Today is the Labor Day holiday in the USA, so to honor the more vulnerable parts of our society and economy I’m engaging in this fantasy rethinking of our current economic crisis.  If only……

When the “unsinkable” ship Titanic hit an iceberg and sank on its maiden voyage in 1911, as any teenage girl will tell you, the rich people got nearly all the lifeboats (except for John Jacob Astor IV who ordered another drink, giving up his seat), dooming the lower-class passengers including, of course, poor Leonardo DiCaprio. Much the same thing seems to be happening in the case of the current economic crisis, where the people who are hurting the most seem to be getting the least.  I’m beginning to believe the crisis could have been fixed quicker and cheaper simply by helping the women and children instead of the bankers.

This began as a mortgage crisis.  Lenders dropped their standards on loans, giving them to people who shouldn’t have qualified (yes, they applied for those loans so are also culpable), driving housing prices up in a bubble that eventually popped and here we are with eight percent of all mortgaged houses in foreclosure and home prices down 30-40 percent from two years ago.  The technique our government used to deal with this was to prop-up the bankers, not the borrowers.

Why?

That’s a question I have been asking all over and the smart money answer generally comes down to: 1) that’s the way the system is set-up; 2) that’s the way we’ve always done it, and; 3) it would be too complex to deal with individuals — better to deal, instead, with a few dozen banks.

Why?

The system was widely perverted to deal with the current crisis; it wasn’t “business as usual” at all.  Companies that weren’t (and still aren’t) bank holding companies were declared to be so and got money from the Fed and Treasury as a result.  Same for insurance companies and brokerage firms and car companies that remained as they were but got money still from the Congress or through sleight-of-hand by Fed chairman Bernanke.

Doing things “the way we’ve always done it” is what got us into this mess.

And the miracle of information technology makes it just as easy to send money to people as it is to take it from them in the form of taxes.  Saying that a bank has to be in the middle makes no sense at all. PayPal would gladly assume that function, if it is truly needed.

I’m beginning to realize we could have taken a completely different approach to the problem and simply treated the symptom, inserting what computer jocks call a “wait state” into the mortgage system so panic could subside, rational adjustments could be made, and life could be eased back to normal.

Remember that economies are cyclical and a lot of good financial planning is simply having enough reserves to survive until things get better.  That could have been our major economic tactic in dealing with the crisis in 2008. Instead of pumping $700 billion to $1.3 trillion (nobody knows the real number) into economic stimulus and bail-outs, the U.S. government could have simply paid everyone’s mortgage — EVERYONE’S — for six months.

There are 51 million mortgages in America and the average mortgage payment in 2006 was $1686, so paying everyone’s mortgage for six months would have cost $516 billion — hundreds of billions less than the Bush/Paulson/Obama/Geithner/Bernanke plan, and quicker, too.

The money that people would otherwise have used to make their mortgage payments could have gone in part for other things, making it effectively a huge economic stimulus in its own right.  With mortgages paid in full there would have been no foreclosures OR bank failures during that six month period.  Yes, there would still have been problems with the banking system that needed  correction, but there would have been six months to do the correcting.

Lehman Brothers would still be in business, Bear Stearns, too.  Merrill Lynch would be independent. AIG would not have failed. Even Bernie Madoff would probably still be in business — at least for awhile.

So why didn’t we do it that way?  Because it would have been putting women and children first.

I need a drink.

Adam Smith is a best-selling author and for 14 years had a weekly show on PBS called Adam Smith’s Money World that won four Emmys and a Peabody Award.  He’s a very smart guy.  Smith was Tom Wolfe’s editor at Esquire, founded Institutional Investor and New York magazines, and somewhere in there about 25 years ago became a friend of mine.  I try to collect heroes and this guy is definitely one of mine.

Smith lives in Princeton, NJ, next-door to Paul Krugman, Princeton professor, New York Times Op-Ed columnist and oh, by-the-way, winner of the 2009 Nobel Prize in Economics.

I wonder how he invested that money?

On July 8th Smith and Krugman put on a little show for fewer than 100 folks at a meeting in Princeton of New Jersey Common Cause. Someone was there to take bad video of the event which I have here and intend to share with you over three posts today and tomorrow then we can get back to health care.

Krugman is a very smart economist working at the top of his game and explains things pretty well.  In these clips (there are 17 in all) he presents what could easily be the contents of a dozen or more columns.  And what I like is it is presented colloquially with us getting a much better sense of the man than from his very polished work in the Times.

I am not saying Krugman is right about everything, but I think these clips are very worth watching for a sense of our time and current thinking about it.  And it is odd how little it has to do, really, with economics and how much with government and just the way things do and don’t get done in our culture.

I look forward to reading your comments.

