The Only Solution for this Mortgage Driven Recession

This post may appear to be long, about 4,000 words.  It needs to be, if we are to outline the problem, the solution, and why the solution will work.  It is a complex problem.

Perhaps instead of the social engineering non-stimulus, stimulus package and the wildly off the mark mortgage bailout, we might actually attack the problem from the correct end of the black hole.  Bank capitalization and reserves are in a downward spiral due to the declining value in mortgages they hold and the tanking mortgage backed securities they hold.  Banks are not lending since the mortgages and mortgage backed securities are now placing their capitalization and reserve in a precarious dangerously weakened position.  The mortgages the banks hold and the mortgage backed securities are tanking because the property values in residential real estate are tanking.  Foreclosures are forcing property values down and the Mortgage Bankers Association and Credit Suisse are projecting 7.7 million cumulative foreclosures by 2013 up from the 1.8 million cumulative projected foreclosures starting 2009.  The mortgages are falling into foreclosure do to the high percentage mix of sub-prime borrowers in the portfolio.  Don’t let any politician tell you that these people are in sub-prime mortgages.  There is no such thing as a sub-prime mortgage.  There are only sub-prime borrowers.   These borrowers for some time have been called sub-prime because their credit history and ability to pay were less than prime.  These are the folks with high risk credit scores.  No matter how badly the politicians flail at getting us out of this financial crisis, they keep trying to save the sub-prime borrowers and risk losing the entire ship of state.

This recession was brought about by an unrealistic multiplier (The Mulitplier Effect) of the money supply from the size and amount of sub-prime credit, both mortgage and credit card availablility.  People used the equity in their homes to make major purchases and home renovations.  This credit products also multiplied the money supply.   The gas crisis, remember that problem, that was ignored by the Bush administration and the Federal Reserve, severely reduced the amount of disposable income for individuals and businesses.  Spending lessened and loans started to go past due.  Foreclosures started to pick up pace and as they picked up pace home values fell exacerbating the foreclosure problem.  Gimmick low rate initial payment loan terms went away and mortgages reset with higher rates adding to the squeeze on disposable income.  The loss in home value meant that the spending your home’s equity on major purchases would dry up.  Neither the Bush or Obama Administrations seemed alert to spot this trend.  The unrealistic multiplier of the money supply, credit, started to shrink, shrinking the money supply.   The first group to take the hit so to speak were these sub-prime borrowers who should have not been in mortgages at all.   Yet they were encouraged to seek loans and our banks were strongly encouraged to make these flimsy mortgages by our politicians, a good majority of them democratic politicians.

What Does Multiplier Effect Mean?
The expansion of a country’s money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited.

Investopedia explains Multiplier Effect
The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the multiplier effect on the money supply, we start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64. This cycle continues – as more people deposit money and more banks continue lending it – until finally the $100 initially deposited creates a total of $500 ($100 / 0.2) in deposits. This creation of deposits is the multiplier effect.

The above is an excerpt from Investopedia, a Forbes digital Company, it describes the effect of the credit multiplier on money supply.

We must cut the sub-prime borrowers adrift – yes they will lose their home, but they will find a place to live.  Foreclosure does not mean that you are now living in a refrigerator carton.  We must focus on salvaging the people who play by the rules and pay their bills, even when things get tight.  If we don’t cut the sub-prime borrowers loose and save the rule playing borrowers now, the entire economic system of this country will crash.  This country’s economic and monetary systems simply cannot handle the loss in wealth caused by the further exaggerated decline in the stock market, retirement portfolios, invested pension plans, and home values brought about be destabilization of the residential and soon the commercial real estate markets.  The next credit exposure shoe to fall, and it has started, is the short term and revolving credit industry with charge and credit cards, and auto loans.  The value of personal and business vehicle fleets is also of concern.  That wealth is declining at a rapid rate as well.  Further delinquency here will erode the bank’s capitalization reserves even more so.

To date from our Bush Administration, we had a plan to save the banks and investment houses by injecting capital (life blood) into the financial institutions without sealing the bleeding artery. Then the Obama Administration took a shot and chose a populist approach.  Let’s use this crisis to make people beholden to their government for life, with the great stimulus package that has no hope of stimulating, and let’s reward our friends with perks.  They chose to selectively decide who gets help and who does not, instead of trying to seal that bleeding artery and attack the root cause.  Their insatiable desire to save those sub-prime folks in foreclosure or heading to foreclosure is the driver of the miniscule $75 Billion current mortgage rescue plan.  We can spend $8 Billion on a train from Los Angeles to Las Vegas, and another $300 Billion on long term non-stimulus plans, but we cannot use the full financial effort to stop the bleeding – the downward spiral of home values, which begets more downward spiral, etc.

