Thursday, February 12, 2009

Market Conditions

Another month, another plunging stock market. This marks the fifth month in a row that the market has experienced abnormal fluctuation. I don't know about you, but I'm getting a bit tired of it.

I have little doubt that this latest plunge is due to a continued lack of leadership and outright irresponsibility by our congressional leaders and our new President. Promising hope and change we have gotten the exact same type of irresponsibility that the last four congresses have brought us.

The AP reported yesterday that Americans should start seeing an extra $13 in their paychecks soon, that should really stimulate things.

For nearly a year I have stated that we need to deal with the underlying issues, we need to treat the disease not the symptoms. Instead we are going to continue to ignore the disease as if it can't be diagnosed or isn't real. In the President's first press conference he outlined his priorities:

Priority One

"A particularly urgent priority is a further extension of unemployment insurance benefits for workers who cannot find work in the increasingly weak economy."

Priority Two

"Second, we have to address the spreading impact of the financial crisis on the other sectors of our economy -- small businesses that are struggling to meet their payrolls and finance their holiday inventories, and state and municipal governments facing devastating budget cuts and tax increases."

Priority Three

"In addition, I have made it a high priority for my transition team to work on additional policy options to help the auto industry adjust, weather the financial crisis, and succeed in producing fuel-efficient cars here in the United States of America."

Priority Four

"we will review the implementation of this administration's financial program to ensure that the government's efforts are achieving their central goal of stabilizing financial markets while protecting taxpayers, helping homeowners and not unduly rewarding the management of financial firms that are receiving government assistance."

Fixing the actual problem, which is an over-leveraged America barely makes the fourth priority (and only $50 billion has been pledged). This has to be the first priority and it has to start with a comprehensive plan to determine how best to handle all the homeowners who either can't afford their mortgage or have a financial incentive to give the home back. There are certain people that should be foreclosed on, but many others that the right thing to do financially is to write down the mortgage permanently.

Since this press conference and the two days of press conferences and congressional testimony by Treasury Secretary Timothy Geithner the markets have plunged, despite the passage of the "stimulus" bill that would save us all. Kind of reminds me of last year when a President, a Congress and a Treasury Secretary said that the world would fall apart if we didn't pass an $800 billion dollar plunged after it was passed.

It is clear that the market sees no leadership on the economy and is making its concern known.

Regardless of how you feel about Obama or the congress (judging by poll numbers most people still like Obama and still despise congress) he has America's priorities backwards.

Extending unemployment benefits is well and good, but allowing the private sector to provide long lasting jobs should be priority one.

I was against President Bush's stimulus package last year and grudgingly supported the TARP legislation despite the sick, twisted and demented pork that was added to it to bribe senators and congressman to vote for it. I want to make it clear that I do not oppose the stimulus because Obama supports it, I do not support it because it is makes no economic sense.

What needs to happen is the following:

1. Stimulus package must be killed or re-tooled. This won't happen so we'll have to live with it.
2. The first priority of the President, Congress, the Fed and the Treasury Secretary needs to be the Credit Crisis.
3. Banks must be allowed to fail
4. A mass write-down of mortgages must be undertaken (more on this in a minute)
5. Bad assets must be dealt with in a methodical way
6. We must incentivise business by cutting their taxes
7. We must not adhere to or pass anymore "buy american" clauses and we need Judd Gregg and Hillary Clinton to embark on a world tour of our partners to ensure they understand how much we need them (and vice versa). A trade war will doom the economy as it did during the 30's.
8. Reduce the tax burden on the middle class.

Much of the above might be controversial, however the most controversial is number 4, the mass write down of mortgage and other loans. People are upset that their tax dollars might go to pay off someone's mortgage that never should have been given a mortgage in the first place - this is understandable, however it is also unavoidable. This can be done though on a mass scale and in a way in which taxpayers don't share the entire burden and in fact will benefit.

The reason we can't move forward with our economy is because America as a whole is overleveraged - there is no capacity to borrow even if the money was available (which it isn't because institutions finally realized its stupid to lend to people who can't pay it back.....even if the government tells them it is ok).

