Thursday, March 31, 2011

Getting It Over With: IER Reviews Karl Denninger's Plan For Credit Market Recovery

Peer review:
a process of self-regulation by a profession or a process of evaluation involving qualified individuals within the relevant field. Peer review methods are employed to maintain standards, improve performance and provide credibility.
Today, we shall be reviewing Karl Denninger's "Four Point Plan" on how we can put this credit monster in the rear view mirror.

Citations of Denninger are taken from his podcast of July 20, 2009.  If anyone can forward the link to his actual white paper on the subject, I would be glad to refine my remarks to reflect more accurate and detailed information.

Summary:  Denninger's proposal is essentially an accelerated cleansing of our credit markets from the decades long debt binge that brought us here.  Think of it as a fiscal "porcelain princess hugging" after a three day bender with Charlie Sheen.  He makes no apologies for the abruptness of his approach and this is the primary feature so loved by the IER.  Essentially, Mr. Market is awakened from the morphine drip he has courtesy of the US Treasury and Federal Reserve, and weighs into the battle hopped up on Red Bull, khat, and that enormous pile of blow Tony Montana inhaled in the final scene of Scarface, taking no prisoners and leaving piles of red protoplasm where mortal men once stood.

POINT NUMBER ONE - Stabilizing Housing Prices.

Denninger called for Uncle Sugar to rewrite and backstop new loans for existing primary residences with the following features:

  • Existing mortgages - not new mortgages
  • Primary residences - not vacation homes, rentals, cottages, etc.
  • 4.5% / 30yr fixed.
  • Must qualify without FICO
  • Must qualify under 36% Debt to Income (DTI)
  • Loan rebased to the lower of outstanding balance or appraised value.
  • Marketable by Ginnie Mae
  • Borrower's credit hit on reset as if it was short-saled or foreclosed
  • This program runs for exactly six months.
  • All delinquent mortgages (defined as 90 days or greater delinquent) are to be foreclosed by the note holder and then have properties sold into the open market by auction, if necessary.

Assuming this is an accurate reflection of Denninger's first point, the IER likes it, but let's break this out point by point.

Forcing the banks (and we assume the money markets, retirement funds, and other investors) to take back and disgorge all the delinquent properties is an idea whose time is long overdue.  Approximately 14% of all housing in the United States is vacant.  That's 1 in 7.  Getting all this out into the market place at auction will bring about cash sales with very low prices.  We are talking about prices that make living in a house cheaper than living in a Ford Econoline down by the river.  Most of them will be snapped up by PEOPLE WHO HAVE SAVED CASH AND AVOIDED DEBT!!!  Perhaps Generation Y can finally move out of their mother's basement and surf the porn sites and play D&D in their own homes.

I'd go a step further and require, as a condition of non-judicial foreclosure, that the institution so foreclosing must sell the property to a disinterested third party no later than 183 days after taking possession.  No bank licensed to do business in the state can hold REO longer than 183 days.  If the bank can't sell it via Cookie and Candi, then the sheriff sells it on the courthouse steps.

Those who find themselves holding title to a bunch of new properties at fabulous prices will now have the ability to either fix them up and sell them for a tidy profit, thus establishing the new baseline for housing of that class, or rent them out for a very appealing ROI and have true income properties.  Go long HD stock.

This provision would certainly turn any large lending institution or retirement fund into a road pizza, but new banks would pop up and take their place.  Prudence is rewarded while tomfoolery is punished - exactly the way it should be.  Current home owners, including those that refied under Denninger's Ginnie Mae provision, would be massively underwater.  This changes nothing in this regard other than the timing.  This just gets us to where we are going in a faster manner. 

