How to End the Credit Crisis at No Cost to US Taxpayers

[AlphaCentauri]

Shah Gilani writes: While it's clear from the current credit crisis that our financial system is at a critical juncture, it's just as clear that there's no agreement over how we should fix the problems we face. The reality is that neither the plan put forth by U.S. Treasury Secretary Henry M. "Hank" Paulson Jr . - nor any of the addendums offered up by Congress or the lobbyists - will resolve this crisis.

The key culprits are the structured financial products that reside on the balance sheets of banks, dead investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide , as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) market.

Because all these securities , and in the case of credit default swaps, bilateral contracts , are impossible to value and impossible to guarantee, no one trusts them . As a result, everyone is afraid of these securities and contracts.

Banks are currently not lending to one another because they are afraid that the next round of write-downs and losses may imperil some of their trading partner banks to which they formerly lent billions and billions of dollars to every night. If the answer were really as simple as adding liquidity, the Federal Reserve would have lowered the Fed Funds target. But that won't work. It's a vicious cycle that's eroding banks' faith in one another, and worse, our faith in our banks.

Unfortunately, I don't see the Treasury Department's much-needed rescue plan being effective without actually addressing the pricing of - indeed, the very existence of - credit default swaps and collateralized debt obligations . As well intentioned as it is, the Treasury plan will create more problems than it solves and will eventually saddle taxpayers with so much debt that it will tank the dollar. It could even put the U.S. government's AAA investment rating at risk. That would be calamitous.

I have a modest proposal that I'm calling the Money Morning Plan, because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. The bottom line is that my plan will end the credit crisis quickly with potentially little or no cost to taxpayers. And those are the two most important benefits of all. I present my plan as an open letter for public debate.

Contributing Editor and credit expert Shah Gilani outlines a bailout plan that could ease the banking crisis at a minimum cost for U.S. taxpayers. It’s a complicated issue, no doubt. Please take a look at the "Money Morning Plan" below. If you believe some (or all) of these points make sense, we urge to pass them along to your state’s representatives, as the Congressional dialogue is now in full force and time is of the click here to get a listing of your state’s representatives.

An open letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. Bernanke, Distinguished Members of Congress, and the American Taxpayers:

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Dear Ladies and Gentlemen,

How we respond to the upheavals in our financial markets will define the American character at home and in the eyes of the world. With our cherished history of free markets and entrepreneurial spirit, we should guide ourselves as we always have, trusting our collective financial interests to our Constitution, which created a government by the people, for the people. Trying times are not a mandate to foreswear our personal, financial nor collective economic interests to any lobby or government other than one that protects all our rights, especially the right to not be taxed unfairly or unjustly.

The proposed Treasury Department rescue plan before Congress has not been presented without due consideration. There are, however, other proposals that merit our collective contemplation. As a taxpayer and investor, I am proposing an alternative plan for open discussion. We need to act quickly, but we need to act responsibly.

Respectfully;