Housing in many area's is down over 50%, in some area's 70%. In those area's even the people who are current and can afford their mortgage have a huge financial incentive to walk away and they will. Others simply couldn't afford the home they bought, still others lost their job and have no income. The solution is not to allow people who can't afford the mortgage to stay in the home, those people must be foreclosed on (flippers as well). Here is the solution:

1. Determine the value of the property
2. Determine if the current homeowners could afford the property at the current value or at 20% above the current value.
3. If so, re-write the mortgage to a 30 year amortized loan at a reasonable rate and let them stay in the home, if not, foreclose.
4. As part of the principal reduction in the loan the homeowner must give up appreciation rights. The appreciation rights they give up can't be too little or too much as their would be no incentive - but lets say they must give up 25% of future appreciation in exchange for the write down.

The announcement of a plan like this will automatically spur home prices upward, in some area's by a little, in other areas by 10% or more. Let's go through an example:

Homeowner bought a house for $500,000, it is now worth $185,000 (yes, its that bad in many places). If the there is no plan this homeowner will walk in all probability (whether they can afford the payments or not). If the homeowner walks the bank will own the property and it will sit there for a long time, the bank will be responsible for upkeep and property taxes. Eventually the house might sell for $185,000, but in all likelihood it will sell for lower and after legal costs the bank will net about $140,000, a loss of 72%.

Under my plan the house would probably be worth at least $200,000 after the announcement as people who had planned to go into foreclosure (or were in it) decide not to go through that process. The price may go up even more as it was artificially depressed by all the other foreclosures that caused the downward spiral in the first place.

Let's be conservative and put the value at $200,000. The bank offers the homeowner to write the mortgage down by 50% to $250,000, or 25% higher than the house appraised for. The homeowner is expected to share in some of the losses. Yes, the bank now has a loan that is at 125% loan to value, but that is better than 270% loan to value (that will foreclose). In addition, the interest rate drops to 5% and is fixed for 30 years and amortized. The homeowner agrees to give up 25% of all appreciation over and above $250,000 (the bank gets the first $50,000). Granted, the 25% number can be adjusted. 30 years from now the home is paid off and worth $500,000, the homeowner could borrow to pay off the appreciation rights or sell the home and net $387,500. The payment would drop to about $1,350, from close to $3,000. This could be supported with a job that pays in the $50,000 range. To incentive the banks to do this the government would add in a guarantee of a certain amount if the loan goes back into default.

The numbers can be adjusted to whatever makes sense, the above is just an example. This would take time to work out, but it would represent exactly what President Obama has asked of us all, "Shared Sacrifice". The bank takes a loss, the homeowner shares in the loss (and gives up future appreciation), the government shares in the loss (of which they had some responsibility for) and the country as a whole can begin the difficult steps of moving forward.

So how do we pay for this.......good question. There is only one way to pay for it - print more money. That is how we are financing the stimulus package. My mortgage write-down program would negate the need for the stimulus as it would be a stimulus in and of itself. The family above would have $1,700 more per month to spend - of course the above is a bit of an exaggeration, but there would be more money to spend, save and invest. In addition, without all that extra mortgage interest being deducted there would be more tax dollars coming in.

I hate the printing of money, but our other option is to become Japan and ignore our fundamental issues.

Of course none of my plan addresses the real structural issues of our country - Social Security and Medicare (and excessive state and congressional spending by both Republicans and Democrats). These issues I'm going to leave to President Obama, I think that he might be able to do what he couldn't do with the stimulus, reach a real consensus that all American's can support.

There is an enormous amount of pressure right now on the American family, it will be relieved one way or another, we have to find the best way to do it. In my above example the bank takes a 73% loss if that family goes into foreclosure, but if they agree to the plan the loss is only 50% immediately and becomes less each year as real estate recovers. The bank would receive $486,000 over that 30 year period in principal and interest, plus the $100,000 or so in shared appreciation for a total of about $585,000.......a gain of $85,000. Sure its only a return of .52% annually over 30 years, but that is better than a treasury bill is paying right now! Would you rather take a 72% loss now or have a half percent annual return over the next 30 years? This is why it makes sense to solve the foreclosure problem, even if it "rewards bad behavior". Stand by your principles of rewarding bad behavior and lose 72% of your money or do something about the problem and eke out a return? You decide.

The Market lacks leadership and until it sees some it will not recover. This week was a complete disaster for the Obama Administration and especially for the new Treasury Secretary Timothy Geithner. I believe that these guys are smart people and even though they haven't gotten it right.........perhaps in a week or two they will. We can hope, right?

Scott Dauenhauer CFP, MSFP, AIF