Anyone who has partied a little too hard knows all too well the Technicolor yawn is coming sooner or later, so just stick your fingers down your throat and get it over with.  There is no way to avoid this outcome.  Imprudent banks and homeowners (lending and buying at the peak) are facing this reality.  The only game we are playing is a multi-trillion dollar game of musical chairs.  Either way, the problem is still there, we are only determining whose butt isn't in a chair when the music stops.  Someone has to take the hit, so let it be the ones that loaned and purchased at the peak, rather than suckering in those who didn't.  Cosmic justice, folks...cosmic justice.  It's how an intact society is passed from one generation to another.

The idea that new housing loans must conform to a framework of sane lending is also a fantastic idea and Denninger has been pounding the table on this for at least 4 years.  36% DTI (back end) is a great place to start.  This would certainly cut off those recent graduates from the local degree mill who have racked up over $100 grand in non-dischargeable debt from qualifying.  Believe it or not, this is a good thing.  First off, it will reduce the price of homes in the lower tier to reflect the lower demand.  It will allow those who prudently managed college debt to enter into a higher strata of home, and it will put some curb on Big Ed, as kiddies won't want to tie on that much debt just to have a degree in Ancient Peruvian Poetry or Ethno-psychobabble.

I've been following Denninger for the last 4 years and know that he also advocates (and I assume is implied in his plan) that 28% of income be the limit for housing costs, which includes maintenance and some utilities.  That would also clamp down on home prices.  People would have to qualify on both counts.  He also believes that a hard 20% CASH down payment (not another loan or PMI) be part of qualifying.  This is essential because it goes to the heart of showing how a couple can save for the unforeseen event, but more important to our discussion, it puts quite a bit of borrower skin in the game while giving the banks plenty of lead time to grab and sell that home in the event of delinquency.  In this case, the borrower is ruined, not the bank.

The 20% down requirement would have single-handedly saved the banks in 2008.  NONE of the banks would have swirled the bowl, because the 20% down requirement would not have allowed prices to escalate to unsustainable levels and the entire brunt of it would have been borne by the borrowers.  Risk management is always said to contain two components:  frequency and magnitude.  I say that prudent risk management contains a third element - placement.  I can manage likelihood and enormity a lot better if I can place that risk on someone else.  In this case, the borrower sustains all the risk.  That's a risk management profile any banker should love.

I scratched my head and wondered why Denninger wants Uncle Sugar, who is already tapped out to the tune of $14 trillion, to underwrite more paper.  At first, I assumed his better angels were winning the day and he was trying to save homes for those who genuinely want them for the purposes of living, not speculating.  He ameliorates the seemingly goodie-goodie program by insisting that the new loan be marketable into the secondary market but only for the amount of the outstanding or appraised value.  I queried Denninger about this and he had an interesting take.

He is not looking at the humanitarian issues, but is looking at the unbridled jackassery the Treasury Department displayed when it changed the "implied" guarantee of Fanron and Fredron paper to an "explicit" one back in 2008.  His program rewrites the existing mortgages Uncle Sugar is presently underwriting and shifts the bulk of the burden over to the borrower.  He believes we can get out for probably 10 cents on the dollar compared to what we are presently doing.  This is probably the closest we will get to undoing Fan/Fred, so this gets top marks.

Any plan to reissue mortgages based upon appraisals must carry very strict guidelines and harsh penalties to prevent and punish abuse.  I promise you that any program that will have Uncle Sugar cosign based upon an appraiser's value will be rife with wall-to-wall fraud.  If anyone thought that the appraisers were pressured by Candi and Cookie to "hit the number" during the go-go years, they have not seen anything yet.  If I read Denninger correctly, your garden variety appraiser is going to be able to sign for the full faith and credit of the US government, so they had better be very tightly regulated.

