Wednesday, March 04, 2009

Breaking the Financial Spiral

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Many have talked about how to solve the current crisis. I have my own view. I’ve written this as two comments so far; on Tom Evslin’s blog and Fred Wilson’s blog. At Fred’s suggestion and prompted by Neil Ferguson’s recent article in the Australian about similar proposal I’m turning this into a blog post.

The continual drip feed of rescues and bailouts is like keeping someone who has been bitten by a snake on life-support without removing the poison from the body and wondering why you have to keep treating heart attacks and seizures. Until the poison is removed from the body nothing is going to change. The economy is poisoned and the rescues and bailouts are doing nothing to remove the poison.

The poison is fear. Fear of investors who don’t know where the risk is and how risk exists. Fear of households who don’t know whether they will be able to keep food on the table or a roof over their heads. Fear breads fear. It feeds off it and becomes self perpetuating. To begin recovery, initiatives need to short circuit the fear.

The poison entered the system via inflated asset prices and loans. The principal on loans is simply too large. Now the loans are sucking up increasing amounts of income to pay off reducing consumption and increasing default rates, both feeding into the broader economy to reduce demand and in an on-going spiral leading to a recession, job losses and further defaults. As job losses mount consumers reduce their expenditure as they fear losing their own jobs and not being able to put food onto the table and a roof over their heads.

Investors injected fear as they suddenly found themselves in the unknown. Their safe investment s weren’t and now they had no idea where the risk is or how much, leaving them to stop investing and lending causing liquidity to dry up. The liquidity loss caused further increase in risk and default feeding further problems. It is all a spiral and until the spiral is broken it keeps going.

So far initiatives have halted the convulsions and resuscitated from heart attacks, but it is now time to draw the poison from the system.

Drawing the poison starts with loans. Until loans reflect the actual value of the assets, foreclosure rate will be high, subsidised payments and modifications notwithstanding. It simply doesn't make sense to continue to pay a mortgage, even at subsidised rates, when the value of the underlying asset is 20% or more less than the mortgage. In the end the mortgage principal needs to be reset to be within shouting distance of the underlying value of the asset.

Governments need to look at wholesale reduction in principal, something along the lines of financial institutions writing down the principal by 15 to 30%, the government purchasing 30% of the principal from the institutions. Depending on the location the Government can either write-off their purchase principal, suspend interest on their part of the principal or do nothing. The mortgage principal in effect is reduced by between 30 to 60%. The price of housing gets a massive reset to something resembling reason and underlying value. The principal reset has the effect of creating massive re-balancing of household balancesheets and freeing up income for discretionary spending.

Where it that simple of course. Unfortunately, underwater equity is only a small (although extremely toxic) part of the problem. The abject fear of not being able to keep food on the table and roof over their head is causing consumers to save. That fear undermines all stimulator policies. While new jobs may be created they are not going to be created fast enough to replace the jobs lost. Job loss happens far faster than job creation. The fear is creating a spiral to disaster that needs to be short-circuited. A short circuit would be to guarantee 75% to 90% of previous salary for a period of 12 to 24 months (the time length depends on time lag between job loss and job creation). This would remove the fear of not being able to buy food or keep a roof over their heads.

Existing unemployment benefits don't work in this situation as people can't downsize their life nor do you want people to down size their life quickly as that only exacerbates the asset and consumption problem. Broadly, the economy needs a short circuit and breathing room to allow stimulus and automatic re-adjustment to gain traction. The current disaster spiral overwhelms normal automatic adjustment in the economy.

Reducing principal and supporting salaries will draw the poison for the system and provide breathing space to begin recovery. But just like a patient, the economy needs physical therapy to return to full health. This is where the stimulus comes in.

Part 2: Stimulus and more
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