What Needs to be Done – The Follow Through Plan

Momentum is a beautiful force, especially if moving in the desired direction. However, economic momentum can be lost quickly if the inertia that mobilized it dissipates with waning enthusiasm. This article is about the continuation of what needs to be done to maintain positive economic inertia and provide a kinetic boost that will charge the US economy successfully into the foreseeable future.

Although time is of the essence in any equation dealing with momentum, some of the “Follow Through Plan’s” planks discussed below have greater priority versus the remaining. But let us not pretend that if some of the plan is sacrificed due to the “feel good” inspirations fostered by the beginnings of proactive economic stimulus, it will not be sustainable if the core retains the properties of risk-tails that can demolish the forward curve permanently … and swiftly.

Black Swan events, or those considered to be Gaussian anomalies or 9th degree standard deviation eclipses do not, and have not, occurred at the interval statistical quants have modeled. In fact the anomaly is to believe that Black Swan events are anything but a force of nature and occur about as common, as frequent and as necessary as the changing of the seasons.

The “Follow Through Plan”, needed to retain economic leadership of the United States well into the 21st century, should include all of the following critical levels of change and direction. The order iterated is roughly paramount to its relative importance; however some of the quantum policy shifts have been deferred to the end of this dialogue even though their importance and measure of affect are considerably greater than the former tenets of the Plan.

1) The Stimulus Package

The key focus of any Stimulus Package needs to center on three central themes;

• Infrastructure; rebuilding all aspects from the deterioration of the current infrastructure coupled with the modernization to meet the demands of a progressive economy going forwards
• Long-term employment; this Stimulus Package is all about improvement on a longer term basis similar to the Eisenhower Interstate Highway Program of the Fifties. The employment of many displaced construction workers and numerous services on the periphery throughout the US. This will also improve the housing market and consumer discretionary sectors with a proportionate increase in real wages.
• Alternative Energy; tax incentives and capital preferences to technology that increase the 2008 mpg by 100%. This of course would radically shift the demand curve away from imported oil, import/export balance of payments and longer term security versus the competing demand for energy. This program should also have similar aim at the housing market to reduce energy demand by creating “green” homes both on a new construction and retro basis.

2) Mortgages

The Paulson perpetuated death spiral in mortgages needs to decelerate … soon. To accomplish this, there needs to be a modicum of daylight that the unraveling need not continue and a floor is felt. To provide an effective solution one must understand the dynamics of the Paulson Death Spiral.

The Paulson Death Spiral

 Abandoning Congressional demands of the fear induced bail-out by diverting $350 Billion (1/2 the total and 100% of what was permissible without further Congressional approval) to the capital structure of NY banks. This money was given to these banks without any stipulations; it has been hoarded and specifically not used to address the problems. The use of funds has been as outlandish as providing lavish tea parties (AIG) to fattening the deferred bonuses of Paulson’s elite group of banking friends. Some of the banks have used the money to also leverage buy the assets of other banks with reckless disregard to the plight of Main Street. Sixty percent of all the defaults and foreclosures are from toxic loans that were meant to be purchased by the Congressional Act that Paulson is in specific contempt thereof.
 Mortgage prices collapse.
 Bank equity gets wiped out.
 Banks with reduced equity capital (capital less the haircut of their ever diminishing loan collateral) are forced to cut back, if not eliminate, extensions of credit for both commercial and residential purposes.
 Financing, especially for mortgage loans, dries up.
 House values continue to sink because of the increased supply due to foreclosures, lack of demand for buyers willing yet unable to acquire proper credit financing and the spiraling down of loan collateral that the banks hold.
 Mortgage securities decline further in value, bids disappear and credit default swaps increase in value due to the likelihood of more and more institutional failures which extends or accelerates the spiral starting from the second step above on down.

