By Shah Gilani
While it's clear from the current credit crisis that our financial system is at a critical juncture, it's just as clear that there's no agreement over how we should fix the problems we face. The reality is that neither the plan put forth by U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. – nor any of the addendums offered up by Congress or the lobbyists – will resolve this crisis.
The key culprits are the structured financial products that reside on the balance sheets of banks, dead investment banks, insurance companies, hedge funds and all manner of other duped and unsuspecting investor entities worldwide, as well as the proliferation of the unregulated $62 trillion credit default swaps (CDS) market.
Because all these securities, and in the case of credit default swaps, bilateral contracts, are impossible to value and impossible to guarantee, no one trusts them. As a result, everyone is afraid of these securities and contracts.
Banks are currently not lending to one another because they are afraid that the next round of write-downs and losses may imperil some of their trading partner banks to which they formerly lent billions and billions of dollars to every night. If the answer were really as simple as adding liquidity, the Federal Reserve would have lowered the Fed Funds target. But that won't work. It's a vicious cycle that's eroding banks' faith in one another, and worse, our faith in our banks.
Unfortunately, I don't see the Treasury Department's much-needed rescue plan being effective without actually addressing the pricing of – indeed, the very existence of – credit default swaps and collateralized debt obligations. As well intentioned as it is, the Treasury plan will create more problems than it solves and will eventually saddle taxpayers with so much debt that it will tank the dollar. It could even put the U.S. government's AAA investment rating at risk. That would be calamitous.
I have a modest proposal that I'm calling the Money Morning Plan, because it potentially heralds a new dawn in the credit crisis, addressing the problems from the bottom up, and not from the top down. The bottom line is that my plan will end the credit crisis quickly with potentially little or no cost to taxpayers. And those are the two most important benefits of all. I present my plan as an open letter for public debate.
- Contributing Editor and credit expert Shah Gilani outlines a bailout plan that could ease the banking crisis at a minimum cost for U.S. taxpayers. It's a complicated issue, no doubt. Please take a look at the "Money Morning Plan" below. If you believe some (or all) of these points make sense, we urge to pass them along to your state's representatives, as the Congressional dialogue is now in full force and time is of the essence. Just
click here to get a listing of your state's representatives.
An open letter to U.S. Treasury Secretary Henry M. Paulson, Federal Reserve Chairman Ben S. Bernanke, Distinguished Members of Congress, and the American Taxpayers:
Dear Ladies and Gentlemen,
How we respond to the upheavals in our financial markets will define the American character at home and in the eyes of the world. With our cherished history of free markets and entrepreneurial spirit, we should guide ourselves as we always have, trusting our collective financial interests to our Constitution, which created a government by the people, for the people. Trying times are not a mandate to foreswear our personal, financial nor collective economic interests to any lobby or government other than one that protects all our rights, especially the right to not be taxed unfairly or unjustly.
The proposed Treasury Department rescue plan before Congress has not been presented without due consideration. There are, however, other proposals that merit our collective contemplation. As a taxpayer and investor, I am proposing an alternative plan for open discussion. We need to act quickly, but we need to act responsibly.
The Money Morning Plan
- Establish an empowered, not overpowering, regulatory apparatus to rein-in structured products and establish protocols for the creation and tradability of financial products based on real-world economics and hedging considerations. Products must be transparent, easily valued and rated on a universal ratings model.
- Establish regulated standards to support the universal ratings model and allow free-market competition for providing rating services based on a "pooled-income revenue model," whereby all issuers that either want to be rated, or that are required to be rated, pool funds on a per-volume, pro-rata basis and ratings providers are paid blindly for rating services.
- Immediately stop the issuance of credit default swaps without mandatory reserve requirements and safeguards typical of what insurance regulations already require of legitimate insurers. Net out all existing credit default swaps to tighten counterparty risk and unwind positions that cannot be secured by issuers meeting adequate reserve requirements. Eliminate virtual insurers.
- Only allow issuance of credit default swaps up to the actual outstanding dollar value of corporate debts and loans outstanding. This will ensure legitimate hedging and eliminate undue pressure on outstanding debt issuers.
- Create a class of "eligible (mortgage-related only) securities" that constitutes problem securities. Leave all eligible securities on the books of existing holders.
