How to Prevent a Second Great Depression

Editor's note: Jim Cramer will present his 2009 stock outlook for the first time at TheStreet.com Investment Conference on Saturday, Oct. 25. Click for details.

In this horribly negative, whatever-can-go-wrong-will-go-wrong era, it is only natural to presume that the $700 billion Troubled Asset Relief Program legislation will do nothing.

But on the off chance anyone is listening, I think there's a way to make the legislation do something (even though I don't think it will send the stock market higher).

I think it could: 1.) Limit the Dow to a fall to 8,400, rather than one to 5,000, and 2.) Keep the coming depression -- no, it won't be a mere recession -- shorter than the Great Depression.

With that low bar in mind, let me tell you what I would do if I were coordinating the package at Treasury -- and I would take that job in a heartbeat. Here's the order of things:

• Call in Sheila Bair, the now rogue confiscator at the Federal Deposit Insurance Corp., and say, "After you seize Downey Financial (DSL - commentary - Cramer's Take) and BankUnited Financial (BKUNA - commentary - Cramer's Take), the last of the option ARMs lenders, you are done. You will publicly state that there will be no more seizures." The rest will be worked out with TARP. That will allow money to flow back into bank preferreds and bring capital into the market for banks, which is the real issue here. With the $250,000 deposit insurance and the purchase of whole loans there's no more reason to seize anything. The only question mark is Citigroup (C - commentary - Cramer's Take), which did not do an equity offering. If it doesn't get Wachovia (WB - commentary - Cramer's Take) it could still be in huge trouble because it is in the Lehman "too big to fail but let it fail anyway" category until declared otherwise as part of the overall non-seizure ban.
• Buy whole loans first. It's true that there is lots of bad mortgage paper out there, and much of it will be hard to locate and buy. The exception is whole loans, like the loans on the books at Wachovia and Washington Mutual. When the government gets a whole loan it can immediately end the foreclosure proceeding and begin the workout on the loan. It is possible that there is more than $100 billion worth of whole loans on the books that can be purchased quickly, taken out of the foreclosure pool and removed from the books of the banks so they can lend. This would be especially important for the Wells Fargo (WFC - commentary - Cramer's Take)/Wachovia link up and Bank of America (BAC - commentary - Cramer's Take)/Countrywide/Merrill (MER - commentary - Cramer's Take). We get those two back on their feet along with JPMorgan Chase (JPM - commentary - Cramer's Take) and we have markets. Taking whole loans from National City (NCC - commentary - Cramer's Take) and the like in the Midwest will allow Goldman Sachs (GS - commentary - Cramer's Take) and Morgan Stanley (MS - commentary - Cramer's Take) to get deposits cheaply.
• Buy CDOs next. These are very complicated because the government can't buy a whole trust. It can buy only pieces of it from banks and hedge funds and pensions and whoever else owns it -- nobody volunteers that they own this junk, but they do. A scale will have to be set up -- it can be set up -- that will describe what needs to be purchased. This typically will be done by year, as you can't do geography -- too diverse -- or even credit, because of the flow-through nature of the darned things. You can't just say, "We want the AAA portion that is still paying off, usually at about 60%," because that will leave nothing for the mezzanine tranche. So they have to be purchased whole. The trick here is simply to establish a market, because right now there is tons of sideline money that wants in but can't get in because this stuff can't be used as collateral; it can't be used in repos (repurchase agreements). That means no one can borrow money to buy the stuff. Everything is done with cash and it is too risky. Once we get a market, then we will see the private sector come in to buy the stuff and the brokers will lend against it.
• Lastly, we need to see home equity loans be bought, even if it is for pennies, because that stuff has to come off the books somehow. This stuff will be very bad as it will require huge hits to capital, which is where the equity stakes come in as most of it is worthless.

You can see how, with some hurry, we could: 1.) Stabilize foreclosure through whole loans and 2.) Free up capital to lend, with the CDOs stored.

None of this is ideal, but it sure beats doing something piecemeal, which is the only other suggestion I have seen out there.

The plan is not a bad one if you run the numbers. There are $3 trillion of floating-rate mortgages made from 2005 to the first quarter of 2007. Those are the troubled vintages. Much of this was securitized. (However, a lot is with Fannie Mae (FNM - commentary - Cramer's Take), which is whole loan; that's good news because it can be worked out relatively quickly.) If you presume that 33% of the floating-rate loans will go bad -- we're not seeing anything near that percentage now, but it could easily reach that level with an 8% unemployment rate -- you will have taken out the bad loans with $700 million. So the number is not a thin air number. Right now JPMorgan Chase is using a 20% foreclosure rate for some of the worst option ARMs, so you are still using a very big safety factor.

One of the things that is missing in all of the coverage is that there is a way to figure out the prices historically, and it will be done relatively quickly despite protestations to the contrary by Congress and the media.

So that's how I would work the plan for quick action. Given the knowledge and data, I think it would take no more than six months if done effectively.

That's not fast enough to free up capital, and it leaves some very big bankruptcies out there, including any company that can't roll over its commercial paper.

But keep in mind I am not thinking the plan makes stocks a buy. I am only thinking that we can take the Second Great Depression off the table. It's a low bar, but it's a realistic one.

At the time of publication, Cramer was long GS, JPM and MS.

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