (or for the most part) behind us. Then, of course, there is the fact that it is just the right thing to do. If we wait much longer, the statute of limitation will run out on many of these crimes, and people like Angelo Mozillo will never pay for their crimes.

3.                  With regard to bankruptcy and reorganization, there are normally lenders available that lend money to companies who have filed for chapter 11 reorganization. They are called “debtor in possession” (DIP) financers because they have senior rights to the assets of the bankrupt company, to insure that they get repaid. With the credit markets frozen, here is where the U.S. government can act in a responsible manner—as a DIP financier. However, this should only occur in the event a private party DIP financier isn’t forthcoming. For instance, the only practical way for GM to survive is to reorganize in a chapter 11 setting. Giving them a $25 billion check will only delay the inevitable bankruptcy filing by six to 12 months. But how does this fix credibility, you ask? Well, right now the financial world has no idea what the U.S. is really doing with any of this bailout money. Do you? Why let Lehman go but double down on AIG? Of course, like you, I have heard the argument that some of these institutions are just too large to let fail. But did any one of you notice anything different happen after Lehman filed the largest ($639 billion) bankruptcy in U.S. history? I didn’t think so. So if the U.S. treated all companies equally and allowed bad companies to fail and/or reorganize in this logical, historically proven fashion, the markets would at least understand the policy. Not to mention, it would save us, the tax payer, a tremendous amount in the long run (see below).

4.                  Housing is estimated to directly economically affect one out of three U.S. citizens. Getting the housing market righted is certainly a priority. Several large banks like Citi and Chase have already placed a moratorium on foreclosures and are pursuing renegotiations with their book of sub-prime borrowers. In essence, they have come to the realization on their own (or with government encouragement, ala the recent FDIC proposal) that they will pare their ultimate losses in this fashion. That’s all good and fine. But what we need immediately is for Fannie Mae and Freddie Mac to raise their loan limits for the next two years to $1 million. Even if we locked up all the crooks at the bond rating companies tomorrow, it wouldn’t heal the damage done to trust in our system overnight. Meanwhile, there is an overwhelming pent-up demand in the jumbo housing market to move and refinance. It is just too bad that current political thought seems to believe that punishing the “investment class” of the population has merit in solving the current meltdown. This isn’t new either. During the Great Depression, the marginal tax rate for those in the top tax bracket was raised from 25 to 94 percent. Not only did it prolong the Depression, it added to job losses. It turns out that wealthy people just move and take their money with them. You see, the economy doesn’t turn around when Joe the bus driver has an extra five dollars so he can upgrade his choice of beer. Instead, the real recovery comes when Skip the multi-millionaire decides to build a new factory. Who would have thought?

5.                  Finally, I think part of the solution will require an international court of arbitration to settle claims resulting from the unwinding of these phony credit swaps. This is likely a $20 to $30 trillion problem that the average court will be ill equipped to deal with on a piece meal basis. If it took physicists to create the math underlying these instruments, then the average U.S. district judge doesn’t stand a chance of rendering a competent verdict. Ultimately, and where possible, those institutions that unknowingly were duped into buying these fake insurance policies should have some remedy available. I would also love to see something like “crimes against humanity” trials conducted by the International Criminal Court in the Hague. These individuals who participated in these phony credit swap schemes will have wrecked many foreign economies by the end of this. They will have caused outright starvation levels to jump accordingly. Osama bin Laden could never have caused this kind of destruction in his wildest dreams. Call it “economic terrorism” and send them to real prisons in Eastern Bloc countries—not some golf camp like they do here in the U.S.

So, in conclusion, we essentially have two choices before us and both will be extremely painful. I apologize if you had hoped for an anesthetic before surgery. The difference is only how fast we get this over with and return to a normally functioning economy. Unfortunately, the politicians appear to be taking the second option at this point. By throwing money at the problem (and in a haphazard, ad hoc manner to boot), they are merely prolonging the ultimate solution that the market will always provide. The economic devastation of going through with this second option won’t just be that we stay in a dramatic recession much longer than necessary. There is a very real potential for the outright collapse of our currency.  And if you want to see what a New Great Depression is really like, then try the combination of a broken economy with a worthless currency.