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Sunday, March 16th, 2008

Time Event
10:29p
Bear Sterns Would Have Been Better Off With My Solution.
Back in August, I proposed a straightforward remedy for the mortgage meltdown. The federal government would buy any commercial paper backed by a mortgage on a primary residence. The catch? The government would pay only a percentage on the dollar (I proposed a quarter, but would have been willing to go higher on the basis of real analysis). The feds would then renegotiate the loans with the individual owners and work to prevent defaults and foreclosures.

At the time, I argued it was a good deal for everyone. Financial houses would get to clear the bad debt and start over, but take enough of a hit to avoid the "moral hazard" problem. The federal government would avoid the problem of spending trillions on a bail out, because the book value of the loans would recover and the fed would not be "writing down" the value because they would acquire the paper at a lower value then its ultimate worth after avoiding foreclosure. And, even if the fed had to write down the value again and took book losses of a couple of trillion, it would still be better than just printing the money and spending it.

Finally, we'd avoid the foreclosure problem, which threatened to do huge damage to the economy as a whole.

A number of folks had difficulty wrapping their heads around this. Why would banks and other financial institutions sell off the loans at a fraction of the value (no one wanted to argue the amount was too low, it was the principle of the thing). After all, all this commercial paper was secured by property subject to foreclosure. How on earth could paper backed by property lose sufficient value that you would sell it for only a percentage of its paper value?

Two words: Bear Sterns.

As the Bear Sterns experience indicates, liquidity and exposure to future risk matter. Bear Sterns is selling itself for a fraction of its stock value because it has no more cash to pay margin calls and because it (and therefore investors) still cannot guess the level of exposure. They would have done better under my proposed solution, where they only would have lost 1/4 to 1/2 value.

Anytime Bernacke wants to ask me, he can find me here. Until then, I expect the Fed to keep printing money and for W to keep looking more Hooveresque every day.

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