Thursday, October 2, 2008

Financial Crisis Update!

Here are some Ideas on How to Solve this Financial Crisis:
I thought the upcoming US election would be the polarizing event of the year. But the McCain / Obama showdown looks like a love fest compared to the visceral reaction to the proposed US bailout plan.

Many of my friends have been understandably vocal about the credit crisis, the Paulson proposal, and the House’s subsequent rejection of the plan. As of this writing, it appears that the Senate will pass the new and improved version of the bailout plan, which comes complete with more tax cuts to send the deficit even more into the red.

So I thought I’d compile some of the best comments from I have read and share them with you. Some of you have put forth your own bailout plans. Others have used forums to rant and rave. I welcome all of your comments. Keep them coming.

Let’s focus on the solutions offered by some of my readers.

Advice in response to an article titled, “Should AIG be Saved?”:

• Decrease leverage to a maximum of 20 to 1;
• Each investment firm must have a qualified risk management department that is not compensated by the performance of the trading desks;
• Top management has to be educated on the risk of new products and not get involved until they do understand the risks;
• Compensation should be geared to completed transactions not on marked to market valuations.

Most seem to agree with my assessment that leverage is the problem here, and the suggestion of going back to an 11 to 1 ratio.

Speculators thrive on leverage. At 100:1, a 1% move in the right direction means a 100% profit. Of course, in the wrong direction it means a wipe-out. And more than 1% the wrong way, without backup assets, it means someone else goes down with you.
In the good old days, before deregulation by Congress, commercial banks were required to have a ratio of assets to capital somewhere in the 11:1 range.

When Long-Term Capital Management went bust, it had a ratio of 28:1, which everyone thought was insane. Bear Stearns went belly up with a 33:1 ratio!

Back in March, the Wall Street Journal reported the leverage ratios of major operators: Morgan Stanley 33:1; Lehman 31:1; Merrill Lynch 28:1, and Goldman Sachs 26:1.

Leverage is of course great in a bull market but deadly in a bear market. How deadly for these big names? Lehman is gone already. Bank of America took over Merrill Lynch. Morgan Stanley took over Bear Sterns.

What's next?

I think the "man in the street" shows more sense than the government when he rejects the proposed bailout of the banks, even though he fears that his rejection may lead to another great depression. However, there is no guarantee that the depression will be avoided with the bailout.

Anyway the "domino effect" has already started and can't be stopped until the last domino has fallen. The government should keep its $700B in reserve until that time and then use it to rebuild the USA.

In response to an article on how to profit from Gold & Oil Stocks here are some ideas on how to fix the system:

Standardization: All mortgage forms, applications, and trust deeds should be standardized nationwide and capable of having someone with an 8th grade education understand exactly what they are getting into. A minimum of 10% down-payment on the property has to be paid. If you are not willing to put your own money into a property, then why should anyone else? Anyone putting less than 20% down must carry mortgage insurance until their payments have reached 20% of the original purchase price.

Due Diligence: If you are not willing to perform due diligence on an application, then you have no business being in the market to start with. You have to know exactly what the property is, where it is located and whether the applicant can truly afford the payments or not.

Education: I would like to see mandatory basic financial education in all schools nationwide. I don't think you should be able to graduate high school without being able to read and fully understand a mortgage application and how the payments are figured. If the schools won't do it, then Wall Street and bankers nationwide should volunteer their time to the school systems for assemblies. The people of the United States, had better start learning how money works before they start spending what they don't have.

Also under education, the next time Congress or a President comes up with a plan to increase home ownership by reducing the mortgage standards, Wall Street should tell them to take a flying leap off a rolling doughnut and…. spend the money to produce the TV commercials and remind the American people about what they are all going through now.

Responsibility: If someone walks away from a house and mortgage, then they can never get another mortgage in the USA. If they trash the house before it goes into foreclosure, they should be responsible for the cleanup costs. If the house goes into a short sale, the borrower has to work with the lender to find a common amount that they still owe before they can ever get another mortgage in the USA.

On the lender side, it is better to work with your clients than to just hang them out to dry. If someone loses their job or other source of income, then work with them. It is still better to get some payment each month than to go into foreclosure. Especially in times like these when property values keep falling. If it becomes a habit though, give them 60-days notice and then sell it.

Her are some rather creative ideas to help resolve the financial crisis:

The government should not only allow, but insist that every person that has a 401K that is tied into a sub-prime or prime loan that is in danger of default must use their 401K, without any penalties for early withdrawal and without any taxes applied to the 401K balance, toward paying off their current mortgage holder to lower the loan balance.

In return, the mortgage holder must refinance the remaining balance at an attractive fixed-rate 30-year (or fewer) mortgage with no creativity allowed. For a refinance, that is less than:

• 70% of current "fair and reasonable" appraisal value a 3% or less rate;
• 70% to 75% to 3.5% to 4.0% rate;
• 75% to 80% to 4.1% to 5.0% rate;
• 80% to 95% to 5.1% to a maximum of 6.5% rate

If applying one’s entire 401K to their outstanding mortgage balance does not bring the mortgage balance to at or below 95% of the "fair and reasonable" market value, then that individual or couples, in cases of the married, 401K is not to be used and be left alone. If their mortgage goes into default, it will be up to the market forces at hand to resolve the issue.

Some specific recommendations I received for where to put money in the current climate:

• buying shares in gold and silver miners. A 20% increase in their commodities prices translates into a 50% increase in profits. No matter what the government does, gold and silver go higher.”
• Buying shares in banks as they will lead the rally when the bull market returns. The reasoning being that “Financials will have to finance big companies and little companies to grow and expand. They have big fears of loaning money to risky investments right now but they will loan money on safe bets that have a good credit risk. In doing so, their stocks will lead the bull market return whenever it does happen!”

Thanks, all for submitting your thoughts on the current economic crisis. Keep them coming!