When Barack Obama was running for President one of his favorite sound bites was that any financial bailout should not just involve Wall Street, but Main Street, too – that the government’s responsibility was to help both bankers and homeowners. But now that the election is won and Obama is in office, the two streets are still being treated very differently, with Main Street getting a lot less help from Washington.

This is a HOUSING crisis, not a BANKING crisis, yet $700+ billion has gone to help bankers and only $75 billion to “help” homeowners. The banker’s money has mainly been spent and the homeowner money has hardly been touched. If this is a HOUSING crisis, why aren’t more resources being devoted to housing?

It comes down to an issue of morality, believe it or not, with homeowners expected to be moral and bankers not. Everybody blew it, but the homeowners are being disproportionately punished for their actions.

There is no morality issue in the bank bailout. Banks are having their capital boosted based not on whether they are well run or in some way “deserving,” but purely on the basis of whether they are viewed as being in three groups: 1) doomed; 2) capable of being saved through injecting government funds, or; 3) too big to be allowed to fail no matter how poorly run. This means the least-deserving banks tend to get the most help.

But the Obama Administration’s attempt to help mortgage holders is different. If you hope for government help in restructuring your mortgage you’d better not be behind in your payments. If you missed a mortgage payment months into this crisis, you are out of luck. If your mortgage isn’t guaranteed by Fannie Mae or Freddie Mac, you are out of luck. If your mortgage is jumbo you are out of luck. And if you owe more than 105 percent of the value of your home you are out of luck.

That’s a lot of homeowners out of luck. No wonder the Obama Administration thinks it needs only $75 billion to do the job, it is excluding so many people.

Let’s try applying the homeowner rules to the banks. If both played by the same rules, then banks with mortgage portfolios that have dropped by more than about 15 percent (are five percent or more underwater) would be ineligible for government assistance. Banks that MADE jumbo loans would be ineligible for assistance. Banks that made loans with private insurance or no insurance would be ineligible for assistance. Banks that had shown themselves unable to meet capital requirements (had effectively missed a payment) would be ineligible for assistance. In each case, these criteria define EVERY bank that has received assistance. They ALL have mortgage portfolios down in value by 15 percent or more, ALL made jumbo loans, ALL made uninsured loans, and ALL are under capitalized.

So if we apply to banks the same rules that are being applied to homeowners, then no banks deserve support and there should be no bank bailout. Well that can’t be, can it? So screw the rules, screw the idea of there being a moral issue with bankers, just start handing out cash without even requiring that they use any of it to make or restructure loans.

So that’s what the Treasury and the Fed have done – bailed out the bankers without regard to their past OR FUTURE behavior. And $700+ billion later do we really truly feel better as a result?

Hell no we don’t, because we still can’t pay our mortgages!

This bailout is broken, it is unfair, and it is incredibly inefficient as a result. The bank bailout is based entirely on providing INCENTIVES to the banks – bribing them to THINK ABOUT doing the right thing.The government won’t MAKE the banks do anything. They just ENCOURAGE the banks by giving money.

Where are the incentives in the much smaller housing bailout? There are incentives. THEY ARE ALL BEING GIVEN TO THE BANKS. It is very difficult to find in the new Federal mortgage modification rules much of anything that truly helps homeowners. Banks aren’t REQUIRED to do anything; they can reject any mortgage holder for any financial reason. The banks are PAID to restructure the mortgages and the way those mortgages are being restructured (primarily through increasing term and adding balloon payments) not only costs the banks nothing, it tends to make them MORE money over the life of the loan.

So that $75 billion allocated to modifying mortgages and keeping people in their homes, how much of that $75 billion will actually go to homeowners? About 25 percent, or $18 billion almost entirely in first-time buyer tax credits. This means the bank bailout isn’t $700+ billion, it is $758+ billion or FORTY-TWO TIMES the size of the housing bailout.

And why only first-time buyers? What makes them more deserving of help? The theory is that these are new homeowners so they’ll be buying-up excess inventory and helping to firm prices. They aren’t people selling one house to buy another. In another view they are virginal and uncorrupted by the housing bubble.It wasn’t their fault, so they are being rewarded. More morality, inequitably applied.

Main Street isn’t doing very well under this policy. Main Street is being cheated.

This is a bad plan, unfair and poorly executed. It places a moral burden on individuals and not on banks, yet there is no good explanation for why it has to be so.

What is it about banks that make them deserving of 42 times as much support as your Mom?

Nothing.

Like the Bush Administration before it, the Obama Administration has a bias for helping Wall Street. They couch this as a claimed inability to come up with any better ideas. Yet better ideas – ideas NOT couched in moral argument (or more appropriately couched in EQUAL moral justification) were presented right in this spot in the post titled The Not So Bad Bank. That’s a plan that helps banks and homeowners equally, doesn’t require incentives to work, acts faster, and costs a tenth as much.