Shah Gilani
Contributing Editor
Money Morning
www.moneymorning.com

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The Money Morning Plan
Establish an empowered, not overpowering, regulatory apparatus to rein-in structured products and establish protocols for the creation and tradability of financial products based on real-world economics and hedging considerations. Products must be transparent, easily valued and rated on a universal ratings model .
Establish regulated standards to support the universal ratings model and allow free-market competition for providing rating services based on a "pooled-income revenue model," whereby all issuers that either want to be rated, or that are required to be rated, pool funds on a per-volume, pro-rata basis and ratings providers are paid blindly for rating services.
Immediately stop the issuance of credit default swaps without mandatory reserve requirements and safeguards typical of what insurance regulations already require of legitimate insurers. Net out all existing credit default swaps to tighten counterparty risk and unwind positions that cannot be secured by issuers meeting adequate reserve requirements. Eliminate virtual insurers .
Only allow issuance of credit default swaps up to the actual outstanding dollar value of corporate debts and loans outstanding. This will ensure legitimate hedging and eliminate undue pressure on outstanding debt issuers.
Create a class of " eligible (mortgage-related only) securities " that constitutes problem securities. Leave all eligible securities on the books of existing holders.
Have eligible security holders identify to the U.S. Federal Reserve every eligible security by CUSIP and face amount. Only the Fed will have knowledge of institutional and investor positions. This will allow the Fed to correctly assess the risks at hedge funds and others with "significant operations" without exposing their positions to competitors.
Create a new accounting domain in-between " held-to-maturity" and "available-to-trade " where only eligible securities , as of a predetermined valuation date , can be accounted for at their value on the predetermined valuation date and not further subject to fair-value ( marked-to-market ) accounting, while held.
Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date , preferably as soon as the Fed expects all eligible securities to be registered with it. Those who have recently marked their securities have already taken their write-downs; those who haven't will have to. If the totality of the resolution represents a bona-fide solution, investors and speculators will bid up eligible securities to own them before the predetermined valuation date, because of newly ascribed accounting advantages of holding eligible securities .
Reduce the haircut on the reserve requirements for all eligible securities covered by this plan. Since valuations have already fallen precipitously, reducing reserve requirements on eligible securities would additionally enhance their value as balance-sheet assets with upside potential.
Have both the Fed and Treasury determine a liquidation or receivership outcome for holders suffering from insolvency as a result of accurately marking-to-market their holdings on the predetermined valuation date in the event bankruptcy would result in further systemic problems. This scenario would be cheaper and quicker to manage than what's in store for us under the present Treasury draft, and it allows the two to assess the potential fallout of insolvent entities prior to their exposing the financial system to resulting disruptions. Hedge funds would not be saved.
The Fed must establish and manage a conservative, transparent pricing model for eligible securities based on actual underlying cash-flow measures, projections and model specific criteria. Absolutely no trading would be allowed over-the-counter or otherwise on any of the eligible-securities specific pricing models or indexes.
The Fed, with a firm handle on all eligible securities and a transparent-pricing methodology, would have to take in any and all eligible securities as collateral against Fed borrowings from the discount window or through its dealer facility.
"Servicers" managing underlying mortgages on behalf of trust entities, under which securitized pools are created, must be empowered to alter and modify terms and conditions of underlying mortgages in conjunction with originating banks or lending institutions.
To incentivize banks and lending institutions to modify existing mortgages and to incentivize homeowners to stay in homes with upside-down mortgage-to-appraised values, eliminate all capital gains on appreciation of newly appraised homes when they are sold by either homeowners, banks or lending institutions.
Create tax-advantaged scenarios for banks and homeowners partnering in the reduction of delinquent obligations whenever loans can be brought to a performing status.

http://www.marketoracle.co.uk/Article6459.html

[LonelyLRLiberal]

1. I am certainly no economist, but this addresses the CDS problem.

The Paulson proposal, nor the additions mentioned so far by the candidates, do.

[AlphaCentauri]

3. I agree, Paulson proposal has many blanks spaces

[denverbill]

2. Wow. I think I'd need someone to explain many of those things to me before I could support it.

However, I agree with the author that the current bailout doesn't seem like a very good answer and doesn't seem to address the base problem. His suggestions certainly merit some research.

[Waiting For Everyman]

4. YES! This is on the right track - it's the securities themselves which are frauds.

I'd only add that tranching should END. Bundle large numbers of WHOLE mortgages together, if banks must, and sell shares in that. But DO NOT create cross-slices of little bits of income-streams across these bundles. That is sheer craziness. It was theoretically (according to Phil Gramm) supposed to lessen the share of risk, but instead, it multiplied it - and credit default swaps multiplied THAT. It's all fictional money, mostly lost by large players who should LOSE and FAIL.

But tranching hurts homeowners too, and they have no say in it. It prevents banks from re-working mortgages in a legitimate modification.

I'm SO glad to see someone in print who is writing what I'm thinking. I just hope the legislators see it in time.

I'll pass it along, and I hope others will too. It's a MUCH better answer. We need to rethink this, not just throw a very expensive bandaid over a huge criminal mess. It won't help, and then we'll be bankrupt too.

[Karenina]

5. This is an EXCELLENT approach.

And I endorse your addendum.