Interesting article from Roubini's Econo-blog. It is a little long, as he says he tends to ramble, but interesting in anycase.
Debt Destruction through Principal Reduction
Rich Hartmann - Miss America | Dec 12, 2008
From time to time, I?ve been told that I ramble on too much, or that I?m a little too wordy, longwinded, tedious, etc? In an effort to be a bit more concise, I?ll get to my point! (HA? yeah right! Buckle up!)
You can?t save the economy, without saving its most important part! The GENERAL PUBLIC (the consumer, producer, service provider). In a nutshell, the problems we face are: Too much Debt, Too little credit, and no transparency between the two. (In order to further break that down, we have to look at the way this affects the following 2 groups: Wall St and Main St. ...and how the problem is addressed by The Powers That Be and the dollar that was. ?but we?ll get to that later.)
Plain and simple, the average person is in over their heads. ?and we have to throw out our grandparent?s book on what needs to be done. We are in unique times. Deflationary trends will rear their heads in the world of excess, but inflationary trends will emerge in the world of necessities. With the cost of living, surviving, and thriving becoming so expensive, those without ?SHOULD? drive the cost of everything down. ?but the levels of debt owed are far too vast to be absorbed by the overburdened system. Since the consumer, wall st, and the government are already so overspent, they no longer have the buffer of existing credit to meet our current obligations.
Faced with this catastrophe, the options that have to immediately be addressed are to add credit and destroy debt. The Powers That Be (TPTB ? The Government, Fed, Treasury, SEC, FASB, etc?) have gone to great lengths to save the Monoliners, Banks, Credit, Financial Firms, Insurers, Auto, etc? in grand socialist fashion. In short, where they had too much debt, TPTB eased the burden of debt obligations by taking debt off the hands of Corporate America. Where they had too little credit, TPTB provided liquidity in every conceivable way and slashed interbank rates to keep markets from freezing. ?and where transparency issues existed, TPTB absorbed the toxic mess, and placed it in the vortex of Unknown Financial Obligations (UFO?s), where they will disappear from existence, but someday, magically reappear as a long term gain. (?while looking and smelling like freshly printed dollars which no one will question 10/20/30 years from now.)
By saving Wall St, we have temporarily saved the arms and legs of our economy? Now it is time to save the body. Main St!
Principal Reduction: (aimed at primary residence)
To immediately address the needs of Main St, debt must be destroyed. Obviously, the overspent consumer can no longer spend without availability of, or access to, credit and current debt obligations. The subsequent obligatory pullback by the consumer will directly feed the deflationary spiral, which then can only be absorbed through inflationary printing by TPTP. (more quantitative easing via ) 0% rate, and T-buy backs)
The most direct way to avoid this death spiral and put money back in the pockets of the consumer, while at the same time, reducing debt obligations, is through principal reductions of debt. Time is of the essence as every day that this is not done exacerbates the speed and depth at which our economy will fall. There is a multiplier affect, which requires immediate action to put the necessary floor down. Currently, the ?wait and see? reactionary approach by TPTB, have us trying to save those already in trouble, rather then taking the proactive approach of saving those who will inevitably be in trouble. (I?m not saying those who are in trouble are not a top concern, but rather they need to be tended to in a manor that addresses the future problems first. Like on an burning airplane, you put the oxygen mask on yourself first?. Then you can help other. Otherwise, you?re just compounding the problem.)
Perhaps a better analogy is, when addressing the Tsunami of debt that our country is in, you don't put up a wall to block the tidal wave that already came in! You put up a wall to block all the future waves that will be coming!!! For the wave that already came in, you sift through the wreckage and repair what you can. In an effort to help the public, TPTB have spent a great deal of time and money working on providing aid for those already in foreclosure. Unfortunately, they have failed to build the wall that is needed to stop the next tidal waves of foreclosures and bankruptcies! The compounding of losses as the concept of waiting for someone to go into foreclosure/bankruptcy is far too late in the process to help.
How Principal Reduction Works?