What’s wrong with doing the job better, faster, and cheaper?

“Where are the tumbrils?” asks my friend Adam Smith. If, like me, you have no idea what is a tumbril, it is a type of horse cart used during the French Revolution to transport condemned prisoners to the guillotine for beheading. What Adam wonders is how we can get so deep into such a hellacious financial crisis without finding at least a few bad guys to behead?

It’s a good question.

In one sense there simply have to be bankers or money managers of some sort who have benefitted greatly from the financial discomfort of the rest of us. On the other hand it is difficult to find many such people. Maybe they are hiding. I know I would.

I’m beginning to think there aren’t as many devils as one might suspect in this passion play. There are a few devils, sure, but also a lot of innocent dopes who may have made the situation much worse while not even making very much money from our pain.

A lot of it comes down to a probable misapplication of technology, something that hasn’t been discussed much in the coverage of this financial crisis. We talk for seconds at a time about the confounding complexity of derivative securities then quickly go on to something more understandable.

Is technology our friend in this mess or our enemy?

If we’ve got a tumbril idling in the driveway and really need to find people for beheading, there are still plenty of successful hedge fund managers to choose from. According to Institutional Investor’s Alpha Magazine, which comes out today, the top 25 hedge fund managers were paid a total of $11.6 billion last year, which isn’t bad for the worst financial year since the Great Depression. Most of those managers correctly foresaw the market fall and found ways to benefit while making as much as $3.7 billion for the year.I could live on that. Heck, I could live on the interest on the interest on that.

But most hedge fund managers DIDN’T make money in 2008 – a very bad year for their industry overall. I have an interesting take on how some of that could have happened.

Let’s start by looking back to the dot-com era, which also happened to be the era of the day trader. Remember them? A successful day trader in the late 1990s could gain a following over Internet chat then use that following to make money by becoming an alpha trader. He’d say “I’m selling this” or “I’m buying that” and copycat day traders would do the same. If enough of them acted they could influence the price down or up and – since the leader was leading – he could almost always liquidate his position with a profit. The quickest of his acolytes would make profits, too. Those who didn’t profit weren’t seen as exposing the inherent flaws of this system, they were just viewed as too slow.

To a certain extent, the heirs of day trading have taken the lessons of that earlier era and applied them with devastating effect in the Twitter Age.

If a bunch of wealthy traders get together at Starbucks and agree to short-sell a company or a financial instrument, driving down that price ideally to the point where it never recovers, well that’s against the law. But with trading automation and the Internet as a platform it is possible to accomplish this same end WITHOUT it being explicitly illegal. It is even possible that the perps don’t know the level of damage they are inflicting, though I doubt that’s true. The trick is to avoid communication. If there is no communication between traders there is no chain of causation, no conspiracy, just an unhappy accident.

Where the alpha day traders of the 1990s were squeezing nickels out of penny stocks and settling-up at the end of every day, trading automation makes it possible today for Wall Street to make bigger and longer bets against much larger targets, with the perfect trade being one that leads to the quick and certain death of its victim.

The ideal short sale, you see, is one that never has to be covered because the company or financial instrument being shorted goes to a value of zero. That’s WAY more profitable than making a few cents or a buck or two here or there before covering that short. It’s much better to go for the headshot.

But as I say, that’s also illegal.

The market hasn’t worried about this much because the SEC hasn’t worried about anything in many years. And the task is viewed as requiring so much financial muscle that it was considered impossible to keep such a huge conspiracy quiet. You can’t take down a Bear Stearns, for example, without a LOT of help. And you can’t get a lot of help without two-way communication, or so the regulators – stupid regulators – thought.

Remember government regulation is by definition reactionary. The regulators have to observe bad behavior before they can move to control or prohibit it.

What ISN’T illegal is for a trader to essentially train the market and then rely on a conditioned response on the part of other traders or trading programs to achieve his deadly end.

Think of this in terms of physics. Force equals mass times acceleration. In order to have the greatest economic impact on the market you need to concentrate your efforts on a single target. It is much more lucrative to bet that a single company will die, for example, rather than that a market sector will rise or fall. So choose a target, finding leverage on that target, if possible. Apply mass by getting (or attracting – more to come on that) a large number of traders and their capital to your side. Then use acceleration by acting as quickly and as uniformly as possible, ideally within seconds. The effect can’t be anything but devastating.

Remember the story of George Soros and the Bank of England. Soros quickly made $1.1 billion in 1992 by selling the Pound and finally forcing the Bank of England to devalue that currency, thus lowering Soros’s cost of covering his shorts and generating a huge profit. Soros’s success in 1992 came from believing the Bank of England when it said it would defend the pound at any cost. Well the cost was $1.1 billion, thank you, transferred into George Soros’s bank account.

