What Uncle Sam Could Have/ Should Have Done in the 2008 Financial Crisis – by Rick Baron

In 2002, shortly after the Enron, Worldcom and other corporate debacles, our political leaders passed the Sarbanes-Oxley Act to try to prevent another Enron-type scenario from happening again.

A critical component of the Act was the “Mark-To-Market Rule” which required that any publicly held corporation that had marketable securities (assets) on its books must value them at market value for accounting purposes, even if they had no intention of selling the securities.

When the sub-prime and Alt-A mortgage-backed securities market began to collapse in 2007 and into 2008, financial institutions in the U.S. and around the world that had bought these securities suddenly found themselves holding assets that had lost between 80% and 95% of their value.

In case you don’t know, through most of history banks and financial institutions were restricted from loaning out or borrowing more than 10 times the amount of their assets. However, in 2004, the Financial Accounting Standards Board (FASB) loosened this restriction to allow them to loan or borrow up to 30 times their assets. Most of them did just that.

So, if I’m a Mega Bank and I have $1 billion worth of sub-prime securities on my books, I’ve loaned out or borrowed (leveraged) $30 billion against it. After the collapse, my $1 billion worth of sub-prime securities is now worth less than $200 million in the market place. Suddenly, using the 30-1 ratio, I should not have more than $6 billion in loans against my asset, so I’m $24 billion over-leveraged. At a 10-1 ratio, I’m $28 billion over-leveraged. Unless I have billions more in other assets, I’m now technically insolvent. Not only can I not loan or borrow any more, I’ve got to raise substantially more cash and dramatically shrink the amount of loans outstanding to shore up my books.

When this issue reached critical mass in the fall of 2008, the majority of lending in this country stopped, and the lack of credit began seriously damaging our economy.

When Treasury Secretary Paulson was screaming for $700 billion in TARP money to “get those toxic securities off the banks’ books”, I was cheering him on because I could see a simple solution.

If the Feds had seized IndyMac, Washington Mutual, Countrywide, and Wachovia (the biggest servicers of sub-prime loans), split the $700 billion between them and given them a 10-1 line of credit with the Federal Reserve, they would be able to buy up to $7 trillion of the securities. Then they could announce that they would pay up to .60 cents on the dollar for any and all sub-prime securities. Just by announcing what they would pay would have had an immediate impact on the financial system. In a mark-to-market crisis, Uncle Sam would have become the “Market Maker”, and by doing so would have instantly limited all financial institutions’ losses to 40% on these securities instead of more than 80%, effectively putting a floor under their write-downs and losses.

Secondly, once they began purchasing these loans and became the investor, they could have systematically modified ALL of the loans to 6.00% fixed rates (most sub-prime loans started in the 7% to 10% range and then nearly doubled in rate after the first two or three years). By systematically modifying the loans, it would at least give the homeowners a fighting chance to keep their homes and would have put a floor under foreclosures.

Within a few months, the government could have contained the crisis, limited bank losses, and minimized the damage to the economy. Eventually, the purchased and modified loans that turned into good performers could have been repackaged and sold to private investors, most likely at a handsome profit.

Instead, they said they would implement some kind of complex “reverse auction” for the securities that no one understood and quickly realized it would take them months, if not years, to implement.

Their solution was to just start throwing money at the financial institutions to help them re-capitalize. Then they suspended the Mark-to-Market rule and replaced it with Mark-to-Model (or Mark-to-Make Up Your Own Number). The Federal Reserve became the lender of first resort for thousands of businesses. Any Federal mortgage aid programs required borrowers to QUALIFY! Uncle Sam began printing, borrowing and spending more money than any country ever in the history of the world in an effort to prop us up.

But because they didn’t attack the problem at its core, I’m afraid all they have done is kick the can down the road, and at a cost that is several times the amount of the solution I outlined above.

The current course is unsustainable, and at some point we will have to pay the piper. But what do I know? I’m just a simple mortgage guy.