This post appeared yesterday on RealMoney. Click here for a free trial, and enjoy incisive commentary all day, every day.Somehow the gravity of this spiraling banking situation is not getting through to the policymakers, particularly Timothy Geithner, the Treasury Secretary. So in the interests of advancing the debate we need to consider how the government could get in control of the banking system without actually taking control of the banking companies.
There are programs in place and institutions and laws and regulations that the government has at its disposal to take control. These are the same ones that were used successfully by the Federal Savings and Loan Insurance Corp., the Resolution Trust Corp. and the Federal Deposit Insurance Corp. to get control of the system in another time. What are the goals of the government? First, is to restore order and function to the banking system before the marketplace makes that impossible by starving the banks of any means to raise capital. Second, is to keep people in their homes, in order to stabilize the housing market and ultimately allow it to appreciate, taking the pressure off trillions of dollars in soon-to-be-defaulting mortgages. Third, is to increase credit in a responsible way that does not allow the banks to run afoul of the regulators. Fourth, is not to bankrupt the Treasury or the American people's future in the process, something that both nationalization and the cruel hand of the marketplace would most certainly do. Fifth, unfortunately, and ultimately, is to prevent social chaos and unrest, which might, as it did during the Great Depression, lead to social upheaval, fascism and war. I propose a two-step plan for solving the problem over time. The first step addresses taking control of the banking system, not the banks, before it is too late and all our banks are insolvent and in danger of closing. Soon, no bank will be able to pass any stress test and will be put into receivership/nationalization. To these ends, the Federal Reserve should issue certificates of net worth to banks giving them as much capital as they need in return for notes from the banks promising to pay for the capital when times get better. The Fed has the ability to do this under its charter. Banks will then be able to finance on their own and use the certificates to insure that they are not wiped out by the gradual disposal of bad loans over time. This system of forbearance was used successfully in 1989-1990 and can be used again. If there are institutions that cannot be considered solvent and are beyond redemption even after receiving the certificate (and given a chance over time to improve the situation), then they should be seized by the FDIC. At least that way there would be some institutions left to which deposits could be sold. Others will have the time to be created through private/public facilities.
The second step addresses the root cause of the banking system's problems: home-price depreciation and subsequent defaults on mortgages. By asserting the imperative of keeping people in their homes, while at the same time not favoring them over people who are working hard and meeting payments, the federal government should, for a period of 18 months, simply get into the mortgage business or insure mortgages that have a 4% rate and a 40-year maturity. This rate could also be given to all people seeking to refinance their homes. If you extend the low rate to everyone, you avoid the moral hazard for those who are diligently staying current and are trying to stay in their homes, and you ease the anger over the subsidies for the overstretched. These mortgages would not be for the current principal amounts, but would be for a reduced principal equal to some percentage of the current appraised values of the homes. We have seen time and again that a simple reduction in interest rates will not succeed in keeping people in their homes. An adjusted principal amount can keep them in their homes. This in the interest of these people, the banking system -- which falters when a house is foreclosed upon -- and all who are current on their home mortgages but are seeing the value of their properties diminish because of neighborhood foreclosures. The obvious issue is how the banks can get their money back for the original mortgages and how the regulators will be able to forbear on the banks that take the hit on the mortgages. For that, the government should issue a Certificate of Equity, which would allow a bank to recapture the lost mortgage amounts from the original mortgages upon the sale of the house. Anything above the Certificate of Equity would accrue to the homeowner. The Certificate of Equity would be counted as equity for the purposes of a bank examination and stress test. The mortgage and the Certificate of Equity would be transferable on any sale of the house and must be assumed. Why would anyone be willing to enter into such a transaction? Because it is cheaper than renting on an after-tax basis, and in the vast majority of cases houses have more square footage than apartments. Many people have put hard-earned cash or sweat equity into their homes. Plus there would be no uprooting of their children and painful switching into other schools.
This plan would work well with the 20% of the mortgage loans that were produced between 2004 and 2007, the so-called problem whole loans, that are kept on the books at many of the largest banks. It does not solve the problem of the 80% of the mortgages that are bundled into the CDO form. In the latter, the servicer does not have the latitude of making those principal cuts. The servicer must be incentivized and indemnified to make such cuts. These cuts are ultimately in the interest of the CDO holders, because their proceeds from foreclosures are more meager. Given the nature of the national housing emergency, these servicers and the top-tiered creditors in the CDOs should not be allowed to hold us hostage. The cessation of foreclosures that this program should bring about, coupled with a radical decline in new housing starts to a level of 400,000, should produce housing market stabilization, an integral part of what is necessary to allow the banks to be able to pay back the notes they would be given by the Federal Reserve. To insure that banks do not run afoul of the system (besides having the close scrutiny of the FDIC), the banks' officers must agree to take a substantial portion of their salaries in restricted stock that cannot be sold until after the banks pay off their notes to insure that good faith efforts are made to return to profitability. The executives are therefore invested alongside the government. Such a plan would provide a much less expensive and more efficient solution to a nationalization scheme, which would not have such a compensation plan and would create tremendous inefficiencies, not to mention a pressure to dispose of assets immediately. A nationalization plan would further depress the value of assets that would most likely be viable if left to a time when the economy ultimately improves. I am open to any suggestions about how to hone this two-pronged plan to make it more palatable and less expensive to the government and the taxpayers it must defend. It's already generating lots of buzz -- check out Mark Haefele's response over on RealMoney -- so let's keep the debate going! At the time of publication, Cramer had no positions in securities mentioned.