On Wall Street the Soros story is always told with admiration because he beat the bank and won the game. At the Bank of England they probably look at it somewhat differently. What Soros did, though, was identify the algorithm that governed the behavior of the Bank of England. Then he found a way to take advantage of that algorithm and the Bank’s unwillingness to change or adapt. From today’s view what Soros did was hack the Bank of England.

That was 17 years ago. The average workstation running on Wall Street today has 1000 times the power of its 1992 counterpart. Trading data is today available vastly quicker and in vastly greater volumes than before. It’s time to think about program trading.

We don’t hear much anymore about program trading, which was something that seemed to play a big role in the 1987 stock market crash. Computers back then were for the first time managing lots of money automatically and it took awhile to see the dark side of that – massive trades that were un-commanded and unexpected and only acted to hurt the market. And those trades were very crude with only a dozen or so firms even capable of making them. This was before Soros when computers were FIVE THOUSAND TIMES less powerful than they are today. So we learned from 1987 to put some wait states in the code, to turn off the programs under certain rules conditions, and program trading hasn’t been much of a problems since.

Or so we thought.

Think about piranha fish. These little guys with their big teeth travel in large schools. They kill and eat their prey, which can be as large as cattle drinking in the river. Piranha, too, take advantage of force times acceleration. The trick is getting a lot of fish – hundreds of fish – to attack at exactly the same time.

How do they do it? How do the piranha know to attack? They don’t wait to bump into a cow leg under water. They don’t sniff for the smell of blood in water. Both of those responses are too slow and would lead to too many victims escaping. Force equals mass times acceleration, remember? And besides, piranhas have tiny little brains to go with their big teeth, so don’t look for any insight there. These are just violent little eating machines.

Piranhas hunt as a school and take all their cues from the fish beside them. Only one fish has to smell blood or bump into some food for the entire school to reflexively attack.

Now we’re back on Wall Street in today’s era of hedge funds and genetic trading algorithms. At any given moment in the market there is more than a $1 trillion in cash that can be brought to bear in seconds by computers that are functioning essentially like piranhas. The cash isn’t held in a few funds or hidden behind some mainframe interface – it is held by hundreds of workstations each operating independently yet as part of a global economic system – conscious or not.

These trading workstations are running in hundreds of offices, all scanning the same data. They have learned over time that certain signals lead to certain outcomes. They may be following an alpha trader but they don’t have to because at some point the market signal, itself, is going to be too strong to ignore.

Here it comes. An alpha trader makes a bold move against a firm or, more likely, against one or more of that firm’s financial products. Say the firm is big stupid AIG, an insurance company, and the instrument is a credit default swap sold by AIG.

Though AIG seems to have forgotten or ignores it, Credit Default Swaps act like insurance and are treated by the market like insurance, but they technically AREN’T insurance. They are ultra-hyper-purified demonic risk and nothing else. That’s because CDS’s are not regulated (they are in fact IMMUNE to regulation – funny that), they can be shorted without having to EVER actually own the underlying security (naked shorts of CDS’s are perfectly legal), because they don’t have to be owned the volume available to be shorted isn’t limited, and – here’s the best one of all – there’s no requirement that the trader have any causal, custodial, or familial relationship with the covered debt. In other words, while most credit default swaps are intended to hedge debt defaults, they don’t have to be. It’s like buying a life insurance policy on the guy down the hall because you hear him coughing at night. His death is meaningless to you so buying the policy is just a gamble, not insurance.

Here’s how it works in practice. The alpha trader senses, guesses, or maybe just wishes for weakness on the part of AIG and its particular CDS issue, so he shorts that mother. The signal from that short (it is big and aggressive, having as much force as possible) is detected by 500 trading workstations running genetic algorithms – workstations that are not regulated in any sense whatsoever. AIG’s CDS begins to glow in front of 500 junior traders. Some programs kick-in automatically and sell, too. The CDS glows even brighter and begins to throb as if its heart was beating. Traders pile-on like piranhas, sensing opportunity, smelling blood, until the CDS is oversold to nothing, until it is dead.

What we’ve accomplished here, through the miracle of synthetic derivatives, is buying a $1 billion insurance policy on a $10 million asset.

It isn’t investing, isn’t even trading, it’s just betting.

Nobody started it. Or at least it is impossible to figure out who started it. No one trader could have saved the issue by staying out of the fray (doing so would only have cost easy profit). There was no meeting at Starbucks. Yet the final result was just as certain.

The problem with this scenario is that conditions – primarily technology – have changed enough to allow what were always parasites to become true predators. Parasites need a healthy host to maintain their lifestyle. If they eat too much the host dies and the parasites die with it. But predators just find something else to kill and eat when all of one prey is gone.

In this case that prey is the American mortgage market, which is a fair proxy for the American economy.