He also says that the new loans would be rebased on a 4.5% 30 year product.  I'll assume the 4.5% was just a number that represents the current 30 year rate, as it has changed since he published his four points.  Either way, anyone who buys this paper at par for 4.5% or even 5.5% is going to take an instant bath when interest rates shoot the moon during the rebasing of the housing prices over the following year.  They will know this going in, so the only people buying this paper will be those who absolutely know for an iron clad fact that they will not sell it over its entire life.  Additionally, all those people who qualified under the new (or shall we say old) origination standards (28/36% DTI, 20%, verifiable employment history, etc) are going to be underwater and might have second thoughts about holding the house that just lost another 50% over the next 18 months.  I'm betting that performance on those would be no better than the marine mammal fecal tranche of all those CDOs that went "splat" during 2008.  It is implied that Uncle Sugar has recourse against the borrower under this plan to ensure performance of a debt instrument backed by the government.  Why not?  It presently does against those who borrowed money for a post-adolescent Bacchanalia at Beer Bong State U, so this is not a stretch.

Lower prices would free up consumer discretionary spending and savings.  That spells higher margins and more capital investment - both are going to be needed to kick start the economy.  One of the main reasons the economy stinks is that housing is NOT an investment, but it has tied up all our capital.  Higher housing prices are no more conducive to economic growth than higher energy prices or higher food prices.  Using this market clearing mechanism should be the centerpoint of any government sponsored "recovery plan."  The previous "painless" incarnations of economic recovery have only made things worse.  Pain is part of economics and is a good thing.  It teaches prudence in the same way your central nervous system teaches you not to shave with a cheese grater.


No credit cards (or other forms of unsecured debt) can be issued for more than 10% (1000bps) over current FED FUNDS.

I like this and give it the IER seal of excellence.  Here is why.

Any bank that can't make a profit on their plastic with the swipe fees and 1000bps over their overnight rate has bigger problems than deadbeat mall rats.  I've had a credit card since 1986 and have yet to carry a balance over from month to month.  Total interest paid since 1986?  $0.00.  Not one dime.  Total amount of defaulted credit card debt?  $0.00.

My credit card company makes plenty of scratch on the swipe fees, since I put almost every transaction on the plastic.  So, now that I have shattered the humeral head of my right arm patting myself on the back, why is this important? 

It puts banks back in the business of hiring black hearted meanies to deny people credit.  Perhaps we don't need to be issuing every college kid a credit card with a 5 digit limit.  Perhaps banks need to withdraw credit cards when people don't pay, or lower their credit limits.

In other words, treat credit as a luxury of the responsible, rather than a right of the Great Unwashed.  We need to incentivize the less credit worthy to save and use cash in order to develop the skills of handling their spending in a more responsible manner rather than reinforcing mindless consumerism and allowing those least capable to live beyond their means.

If banks can't subscribe the risk for a customer with FF+10, they shouldn't issue the card.

POINT NUMBER THREE - Repeal Bankruptcy Reform

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was Grade AAA legislative raw sewage.  This was written by MBNA and it shows.

Bottom line:  make debts dischargeable and the lenders will be much more choosy about lending.  This follows all the same philosophical underpinnings of the previous two points, and Denninger is spot on.  This is not populist smack-talk, but forcing bankers to do their jobs and occasionally say "no" when prudent.  I am comfortable speaking for Denninger on this point when I say that banks are debt merchants and they obviously want to sell as much product as is possible.  They also need to bear the risk for issuing their product.  I know for a fact that Denninger is an advocate of prudent risk management in the business sector and on this point he also gets a gold star from the IER.


Banks can not be run as high octane hedge funds nor can speculation firms have deposits guaranteed by the US government. 

Banking and "investment banking" (trading firms and hedge funds) are two distinct and separate business models.  One is in the business of shunning risk and the other is in the business of trading risk, so it stand to reason not to allow the two to co-mingle funds.

Again, spot on.  Banks can originate their own loans and sell them off as whole loans.  Collateral (trust deeds) must not be derivatives or amalgamated, but must be sold whole, by wet ink signature and in accordance with state law.  Banks are free to hold their own debt, but not buy speculative debt or derivatives such as Credit Default Swaps on speculative debt.

