My understanding is that the financial crisis isn't just a result of subprime mortgages, the securitization of mortgages into mortgage-backed securities (MBS's), or the mass packaging of (and later sale of) MBS's into collateralized debt obligations (CDO's – the “toxic assets”), but rather the quasi-insurance contracts called credit default swaps (CDS's) that were created to protect against CDO defaults. Unlike insurance policies that are regulated by states, and which require issuing companies to set aside reserves sufficient to pay-out in case of defaults, the companies that sold CDS's were not regulated and did not have reserves sufficient to pay claims when CDO's defaulted - and the money amount of these obligations is in the multi-trillions of dollars. I believe the $700 billion bailout/rescue fund will be used to purchase CDO's that are in danger of defaulting so that CDS contracts will not be triggered. The CDO's were sold in tranches from low-risk to high-risk (unfortunately many high-risk CDO's were sold because the higher risk packages had higher profit margins built into them), so the government will be buying many high-risk CDO's that have a high default rate. My feeling is that states and the federal government should declare that CDS contracts are, in fact, insurance policies, and that they are therefore subject to regulation the same as other insurance policies. The companies that issued them should be given a definite time period - say 24 months - to unwind and liquidate these contracts, and any future CDS issuers should be required to register with insurance regulators and be subject to their laws.

FINANCIAL RESCUE PLAN PROVISION CAN SAVE $700,000,000,000, END THE CREDIT CRUNCH, HELP HOMEOWNERS AND REDUCE INTEREST RATES

The financial rescue package contains a provision that permits troubled financial institutions to apply for insurance (federal guarantees) and could prevent an outlay of $700,000,000,000. Furthermore, it can cut interest rates substantially, keep troubled homeowners in their homes, and certainly end the credit crunch.

The purchase assets provisions of the bill, buying paper at much less than its face value, will not put the financial institutions in enough funds to mitigate the credit crunch.

In fact the guarantee provision could even go too far in that direction. Administered sensibly by the Treasury Department it could be just right – if they would do it.

How?

If I’m a banker holding 13% sub prime mortgage paper now worth 40 on my books instead of 100, and I get a US Government full faith and credit pledge (insurance, really a guarantee) behind that debt, my lousy paper is worth way more than 100 right now. Maybe 120 or more. No one wants that. Inflation.
Big time.

So , when the banker comes in to get his insurance, he should pay a fee and, most important, agree that the interest rate on his paper will drop to 3.5%. He has to agree, because the US government can’t change his contract unilaterally.

In that way, his paper is worth 100. He sells it. He’s back in cash and the credit crunch is over. Regulations should cut back on the permission that sunk Lehman – ability to leverage cash 30 times. Twenty times does it nicely enough.

If you want to punish him because he was a bad boy, cut the interest a little so he only gets 90 cents on the dollar instead of 100. Less than that. No good. Because he won’t be able to do business and end the credit crunch.

New point. The homeowner who is paying 13% or whatever on the sub prime debt, a victim or a risk take or whatever (we’re at saving the economy not punishing him, his family and us now) should have his mortgage rate reduced to 5% so that he can pay his monthly charges. A sub prime mortgagor (interest rate, say 7and 1/2% or more) who has enough household income to do that should be part of the program. See below for the others.*

The difference between what the banker gets, say, 3.5%, to bring the paper to 100, and 5% ,what the homeowner pays, should go to the federal government to pay the costs of the program and any anticipated defaults.

That’s a program that works.

*For another program, are we, as taxpayers better off if the guy who can’t pay all of his mortgage is thrown into the street, or do we really pay more to keep him in other housing, welfare and so forth. Maybe he should be subsidized some to keep him in his home. As I say, that’s another program.

The program outlined above works. Secretary Paulson has given no assurance that his plan works.

Mike Zarin

Michael S. Zarin
President
Wellfleet Investments LLC
P.O. Box 222142
Great Neck, NY 11022-2142
Direct Delivery:
40 Cutter Mill Road - Suite 200
Great Neck, NY 11021
Tel: 516-487-7450
Fax: 516-487-7480
msz@wellfleetinvestments.com

A healthy dose of skepticism has to surround the bailot (oops! I meant rescue) bill and its implementation.

First, Paulson & Company waited a horribly long time to do anything about the subprime mess. Jim Cramer went nuclear last August about the incipient meltdown, and the Treasury did not send in financial swat teams to investigate the garbage that was rotting in the basement of Lehman or AIG. Something could have been done to put a torniquet on the wounds before September 15th. The delay of the bailout bill was nothing compared to the inaction that Paulson took in investigating Alt-A and subprime holdings. As far as I know, neither Treasury nor the Federal Reserve Board did anything before they called for the bailout bill like Chicken Little.

Second, you are correct. The devil is in the details, and there will be some significant time lag between bill passage and actual implementation. There will be no transparency until the federal regulations are opened up for comment, and the methods that Paulson et. al. take are actually revealed. In the meantime, the market looks like it's headed for a climax low in the interim. So we will have yet more drama economically in the next few weeks or months.

Third, as Jim Cramer has rightly said, if we're facing an existential economic crisis, doesn't it make sense to throw everything we can at the problem, including the kitchen sink? That's why a Home Owners Mortgage Corporation, revision of the bankruptcy laws, reintroduction of a new and improved Glass-Stegall Act, and a speculation tax on derivatives are all necessary components of an ecomomic bailout package that is yet to be implemented.

And the future administration will almost certainly have to get involved in serious antitrust activity to break up the mega-mega institutions that have swallowed up the sickies. This is because the too big to fails now have too much power, and a failure of one of these leviathans would make the $700 billion package look like chicken feed. So, Bank of America et. al. will have to be tackled the same way Standard Oil or the old AT&T were handled. And all of this is no small beans.

Ultimately, we are looking at a profound sea change in American history. We are in the first days of an entirely new era. An apt comparison are the differences between the 1920s and the 1930s. Because of what we know about the economy and computer technology, the changes will be far more rapid than what occurred before.