Better make that two tumbrils.

We’re seven weeks into the Obama Administration and still looking for a way out of both the banking and housing crises.  TARP didn’t seem to work, at least not as its designers intended.  The new housing plan hasn’t been well received and now that more details are out you’d think there would be an even more negative reaction, but the press doesn’t seem to have even noticed the details were released last week.

Had anyone actually read the press release they would have noticed the Obama plan is no longer limited to refinancing 105 percent of a home’s purchase price, but offers instead what’s essentially a 5/1 Adjustable Rate Mortgage for homeowners and lenders who participate.  The new rules do not, however, REQUIRE lenders to accept or approve ANY customers, relying as always on “incentives.” Nor does it require ANY principle reduction on the part of the lenders, allowing instead for a notional 40-year loan term with the deferred principle covered by a balloon payment in some future year. 

This isn’t terrible, but it isn’t great, either.  It serves the primary goals of the government, which are boosting home prices while at the same time limiting the potential price tag for taxpayers. But the government continues to be too much on the side of lenders who shouldn’t be so easily let off the hook for their past behavior. 

This 5/1 ARM strategy essentially spreads the recovery pain over a longer period of time, which is good for lenders.  But it hardly offers the 15- and 30-year fixed-rate loans homeowners should really be looking for.  The government’s choice to completely ignore fixed-rate financing will probably hurt both the success of the program and its utility for homeowners.  The use of balloon payments and no principle reductions simply guarantee that while homeowners may be able to keep their homes for now – some of them – they are in for another unhappy surprise in about five years.

It’s time for a better plan.  And Washington supposedly is open to one.  The Obama Administration has been asking for suggestions, though without giving out any clear method for actually submitting them.  So as a blogger I’ll just hold up my hand and say, “Call on me, Mr. Obama, me, me!  I have an answer!”

And I do, or at least I think I do.

You’ll note this is my third try at such an answer since Washington didn’t pick up and run with ideas one or two.  But I’ve got a million of them, folks, so here’s Plan Number Three, called the Not-So-Bad Bank.

The idea here is to do something that’s different because variations on the same old stuff aren’t working.  The Fed and Treasury keep saying they are using all their tools; well then it is time to invent some better tools.

It might be good to start with some analysis of why what we’ve done so far hasn’t yet been broadly perceived as working or even enough.  

You could get Rush Limbaugh and his two cousins in a room and even they would say things have not yet started to get better and are probably getting worse.  One reason for this might be that we simply haven’t allowed enough time.  That’s probably true for results, but not for perception.  Nobody’s saying, “Well we’ve taken care of that one, now what about health care or Social Security?”  Nope, we’re still stuck on banking and housing. It could be we simply haven’t done enough — not allocated enough money.  It could be that what we’ve done so far were the wrong things to do.  All of these possibilities are discussed in the press every day.  What isn’t discussed, I think, is that we may have the wrong attitude.

The financial world, especially, has ways of doing things, and the number of approaches they’ll generally consider to ending a recession is deliberately limited — limited by what are perceived to be the available tools and limited, too, by how the financial establishment sees itself.  These are proud people who think of themselves as smart and on top of most any situation.  Tom Wolfe called them Masters of the Universe and they like that image.  The problem is that now we’re in a situation none of them (or us) have been in before and we (they) are limited by both lack of experience and by the way we see ourselves.  This is why, for example, banks accept Federal bailout money then don’t lend it.  It’s also why our government gives Federal bailout money then doesn’t attach conditions.  That’s not what they do.

Well maybe it is time to start doing things a little differently.  It is time to start looking at the fundamental processes of this financial engine in a new way.  That is done all the time for profit, of course.  Every time a new derivative security is announced it is some company’s way of grabbing a little errant profit they sense in the market — it is a new way of doing business.  New stuff in that context is considered good.  I just think we need new stuff in EVERY context to track down the causes of our problems and fix them.  Alas, when it comes to that sort of behavior the financial establishment gets a lot less creative.

To this point we as a nation have come up with three ideas about how to help the banks: 1) buy their bad mortgage securities; 2) invest lots of money in them to build their capital bases, and; 3) preserve them at any cost as being too big to fail.  These are perfectly fine ideas, but I think we’re limiting ourselves far too much when it comes to exploring how they might work.  We can be smarter and will have to be smarter before the day is over.

My idea involves only the first of those three parts, buying the bad mortgage securities, the so-called “toxic assets.”  I think this is a valid thing to do but by limiting our view of it to how it helps the banks is keeping us from reaping the benefits this process could afford to all of us.