- Have eligible security holders identify to the U.S. Federal Reserve every eligible security by CUSIP and face amount. Only the Fed will have knowledge of institutional and investor positions. This will allow the Fed to correctly assess the risks at hedge funds and others with "significant operations" without exposing their positions to competitors.
- Create a new accounting domain in-between "held-to-maturity" and "available-to-trade" where only eligible securities, as of a predetermined valuation date, can be accounted for at their value on the predetermined valuation date and not further subject to fair-value (marked-to-market) accounting, while held.
- Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date, preferably as soon as the Fed expects all eligible securities to be registered with it. Those who have recently marked their securities have already taken their write-downs; those who haven't will have to. If the totality of the resolution represents a bona-fide solution, investors and speculators will bid up eligible securities to own them before the predetermined valuation date, because of newly ascribed accounting advantages of holding eligible securities.
- Reduce the haircut on the reserve requirements for all eligible securities covered by this plan. Since valuations have already fallen precipitously, reducing reserve requirements on eligible securities would additionally enhance their value as balance-sheet assets with upside potential.
- Have both the Fed and Treasury determine a liquidation or receivership outcome for holders suffering from insolvency as a result of accurately marking-to-market their holdings on the predetermined valuation date in the event bankruptcy would result in further systemic problems. This scenario would be cheaper and quicker to manage than what's in store for us under the present Treasury draft, and it allows the two to assess the potential fallout of insolvent entities prior to their exposing the financial system to resulting disruptions. Hedge funds would not be saved.
- The Fed must establish and manage a conservative, transparent pricing model for eligible securities based on actual underlying cash-flow measures, projections and model specific criteria. Absolutely no trading would be allowed over-the-counter or otherwise on any of the eligible-securities specific pricing models or indexes.
- The Fed, with a firm handle on all eligible securities and a transparent-pricing methodology, would have to take in any and all eligible securities as collateral against Fed borrowings from the discount window or through its dealer facility.
- "Servicers" managing underlying mortgages on behalf of trust entities, under which securitized pools are created, must be empowered to alter and modify terms and conditions of underlying mortgages in conjunction with originating banks or lending institutions.
- To incentivize banks and lending institutions to modify existing mortgages and to incentivize homeowners to stay in homes with upside-down mortgage-to-appraised values, eliminate all capital gains on appreciation of newly appraised homes when they are sold by either homeowners, banks or lending institutions.
- Create tax-advantaged scenarios for banks and homeowners partnering in the reduction of delinquent obligations whenever loans can be brought to a performing status.
[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis. It's a perspective on the near-financial meltdown that you'll find nowhere else. If you missed Gilani's investigative series, Part I appeared Friday, Part II ran Monday and Part III was published yesterday (Wednesday).]
News and Related Story Links:
- Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One's Talking About.
- Money Morning Special Investigation of the Credit Crisis (Part II):
The Credit Crisis and the Real Story Behind the Collapse of AIG.
- Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System.
Henry M. "Hank" Paulson Jr.
Credit Default Swaps.
Credit Derivatives (Bilateral Contracts).
Structured Financial Product.
- Money Morning Market Commentary:
- Money Morning Market Analysis Series:
Inside Wall Street: Why Hocus-Pocus Accounting Will Perpetuate the Capital Markets Credit Crisis (Part I).
- Money Morning Market Analysis Series:
Inside Wall Street: The Hocus-Pocus Accounting Tricks That Will Perpetuate the Capital Markets Credit Crisis.
Virtual Insurers Will Thrive in a Wired World, Says Futurist at ISO's AISG INSTECH98 Conference.
Collateralized Debt Obligations.
- Money Morning Market Analysis:
Why Mark-to-Market is Bad News for Shareholders.
- Money Morning News Analysis:
The Government's Financial Crisis Fix-it Plan Sends Stocks Soaring, Though Some Argue There's no Quick Fix for this Disaster.
Hi-Yield Debt (Junk Bond).
Mark to Market.
- Chest of Books:
- Money Morning Market Commentary:
Sen. Dirksen: Allow Me to Introduce You to Standard & Poor's.
- Money Morning Special Investment Report:
Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.