This blog post originally appeared on RealMoney Silver on Jan. 23 at 8:48 a.m. EST.
cut its funds and discount rates by 75 basis points, the largest fed funds cut since October 1984 (when Volcker's Fed bailed out Continental Bank) and the largest discount rate cut since December 1991 (when Greenspan's Fed feared the failure of Citibank).
While the Fed's actions will have a salutary impact on the U.S. banking industry's net interest margins, throwing cheap money into the markets will do nothing to address a dysfunctional credit market and the dangerous systemic risks associated with the monoline insurance industry. Nor will dead-at-birth home mortgage market fiscal policy relief (the Paulson plan) and cheap money provide any meaningful short-term relief to the current housing depression -- or to the foreclosed or delinquent mortgages providing much of the current pain.
Policy aimed at providing solutions to the deep-rooted problems of credit and housing must almost, by definition, be more imaginative -- something that, to date, a timid and tardy Federal Reserve and Executive Branch seems unable to grasp. This is particularly true given the already levered state of our maturing economy, in general, and consumers, in particular.
Based on the market's response on Tuesday and the continued weakness in futures this morning, it should be clear that the investment community remains hungry for a solution to the following:
- the imminent business downturn;
- the excessive inventory of unsold homes that has presaged the consumer-led recession; and
- the resolution of the counterparty payment obligations, stemming from the proliferation of structured investment products.
Historically, investors are experienced in economic/profit recessions and their impact on equities in terms of timing, magnitude and duration. Investors' experience with credit dislocations, however, is less clear, and it is the associated counterparty risk fears that seem to be the proximate cause for the pronounced weakness in world equities markets on Friday and Monday.
Solving the Monoline Insurance Crisis
The source of the financial system's Achilles' heel lies in the monoline insurance companies.
The bond insurers,
( ABK), were originally formed to insure bond defaults of municipalities. Though there would be a cost to that insurance, the municipalities saved more in interest expenses than the insurance cost as the insurance that MBIA and Ambac provided those municipal bonds with held the same AAA credit rating of the insurers.
So far so good.
But the bond insurers, intoxicated by the profitability of other instruments, "diversified" away from municipal bonds in the late 1990s into the real estate markets. Unfortunately, at the same time, mortgage originators began to make too many loans to homeowners and commercial owners who could not afford to pay in all but the most optimistic interest rate, economic and real estate assumptions.
And too many of those ill-fated loans were packaged into structured credit products: Residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) begat collateralized loan obligations (CLOs) that morphed into collateralized debt obligations (CDOs) and CDOs-squared. In the fullness of time, even more complex instruments -- including varable interest entities, structured investment vehicles and qualified special purpose vehicles -- entered the picture.
Many of these securities and the credit default swaps that fortified those credit markets were ultimately insured by the incredibly levered monoline insurance industry. The monoline insurance industry's top line grew exponentially coincident with the boom in structured finance. Wall Street embraced the shares of MBIA and Ambac, and, in 2007, the stocks reached record levels.
The risks that MBIA and Ambac were taking on were clearly not recognized by investors or by the companies. Last week, for example, MBIA disclosed that it has over $30 billion of insured mortgage-backed bonds, which includes over $8 billion of CDOs that own other CDOs (i.e., CDO-squareds).
The private mortgage insurance companies -- such as
took a similar route and have suffered as delinquencies and foreclosures have spiked.
The table below sums up nicely (or not so nicely) the magnitude of the five major monoline insurers' losses.
The solution to the emerging failure of the monoline insurers that hold insurance on homes, mortgages, bonds and derivatives is straightforward but requires bold initiatives and imagination. It is a public/private permutation of
that will somehow acquire the equity of the leading monoline insurers and will, with or without private sector partners, retain their portfolios of financial asbestos and sell them over time.
This solution will, importantly, serve to retain the AAA ratings of the individual bonds -- the U.S. government has the highest bond rating extant -- and the portfolios insured by MBIA, Ambac, MGIC Investment, Radian Group and PMI Group. In turn, this would prevent the domino effect of bond and mortgage downgrades and further forced selling and price markdowns at the world's leading financial institutions.
This program will, however, require a degree of financial creativity that has yet to be apparent from a thus far non-creative Executive Branch nor from an equally timid and tardy Federal Reserve, which seems to be
like Milton Friedman's "fool in the shower." It will, if enacted, immediately alleviate the concerns with regard to counterparty risks that have cast a pall over the world's equity markets and wreaked havoc with some of the world's largest financial institutions.
I would note that I have already drawn
a clear parallel
between the S&L crisis of the 1980s and the current credit crisis. So, not surprisingly, the solutions could be similar.
Again, the equities of the monoline insurers have declined by an average in excess of 85% from 2007's highs. The existing industry equity value of under $4 billion is de minimis against the size of the problem and low relative to the cost of a government acquisition of these companies.
Suppose the government acquires these companies en masse at a 50% premium to current prices: At a cost of only $6 billion, the U.S. government will own the majority of the companies that insure mortgages, plain vanilla municipal bonds and structured investment vehicles. More importantly, the total value of the toxic portion of the structured products insured that the government would inherit is manageable and modest relative to the cost of acquisition. For example, MBIA, the largest bond insurer has "only" about $30 billion of insured mortgage-backed bonds.
Solving the Housing Depression
The credit problems facing the world started with housing and moved up the credit ladder. As I have mentioned consistently over the last 24 months, for more than a decade, the normal/historical rigor of lending was abandoned in the residential and non-residential real estate markets. The problems were exacerbated by the ratings agencies, which abrogated their responsibility of providing accurate assessments of risk.
As such, the solution to our currently dysfunctional credit markets lies squarely on the shoulders of housing. Policy must be immediately enacted that provides the framework that will specifically allow homeowners who are now unable to service their mortgages to become current on that payment. We have to stop foreclosures and begin to whittle down the inventory of unsold homes. This will serve to begin to remedy what ails the RMBS, CMBS, CLO and CDO markets -- and aid the monoline insurance companies as, in the fullness of time, banking industry financial writedowns could turn into write-ups.
As Punk Ziegel's Dick Bove reminded me over the weekend, the mechanism and solution for turning around the housing markets is already on the books and requires no new legislation: It is
of the Housing and Community Development Act of 1974.
The solution could take several steps:
- 1. The homeowner who can't currently service his debt and uses his home as a primary residence would refinance his mortgage at a bank with a new fixed mortgage at a subsidized rate of 1% to 2% guaranteed by the Federal Housing Administration (FHA).
2. The bank providing the new mortgage loan pays off the homeowner's previous mortgage with the proceeds of the new loan.
3. The bank gets the new loan off its balance sheet, allowing it to continue to lend, and sells the FHA-guaranteed mortgage to the Government National Mortgage Association (GNMA) at a modest premium to par, which incorporates a bank profit for originating the mortgage.
4. GNMA takes a sizeable loss -- the aggregate cost would be only about $150 billion, which is not bad considering the magnitude of the problem and the solution it could bring -- and sells the mortgage at market rates (5.75% to 6.25% fixed mortgage) to
Fannie Mae( FNM) and
Freddie Mac( FRE).
I am absolutely positive that these two solutions would have a momentous, immediate and profound impact on equities. On Friday night's "Kudlow & Company" I suggested that stocks would literally rise by 10% overnight.
At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.