The way most pundits expect the toxic assets to be bought up is through the creation of what’s called a “bad bank.”  The Resolution Trust Corporation (RTC) was our bad bank the last time we went through something like this during the 1980s savings & loan crisis.  The RTC bought bad assets of those many S&Ls and slowly resold them into the marketplace as houses were sold and mortgages were refinanced.  Though it took 15 years to do so, the RTC eventually got rid of all those toxic assets and even made a small profit, too, holding those assets effectively to maturity. It was a low-risk process but low reward, too, because it took so long.

That’s the archetype for this next Bad Bank; buy up the toxic assets and dribble them back into the market over time.  The one big issue that’s keeping such a bad bank from being created is deciding what price to put on those toxic assets.  The banks want the government to take all the risk and bear all the cost so they’d like to sell their toxic assets for 100 cents on the dollar, please, which is lunacy since such securities are selling now on the open market (when a buyer can be found) for 15-20 CENTS on the dollar.

If the Obama Administration follows recent tradition, they’ll give the banks a good deal.  This is bad in that the cost will be higher but good in that the Credit Default Swap market will be helped and those costs, at least, will be lower.  So I can see reasons to do it both ways, though frankly I’d like to see these bankers and insurance companies pay a bit for their folly.

The problem with the bad bank scenario is that it does nothing – nothing at all – to help homeowners.  Bad banks just help banks, not people who own houses, which is why I think we need a Not-So-Bad Bank  (a term I just invented) that will help the banks AND homeowners.

Here’s how it works.  The so-called toxic assets bought by the bad bank are, for the most part, bonds called Collateralized Mortgage Obligations or CMOs.  These were created originally by pulling together a huge pile of mortgages about $100 million high and chopping that amount of debt into various classes of principle and interest and risk amounting typically to 4-5 different types of bonds that were sold to institutional investors.  CMOs are types of derivative securities, many of which are protected by Credit Default Swaps (CDS’s), another class of derivative securities sold usually to insurance companies like AIG.  That $184 billion given to AIG to keep it afloat was to cover bad bets on CDS’s, remember, because the CMOs were going down in price, homeowners were defaulting in high numbers, The banks were being forced to mark the asset value of their CMO’s to that depressed market value (mark to market) triggering claims against the CDS’s, which turned out to be a VERY bad bet for the insurance companies.

One thing important to remember about CMOs is that, as the banks continually explain, they are so complex and so dispersed that there is no way to put them back together again prior to maturity.  Can’t be done.  And since politicians are particularly stupid when it comes to math (being only able to understand negative numbers, it seems), they buy this argument, which is supported to some extent by experts at the Treasury and the Federal Reserve who I think, frankly, identify maybe a little too closely with the bankers.

The fact is that Wall Street has all the time had the ability to put those CMOs back together again, just like Dorothy was all along able to return to Kansas by simply clicking her heels.  Computers are very good at keeping track of deals like CMOs and they have to because – contrary to what the bankers and brokers tell us — CMO’s are put back together again all the time. This happens every time a mortgage is retired either through the sale of a house or a refinancing.

CMO’s were invented in 1973.  That date stems from the arrival of several market conditions, one of which was having the available technology to both create CMO’s — to tear apart and securitize the mortgage pools — AND TO KEEP TRACK OF ALL THE DISPERSED BITS FOR REPAYMENT.  If we could do it in 1973 we can do it EASILY today and the fact that we are continually told that it is difficult or impossible probably represents ignorance, institutional inertia, or someone not really wanting to try. Heck, I think they’re just lying.

Think about it: you’ve sold your house, the mortgage is gone (repaid), so the CMO, which is where the mortgage debt obligation actually lies, has to have been repaid, too — every little bitty piece of it, held in different proportions by at least four different bondholders. And as long as there have been CMOs it has been thus.

The funny part is that what is supposed to be impossible happens so easily and so often.  A typical CMO deal involves about 10,000 mortgages, the bank knows the shelf life of those loans is three years, which means they get paid off or adjusted after the first year at about 5,000 loans-per-year or around 15 loans-per-day.

So the CMO that was so dense as to be indecipherable is actually deciphered 15 times per day after the first year.

It takes time and effort on the part of mortgage servicers to figure out CMO’s and it costs them money, too.  That’s one reason why they want a pre-payment penalty if you pay off your mortgage in the first year. 

Understanding all this, let’s now go ahead and fix the system by first figuring out how to price the government purchase of those CMO’s.

If President Obama wants to be a good guy, which he will if he’s planning on having a second term, he’ll come up with some plan that doesn’t hurt the banks too much, doesn’t hurt the insurance companies too much, oh and by the way maybe even helps homeowners.  That smooth move would be to create a Not-So-Bad Bank (NSBB).

This has to be done by Congress passing a law creating the bank and giving the bank certain privileges and responsibilities, one of which is the ability to buy-up CMOs, not one bond coupon at a time, but as entire offerings, which would be recaptured and redeemed en masse.  Congress can require this by passing a law, but of course the issue is still what price to offer for those typical $100 million (at issuance) CMO deals.  The banks want the price to be $100 million.  The free market says the CMOs are worth maybe $20 million.  Let’s split the difference and have the NSBB pay $60 million.