Investment banks do not take deposits insured by the government nor are they allowed to speculate in a manner that puts them in a position to make demands on the FF&C of the government.  They may trade their own unleveraged capital in any manner they wish, but no access to any bailouts of any form may occur.  If they blow up, they do so without any obligation of the public to make them whole.

The entire reason this provision was repealed in November 1999 was to increase leverage to keep the wave of liquidity washing over the financial markets rolling and to underpin other unsustainable laws, such as the Community Reinvestment Act.

All in all, Denninger is on the right track.  I'd like to share his optimism for the marketability of the new Ginnie Mae mortgages just prior to a controlled detonation, but other than that, he nails it. 

Open up and say "Ahhh," America.  It's time to blow chunks.

Thursday, March 24, 2011

Nobody Makes A Commission for Moving You To Cash

I know, I know...the IER has been dormant since the Seachickens butterfingered their way out of the playoffs, and the vast and loyal readership of the Westsound's premier economic blog have been jonesing for a fix. Here is a little bit of sanity to tide all of you over until the senior fellows can unclog their inboxes and devote the time needed to keep all of us in the right frame of mind.

I am in the finishing stages of a woodworking tour de force, and have been spending my spare time trying to keep all ten digits attached to my hands as I finish off my 13yo daughter's desk.  It has a leather top, 6 hidden compartments, lever actuators, dovetailed drawers, etc.  During the time in the woodshop, I listen to a fair amount of AM talk radio, just as I have for most of my adult life.  I'm starting to understand that the best fade might be the advertisers on AM radio.

In the final stages of the housing bubble blowoff, we had some fiscal menace with a Georgian accent advertising the "biggest no brainer in the history of Earth," which was just a cash-out-refi scheme to use your house as an ATM.  Let the record show that scheme didn't end so well.  There wasn't a commercial on the air that wasn't some form of housing bubble get-rich-quick scheme.  It got so bad that I had to create a "kill switch" for my radio so I didn't wear out the concrete floor of my garage dashing to and fro in a desperate effort not to hear the K-I-E-L Mortgage jingle.

Well, as the vast and loyal readership of Clearcut Bainbridge know, I'm not drinking the goldbug Flavor-Aid, no matter how many times the yellow metal is pimped on the radio.  I lived in a rental during the housing blowoff (and had to endure the unceasing torrent of finger wags from every shoeshine boy/home owner/RE agent in Western Washington) and in a similar fashion, I am in cash during this idiocy.  Apparently, it's finger wagging season once again.  The US dollar is going to be worthless, dontcha know...

OK, let's get on with the facts.

First off, let's bring out the favorite chart of the goldbugs.  Let's talk about how the US dollar always inflates and therefore you must own something "hard" to compensate for the inexorable fall of the dollar.

As anyone who has completed the 5th grade (7th grade if you went to Port Orchard schools) can plainly see, the US dollar is about as hard as the Stay Puffed Marshmallow Man.  Why golly gee...every single year sees the dollar get smaller and smaller, and look at that "hyperinflation" of the 1970s!!!

Never mind that gold got crushed, and I mean CRUSHED, by the Stay Puffed Marshmallow Man from 1980 to 2002, even though the US dollar got weaker every single year.

How can that be?  After all, gold (or any "hard" asset) is a shelter against inflation.  Right?  Mike Medved says so.

Now is the time for goldbugs to go out and Google "cognitive dissonance" and do a 5 paragraph essay on the subject.

In the meantime, let's extend our X axis out to the left a few years.

 I guess we do get deflation from time to time.  The financial crisis of 1920 was very severe, but it was short lived.  The credit expansion for the worst foreign policy in US history was being corrected by the market with a dollar that was RISING IN VALUE.  We then got the "Roaring 20s" and the rest of the excess was removed during the Hoover Administration.  Had it not been for the arbitrary and capricious nature of the New Deal, we likely would have pulled out of the Great Depression with the rest of the civilized world.  We see credit expansion during WW2, and then a general rise of inflationary expansion to the modern day.