If you bailout every bankrupt person, then responsible people will choose not to pay. You can NOT create fail/reward system. A balanced approach is needed. With that said, to stem further risk of escalating bankruptcy/foreclosures a mathematically modeled approach needs to be taken where the percentage of money owed on primary residences can be reduced by a factor greater then the next projected overall net loss within the spectrum of the consumer?s reduction of spending + obligations.
In a prior article, (
http://www.rgemonitor.com/globalmacro-monitor/254144/friends_romans_countrymen_lend_me_your_ears) I used hypothetical 10% and 20% reductions to draw how this works. What I stated was that many of the underlying secondary market securities have already been written down this much or more already. (many by up to 80%) By reducing the principal value of these assets even further, it would seem to that this would cause these securities to take additional hits. ?but this is not the case. A ?less is more? approach will actually raise the amortized value of the securities, as their likelihood of being repaid increases.
At the same time, when Main St feels the ?rolling stimulus? of reduced the monthly bills, the immediate capital/credit inflow will flow to the following places:
1. Pay off debt
2. Saving
3. Spending
4. Under the mattress.
For the first 3 scenarios, you have cash flowing back into the system, thus feeding the ?less is more? concept. ?Debt repayment? will help aid putting a floor under default or the confidence/fear of default by investors. ?Savings? will immediately recapitalize the banks, thus helping start an upward cycle. And ?Spending? will start to resume when fear resides and credit exists. Unfortunately, ?under the mattress? will have to be addressed. (this can be done through increased bank rates and raising of FDIC caps or restoration of confidence in the fact that the first 3 scenarios are once again working.)
For the portion of written down principal, TPTB would create ?open receivables? in equal amounts. (TPTB could even securitize these severely distressed assets, much like the Tobacco Bond Debt. I wouldn?t be in favor of more securitization? but at least the perverse incentive would be in aiding the economy to recover to the point where even the open receivables were potentially paid off. Investing here would be a true investment in the future/confidence of the net worth of the economy. That?s far better then requiring people to smoke, just so debt can be repaid!!!)
VOLUNTARY!!! Not MANDATORY!
The concept of this stimulus plan is voluntary but equal. For those who do not want to participate (for fear of reducing the ?principal value? of their home further) they do not have to participate. Alternative stimulus should be provided for their responsible behaviors of spending within their means. (Unfortunately, they will eventually come to the realization that their asset isn?t worth what they paid for it or what they felt it should be worth, as the market currently dictates. Their prudence through ?potential? house price recovery could pay off, if the market was to return. (which is most likely through a ?less is more? theory/reality)) For example, those whom have paid off their MTG debt, or choose not to write down their principal: a tax break can be created to reward them annually (similar to a STAR reduction).
For all those that choose to reduce principal, an open receivable is kept on the books for the length of ownership of the home. If the housing market was to recover and you were to see a windfall, the open receivable would have to be paid prior to seeing a profit.
For example, You have a $200,000 mortgage. TPTB writes down 10%.
* TPTB creates an open receivable for $20,000. (which TPTB could then securitize as skin in the game for aiding a recovery focused on the broad US economy)
* The homeowner now has a $1,140 monthly payment as opposed to a $1,266 payment, saving them $126 per month which gets infused back into the financial system (This is your ?rolling stimulus plan?. For a typical $417,000 conforming loan, the savings would be $264 per month.)
To look further down the road, if the housing market were to recover, this is what would happen. You sell your $200,000 home (which you were only paying on $180,000) for $230,000. Instead of walking away with a $50,000 profit (230k ? 180k = 50k) you would have to pay off your open receivable first. So you?d walk away with $30k (or maybe less if interest is added???)
