The cure will be worse than the sickness.
By Daniel at 21 October, 2009, 10:11 am
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This really is no more than simple math. Let’s say on average, banks lent money at 90% loan to value at the height of housing prices. For ease, assume the price of a home was $100,000 and therefore the loan was $90,000. The bank borrowed 95% of the mortgage to fund the homeowner’s mortgage so the amount borrowed was $85,500. On average, home prices are down about 35% off the 2006 highs so the value of the home is now $65,000 and the value of the mortgage that bank owns is no greater than this amount, which is the asset of the bank against which the bank borrowed $85,500. The bank now owes $20,500 more than it borrowed. Now multiply this by billions and the banking system in the US is insolvent on a whole. Likewise, credit cards are even in worse shape because there is no collateral behind those loans and generally chargeoffs on individual credit card loans approach 95% when there is a default. This is why the Federal government suspended mark to market because if the banks marked their loans it would disclose the stunning magnitude of the problem.
No amount of free money from the Fed is going to solve this problem and in fact over time the cure will be worse than the sickness. The solution is simple yet painful. All banks must mark their assets to market. All banks must restructure the liability side of their balance sheet so that their debts are equitized and the existing equity is wiped out. All banks thereafter must not allow leverage to exceed 7x. All loans on a go forward basis should have significant down payments or equity associated with them. This will cause the economy to contract in the medium term but it is the necessary step to ultimately fix what ails the US. This silly policy of cheap easy money as the cure to the problems caused by cheap easy money is analogous to saying the way you cure an alcoholic is to buy him more drinks.
- JMJ1
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