It is the IER's opinion that this massive move of credit expansion ("inflation" to you goldbugs) is really nothing more than leverage upon leverage.  We are avoiding credit contraction ("deflation") by force-feeding CREDIT, not cash, into the system.  Let's do that one more time, but with more elan:

Americans are piling on more and more debt of a riskier and riskier nature to prevent the inevitable and mathematically certain consequences of credit expansion - credit contraction.  After all, the best way to avoid hangovers is to just keep getting really, really wasted.  This is exactly what came to pass in 2008.  Hank and Ben moved us to a more reckless position to take on even more debt to prevent the natural consequences of seculum-long debt binge.  Can anyone say that Hank and Ben did anything other than take on more debt to "fix" the financial crisis of 2008?  Anyone?  Sure, they transferred a bunch of it to the US Treasury, but it is still there, just a different bag holder.

Now, for those who don't like the feeling of blood draining out of your head, you might want to skip the next chart.

My, oh my.  What have we here?  It looks as if the natural consequence of credit-expansion is credit-contraction, and the anomaly isn't deflation, but sustained "inflation."  It would appear that the green ink and blue ink are roughly at parity until we get to WW2, when we get a very long credit-expansion boom.

As we say around the IER, "The boom causes the bust."  Now you know why.  The higher you throw the rock into the air, the harder it hits the ground when it returns to parity. Guess how high we have thrown the current "rock" into the air?  Oh, yeah...

Gentlemen, deploy your barf bags.  When Tim and Ben quit their multi-trillion dollar juggling act, the suckmeter is going to be pegged.

As for now, if you are holding cash, you just have to be at peace with the goldbugs having their time in the sun.  Make no mistake, the repercussions of a credit-contraction on this scale will be positively epic.  Picture what happens when Uncle Sugar can't borrow 42 cents of every dollar he spends.  Pax Americana will get cut, but the real bloodletting will be in entitlements, particularly Medicare and Social Security.  Sorry, but the math doesn't lie.  The suckmeter will be pegged, and that is no understatement.  Picture California without welfare checks...Picture Pike Place Market grommet-heads with no trust fund...Methinks granny is going to move back in with the kids and grand kids, and that ain't bullish for housing.

Perhaps if we just allowed the periodical, natural cleansing of credit-contraction to occur when the market dictates, we wouldn't have this problem, hmmm? (done in my best Dana Carvey "Church Lady" voice)  I'd like to think we would all be better off if the suckmeter needle stayed in the green arc on the gauge, rather than blow right through the amber range, the red range, fuse itself to the peg, and have the gauge explode because it sucks so bad.  This is how you teach fiscal discipline to the next generation.  Those that overdo it on the debt binge get taken out, chopped up, and sold to their cash-laden, well managed competitors.

I will say that the "hyper inflation" meme isn't an impossibility.  If the US government prints up strawberry scented welfare checks denominated in $100,000 increments and sends them out to everyone in the US, I'm on board with the whole "inflation" concept.  Granted, that presumes it stays in circulation.  It also presumes that people will just pay $40 for a gallon of gasoline, and that their employer will pay them $200 per hour.  Good luck with that scenario.  My employer can barely make payroll because of high input costs (Jet-A), so that fancy-schmancy 50% pay raise my union is asking for isn't really being taken seriously.

What is the moral to our story?  All these dire predictions of doom and gloom, coupled with "hyper inflation" are just goldbugs trying to sell you something.  Just as the scary prediction of "buy now or be priced out forever" came from Cooki and Candi, the wonder-twin RE agents, because they were trying to sell you something, the same scare mongering about "hyper inflation" is now coming from the metalheads.  Remember, there is no "sell side" analysis on Wall Street because nobody makes a commission for moving your portfolio to cash.

Every time you turn on the lobotomy box, radio, computer, newspaper, etc, you are being sold something.  Someone is trying to separate you from your money.  Cash doesn't have a salesman.  Food for thought.