Does anyone believe that rewarding the cause of the problem, the entire sub-prime industry from banks to borrowers, will stem this tide?  All we have done is make it okay for these rule playing people to jump to the other side and stop paying, so they can be saved and actually be paid by the government for making mortgage payments in the future.  Since we are intent on spending another $1.2 Trillion beyond what we spent on TARP one, we should reverse course on the stimulus package, the mortgage rescue, and TARP two and shift direction.

First some background:
Today anyone who resides in a home for 2 of 5 years can sell that home and exclude the gain (sale price exclusion) on sale up to $250,000 or up to $500,000 married filing jointly.  This means that they pay no tax on the sale of the home up to the exclusion.  The original price of the home and any material improvements to the home increasing its value was the basis of cost.  So If I sold my home, as a single taxpayer, for $500,000 and the basis of cost was $200,000, I could exclude $250,000 of the $300,000 realized profit and pay taxes only on the remaining $50,000.

Now the solution:
Establish a tax credit in an amount up to the difference between 95% of the current fair market value (FMV) of the home and the total mortgage debt on the home from one or more mortgages.  Say the home’s FMV is $200,000 and the total amount owed is $240,000, then the tax credit would be $50,000 [$240,000 – ($200,000 X 95%) = $50,000].  A fifty thousand dollar special tax credit due on the 2008 tax return – those who already have filed can file an amended return would pay down the principal on the existing mortgage.

The rules would be:

• The tax payer or tax payers filing jointly, as long as one or both are sole owners of the home, agree to waive their future right to the sale price exclusion and further agree to pay a special capital gains tax of 75% of the realized gain on the sale of the home in the future, to be collected at closing and remitted by the title company.
• The 95% amount of the FMV becomes the new basis for property cost.  The tax credit is then sent to the first mortgage holder as a principal payment, and as long as the loan is current, the bank accepting the principal payment must agree to refinance the home including any second mortgages and equity line balances for 30 years at a market prevailing rate based on prime plus 250 basis points (BPS).  (The problem has always been how to unravel the ownership of these mortgages in securitizations.  This payment approach is the only door to unraveling these mortgages.  As mortgages are repaid or paid off this door to the matrix opens and directs the money to the appropriate place – unraveling solved.)
• An example would be prime of 3.25% plus 2.5% = 6%.
• Banks accepting these principal payments will be required to finance the sale of any foreclosure, at prime for 30 years for prime borrowers at 90% of FMV.

The effect of this plan:

• The bleeding artery will be sealed.
• This will lower the exposure of the banking industry by paying off all mortgages held, including mortgages included as a securitized asset.  The capitalization of the banking industry will skyrocket.
• Market capitalization of traded companies will start to rise (Dow, S&P. NASDAQ, etc.)
• Invested pension plans and retirement portfolios will stabilize and begin to grow.
• Banks will be able to loan again.  Credit will start moving again.
• The federal government may recoup some of this bailout money tax credit with future sales, if the market recovers and prices improve.
• Borrowers will have more disposable cash to spend due to the lower debt and lower rates.
• Foreclosures will drop dramatically.
• Banks will be able to sell foreclosures.
• Unsold home inventory will drop.
• Rule Players will be rewarded for playing by the rules.
• Sub-prime borrowers, who brought payments current – out of pocket, no borrowed money – will have an opportunity to actually pay the new mortgage or sell and seek something more akin to their credit history.
• Home sales will again be possible.
• When a home is transferred the new buyer usually spends on durable goods, home maintenance, and beautification materials.  Other home stuff will be purchased, as well.
  Banks that still have a capitalization problem can be allowed to fail, since so many more banks are now stable.
• The immediate disposable stimulus money in the hands of the people will be spent, helping to turn this economy around.
• Jobs will come back.
• Over time, sales of these realized gain exclusion homes will bring a portion of the “tax credit investment” back to the government to be wasted somewhere else on a populist project.

We know that the Obama Administration will not attempt this plan, because they, as good socialists, are fixated on rewarding failure at the expense of the rule players.  As this economy, the stock market, your pension plan and retirement portfolio, your home, and maybe your job continue to tank as we save the failures and sub-prime borrowers, make a mental note for November 2010 to vote against the Representatives and Senators who allowed Mr. Obama to save everyone but the mainstream, mainstreet rule players.  If we don’t make a “Change”, we will lose this country and the economy will go first.  Our standard of living will crumble and our freedom will fade away.  You might say that this crisis is important to fix correctly, without deference to ideology.

I don’t think that I am alone.  Watch this YouTube video.  Lets vote as he said.  Please cast your ballot.