This price accomplishes three important things.  First, it finally sets a price so the secondary CMO market can get moving again.  The price is set high enough that though CMO investors lose something they don’t lose everything.  It’s high enough, too, that insurance companies don’t have to pay so much to cover those CDS’s.  Everyone hurts a bit but nobody dies.

Now we have an entire CMO offering held by the NSBB at a value of $60 million.  This type of transaction would be done over and over again, buying-up deal after deal, though it wouldn’t have to be done for all CMOs because the secondary market would have been unfrozen through this government action and private trading of CMOs resumed with a noticeable firming of house prices as a result. 

Let’s assume that the NSBB uses $50 billion or more tax dollars to buy-up CMOs at 60 cents on the dollar, which reflects less the market value of the securities and more the market value of the underlying assets or collateral, the homes.

With a normal bad bank now would begin the painfully slow process of waiting for people to sell their houses or refinance so the government can get paid back and eventually even make a profit on its $50 billion investment.  Remember this process took the RTC about 15 years to complete.

But we don’t have a bad bank, we have the Not-So-Bad-Bank, which operates differently.  Relying on another clause in the law passed to establish the NSBB, the bank has the right to call all the mortgage loans connected to its CMO portfolio, forcing them to be refinanced all at the same time.  No waiting for people to sell their homes or refinance on their schedule, in this case the government says to do it NOW.

Using as an example this one CMO deal for 10,000 mortgages, that would mean 10,000 refis all at the same time.  Is that bad or good?

Well it turns out to be very good for at least a couple reasons.  There’s an opportunity here for economies of scale and for mortgage arbitrage. Doing the numbers we can see that the NSBB owns the CMO deal for $60 million or 60 cents on the dollar.  So the NSBB turns around and forces all the homeowners to refinance at 70 cents on the dollar, the difference between those two numbers being the NSBB’s gross profit.

We’ve already given the banks and insurance companies a survivable level of pain by redeeming the CMOs at 60 cents.  Now we give the homeowners a break, too, by forcing them to refinance at 70 cents.  If they owed $100,000 on their old mortgage, on the new one they’ll only owe $70,000.  Most loans that were under water will be dragged to dry ground by this action because it affects only the loan balance, NOT the value of the house.  People will owe less, their houses will be worth the same or more, so their equity — which may have been negative — will now suddenly be positive, making it easier to qualify for Fannie, Freddie, Gennie, VA, or FHA refinance loans.  And because those loan balances are all 30 percent lower, the payments will be 30 percent lower, too, making the homes more affordable to own. That’s homeowner relief.

Lower payments and higher equity will lead to lower default rates, avoiding the current mortgage restructuring problems that appear not to improve default rates at all.

The best part about this process from the standpoint of the NSBB is that those mortgages can be then resold in the secondary market or aggregated by outfits like Fannie Mae or Freddie Mac, freeing up the NSBB capital to be reused immediately to buy and retire more CMOs and refinance more mortgages.

Running on a 90 day buy-call-refinance cycle, the NSBB could reuse its capital four times per year and within a couple years (not 15) be out of business, having shown a substantial profit that would go back into the Treasury.    

The Not-So-Bad-Bank would work better than a Bad Bank.  It costs less money, helps firm house prices, gives relief to homeowners, and tempers the distress of banks and insurance companies.  The only real count against it is that it isn’t Ben Bernanke’s, Tim Geithner’s, or Larry Summers’ idea.

Why not give it a try, Mr. Obama?

Yesterday morning in Palm Desert, CA a number of technology startup companies were shown to the public for the first time at the DEMO Conference.  One of these new companies was an Internet mortgage startup called home-account.com (don’t forget the dash).  Home-Account was born in my kitchen in Charleston just over a year ago – long before any of us realized the housing crisis was going to be as bad as it has become.  Just to be clear, I am a co-founder and shareholder in Home-Account.com.

People with ideas are always seeking me out.  In this case my visitor was a mortgage broker from Charlotte, NC. He knew that lenders weren’t helping homeowners own their homes as quickly as they might.  Simply put, it was in the interest of the lender to keep mortgage holders owing as much as possible for as long as possible, with each refinance generally starting the game all over again.  There had to be a better way, but that way also had to still support the broker and his family.

So he created a subscription service with a flat $1500 fee.  With that payment up front the broker would work with homeowners as long as he was needed, helping them to refinance their homes again and again at little or no cost as their fortunes improved and interest rates could be driven down.