In the event, that the market continued to stay depressed, the likelihood of you selling your house at a loss (or flat) versus just filing for bankruptcy/foreclosure would be significantly diminished by the parallel difference between the equity owed versus the current market price. Let?s say, you were somewhat responsible, and put 15% down on the purchase of your home. ($200,000 price, $30,000 equity, $170,000 debt.) In addition, let?s say the market dropped by 40%. Your house would be valued at $120,000. In order to keep the homeowner?s skin in the game, rather then walk away from the negative equity, TPTB will need to lessen the 30% difference of $170,000 owed versus the $120,000 value. If say a 15% Principal Reduction was set, owing $145,000 on a house that you paid $200,000 for, would leave less of a risk of homeowners walking away, and promote potential sales. At the same time, that homeowner would see their monthly debt burden reduced by nearly $150.00 a month. That?s $150, this month, next month, the month after that, and so on. That?s your ?rolling stimulus?. When 150,000,000 homeowners see this reduction of debt, it pans out to over $250,000,000,000.00 billion in new liquidity, and destroyed debt per year. (which like I said earlier, will be printed regardless, as a necessity for replacing the fictional monopoly money (of finance) that has already left the system. (The ?monopoly money? will be further explained in the future post on ?The Financial Industry?s overgrowth?. ? still in pre-production)
Which ever way the market goes, the issue of ?transparency? where homeowners are holding ?illiquid assets? (their house) is addressed as their debt is less, their credit is more, and the glut of unsold houses reverses course due to the momentum in price discovery of a bottom. (this bottom is unattainable right now as people cannot come to grips with the reality of where the current market prices are at versus their equity owned)
***Interest Rate Reductions for Homeowners***
TPTB have already floated around the concept of mass interest rate reductions for homeowners. In theory, and mathematically, this concept looks the same as Principal Reduction, but is flawed. It lacks Incentive! It does NOT put equity in the homeowners hands in relation to their debts. In sum, it only addresses the credit side of the problem.
Quantitative Easing: By taking the drastic measures they have, TPTB have played a high risk game of chicken with the value of the Dollar. When our financial system started to systemically implode, the dollar and all financial companies based in dollars fell with it. The markets dropped as the fear struck the players and well informed financial communities. Eventually, when that fear became reality, and losses started to be felt around the world, the losses around the world balanced out. The subsequent flight to safety saved the US Government, and its entire economy.
The current confidence boost in the power of the dollar has given our current financial decision makers a false sense of confidence. Now that economics has taken over the mainstream media and further educated the masses on large parts of the existing problems, the general public has grown tense. Already gripped with fear, and having seen the value of their general investments cut in half, the public is now too well informed to a blatant devaluing of the dollar. If the government is serious enough to take the next steps in "Quantitative Easing", I believe they run a serious risk of sliding down a slippery slope of trust and good faith in the value of the currency in relation to easing our country's financial burden by inflating our way out of the debt.
The precedent of printing credit without parallel debt destruction becomes cyclical, and hyperinflationary. (Since all solvency issues with the government will be averted through printing) The "ground level fear" of "what has value" that exists on the street will no longer just pit the USD versus import/export products like oil, foreign currency, cheap labor. The reality is: "what has value" will be revised from financial engineering to putting food on your plate. This is reality. Right now, in the current environment, this potential risk is significantly upped if Quantitative easing takes place. We saw oil rise to $147, (when it is currently at $45), which begs the question: Will food be next? Why not? Why is oil capable of inflating by over 200% of its current value, while rice is not? Especially, when hoarding is much easier of food products by the general public.
Playing with the confidence in the value of the dollar is NOT a healthy risk right now!!! Quantitative easing could work if the core (the body and head) of our economy was stable. Currently, the backstop of our economy only owns debt and illiquid assets. As the net redemptions, expenses, losses, etc? continue to grow, the more bad news and debt reality hits. This will cause more obligations, larger bailouts and greater outflows. (Take a moment to work through the logic.) This is a doomed process through liquidity injections alone as the only reasonable solutions would require so much liquidity that hyperinflation would be a guarantee. The time is now. Debt Destruction. It?s time for the public to call upon TPTB and demand it for our economic salvation. Without this, and fast, I fear what?s around the corner. The second the general public is saved, I will be prepared to start giving real investment advice. Until then, our economy is walking blindfolded through a nuclear minefield!
