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.


Veritas Maximus said...


whats my name said...

I think the foreclosure sale window is a little too stringent. I certainly disagree that the motivation for letting the wall street fox into the banking henhouse was to gin up liquidity for CRA, and other government preferences.

Otherwise, I am entirely queasy at the degree to which you, Karl, and I are in agreement.

Eleua said...

Let me quote President Clinton upon signing Graham-Leech-Bliley in November 1999:

will guarantee that our financial system will continue to meet the needs of underserved communities, something that the vice president and I have tried to do through the empowerment zones, the enterprise communities, the community-development financial institutions, but something which has been largely done through the private sector in honoring the Community Reinvestment Act. The legislation I sign today establishes the principles that, as we expand the powers of banks, we will expand the reach of that act.

That was from Clinton's statement during the signing ceremony. He had previously threatened to veto it IF it would scale back minority lending requirements.

Sorry, but thems 'da facts. You can't shove lending risk onto the .gov and have normal market feedback mechanisms in place. By passing this, the .gov could keep the party going longer by increasing the wave of liquidity (in reality - leverage).

They pulled the safeties off the banks and someone got hurt, just as anyone with two firing neurons would expect.

Eleua said...

You can read the official statement at this link:

whats my name said...

How do you know when a politician is lying? This was a cover story for Clinton. It is a credit to his intelligence that he realized this giveaway gets less static if it is sounding like a social good. This was really a source of liquidity for wall street, not government programs.

I was in the national banking system doing credits for 20 years. I was never pressured, let alone forced to lend or approve on substandard underwriting for CRA. We liked to get the credit, and it was a pain to do the tracking, but you were OK by simply not discriminating. I saw one really bad deal justified by CRA. It was a small deal approved under a production team-leader's authority, and it was about making his numbers, not CRA.

What really sunk the big commercial banks was their desire to recreate the top management bonuses they made by buying stocks in the tech boom. When that market busted, and they had to go back to lending money, they wanted to retain the cuts in both direct employment and reserve requirements by holding their loans as securities. Once they could gamble with these via derivatives, and especially credit default swaps, it was a matter of waiting for one big counter-party blowup. The smaller banks got crushed between the resulting liquidity freeze and broke borrowers decimated by the recession. Same trigger, but a different problem.


Theirs no recovery in sight. Just more of the same bleak economic news that is.