And it worked.  Gaming the mortgage system by planning several refinance events ahead, it was possible for those homeowners in Charlotte – 600 of them over seven years – to save an average of $400 per month on their mortgage payments, own their homes quicker, and pay an average of $175,000 less in mortgage interest as a result.

Remember this is real money we’re talking about.  $175,000 is more than the average American personally saves for ANY reason.  It is more money than they save for retirement and more than they invest in the stock market. This means that taking this new approach to buying their home can be the most important financial decision of most people’s lives.

Home-Account just takes that analog process developed in Charlotte and makes it digital and national. And because it is cheaper to use computers than telephones and Home-Account has a chance to serve all of America’s 52 million mortgage holders, that one-time $1500 subscription payment could be dropped to the present $10 per month.

It’s a heck of a deal.

And it’s also a lot harder to do than it looks.  Home-Account is effectively a customer-driven automated mortgage underwriting system – the first such system EVER built. If you’ve shopped for mortgages on the Internet maybe you thought you were using such a system, but you weren’t.  The difference is key: while those guys say you MAY QUALIFY for a certain mortgage at a rate that somehow later always goes up, at Home-Account we say you ARE APPROVED and the rate is LOCKED.  There are never any added broker points or Yield Spread Premium – a term for extra interest payments that go to the broker. 

Loans recommended by Home-Account are the cheapest you can get.  If ours looks more expensive than theirs it is because theirs aren’t real. 

Where those other Internet mortgage sites hand you over to 25-50 banks or brokers who are paying for your lead, Home-Account doesn’t sell you to anyone, instead offering-up to the homeowner or home buyer a handful of real mortgages that we know are the best you can qualify for based on your situation.  The lenders get pre-packaged loan applications ready to be funded and they get them FOR FREE, because Home-Account takes no money from anyone except its subscribers.

The service was announced yesterday morning, gaining some press and a lot of interest but also two important questions were asked again and again:

1) Why should homeowners or those about to buy a house subscribe to Home-Account for more than one month?

2) How do you make enough money charging only $10 per month?

That first question is pretty compelling.  Why not pay $10 for the first month, finance or refinance your house saving an average of $3500 in broker fees and closing costs, then just drop the service, saving that $10 per month in the process?

The answer starts with the fact that many people in the current economy won’t qualify AT ALL for a loan.  If you already own a home and have a mortgage, keeping the one you have may be the best advice.  And it is the advice you’ll get from Home-Account if that’s the case.  But don’t expect the same from any other Internet mortgage site because they will ALL try to drag you into some kind of transaction whether it is in your interest or not.  That’s because they work for the lenders and only Home-Account works for you.

If you don’t qualify we’ll tell you that, but we’ll also tell you what you need to do to become qualified.  The more financial information you give us the more we can help.  We’ll teach you how to improve your credit score, literally telling you which bills to pay off first and how much to pay each month.  Home-Account monitors your progress and keeps you on-track.  It’s precisely the kind of service I wish my parents had bought me as a gift when I was first on my own a zillion years ago.

People with better credit who qualify immediately for loans at Home-Account then drop out can’t take advantage of the strategic advice that’s at the heart of the service.  THEY WON’T save $175,000 in interest charges.  That requires following a multi-year strategy.  They may not even get the very best deal on that initial loan because we might be able to help them quickly improve their credit score enough in a month or two to get a lower rate.

Listen, a big reason we’re in this global financial mess is that people took on more debt than they could handle, at least in part because they really had no idea how much debt they could handle.  Most people don’t know where they stand financially.  At least half of what Home-Account does is help subscribers get a handle on their largest expenditure, their mortgage, after which the rest of a subscriber’s finances just tend to fall into place.  Who — once they had that clarity about where they stand financially —  would give it up just to save $10 per month?

If that’s not enough reason to maintain a subscription maybe it would help to know that services very comparable to LifeLock (ID theft prevention) and MyFICO (credit score management and optimization) come as part of the subscription for no extra cost.  We don’t add them on: they are part of how we do what we do.

It is our hope that enough people recognize the long-term value of this service to subscribe and stay subscribed.

Yeah, but how do we make money?  Home-Account appears to be disintermediating the entire mortgage broker business and $10 per month seems a poor trade for $3500 per loan in lost fees. 

That depends on who you are.  Home-Account is loyal to homeowners and would-be homeowners and for that group the $10-per-month trade for $3500 in fees is GREAT.  And it’s not all that bad for Home-Account, either.  What we do is complex but it scales well.  We have costs, but they go down with volume. There are 52 million potential customers in the U.S. alone so we have plenty of room to grow.

The best way to understand the Home-Account business model is in light of a comparable business.  Our preferred comp is PayPal. Both are Internet financial sites serving markets of comparable size.  And where PayPal’s gross revenue per customer last year was $14.17, Home-Account’s revenue per subscriber is $119.40.

We can live with that.