To alleviate this Paulson induced “death trap”, the following needs to be done effective immediately for any longer term recovery to maintain itself:

• Triage on existing banks performed to eliminate and/or merge weak banks with ones that have greater staying power. This is not to centralize banking with just a few super banks but in fact to decentralize by having several non-money center banks share in the bounty of the government plan. However, only those banks that have proper management, risk measures and limited exposures can participate.
• Government acquires non-performing loans to non-spec homeowners.
• Re-negotiated mortgage rate coupled with equity participation by the bank/government based on the re-negotiated effective reduced loan. The idea is that the reduction in the loan, or a de facto purchase by the government bail-out program to the extent of the re-negotiated loan difference will be repaid in the future by the eventual increase in property value.
• Allow banks with loan portfolios demolished by the current financial crisis to suspend mark-market accounting for a period of three years. This will reduce selling pressure by eliminating a key destructive element of the “death spiral”. This will also give the bail-out plan and the general economy time to “heal” and recover without a self-fulfilling recipe to implode. There are many good aspects of the economy and the unexpected benefit of a “tax credit” due to the deflationary pressure implied upon oil and other related commodities.

3) Mark-to-Market Accounting

Please refer to the dramatic positive effects this will have on the overall condition of the financial community from #2 above. This suspension of mark-to-market accounting should be limited to the loan collateral of banks only and should be held for review by the Fed or other proper regulators to maintain integrity of the overall bail-out plan and not for deception.

4) Credit Default Swaps

This may be the most important pillar of this or any other plan to maintain the longer-term sustainability and stability of the financial community and America at large. The creation and subsequent perversion of this new risk Ponzi scheme is extraordinary from the perspective that it was ever allowed to begin with let alone endorsed by Alan Greenspan, the former purveyor of our economic Armageddon.

Credit Default Swaps are relatively complex instrument or set of instruments to theoretically allow financial institutions to offset the risk of securitizing mortgages. The securitized mortgages are packaged and then sold, with the presumed benefit of default insurance, to other institutional investors and pensions. When viewed from the theoretical world with the naivety of assuming that no one would “game” the system, this swap of risk for capital appears legitimate and well conceived. That is until you pull the sheets off who is issuing the swap, what interest the parties have in purchasing the swap, what leverage is allowed to be used to purchase the swaps and what exposure the issuer has relative to the amount of risk the issuer actually has. Sounds confusing; let me use an example.

Example:

 You own a house worth $1,000,000.
 The bank has lent you $950,000.
 The bank has default risk based on your inability to continue to make the loan installments.
 The bank sells your loan, along with many like yours, to a securities broker who then packages your loan with hundreds of others as an issued security.
 The broker sells your mortgage to the “Street”. The total amount of the mortgages sold equal $100 million for this tranche.
 The Street is looking for yield with low risk or principal assurance.
 “Insurance” is created by the broker or issuer of the collateralized security.
 A credit reporting agency (Moody’s, Standard & Poors, etc.) is paid to “rate” the credit quality of the security. This credit quality is embellished due to the existence of the “insurance” which is the credit default swap.
 The credit default swap is sold to any buyer willing to pay the “premium” for the default risk of the issuer.

Everything so far seems appropriate to the uninitiated. Now let’s pull back the sheets and expose the laundry.

 The issuer of the securities is not limited by regulation as to the amount of “risk” associated with the tranche that it can sell. The issuer can literally sell $1 billion of risk swaps versus the $100 million tranche pocketing the extra “premium” to enhance “profits” … a pure Ponzi scheme given that there is no collateral to back up the nominal value of a default let alone the notional value of the leverage on what was “insured”.
 The purchaser of the “insurance” or credit default swap has no insurable interest in the actual collateral. Simply put, the insurance buyer is the equivalent of fire insurance (life insurance is a proper substitution) on anyone’s home (or life) without the “scam-resistant” test that legitimate insurance companies insist upon … the purchasers insurable interest.
 To add to the hysteria, the purchaser leverages his purchase with borrowed money from the bank that is issuing the insurance.

Can you see the problem yet? How does the purchaser get paid and why is the issuer allowed to collect “premiums” on homes (or lives) that don’t exist? The following is an anatomy of a meltdown:

 The unregulated issuer of insurance is perfecting the Equity Funding Scandal of the early seventies as they issue insurance on many times their actual book. They do so with reckless and wanton disregard to their capital, probability of default and liability to the written exposure. There is no regulation and no market transparency for their actions.
 The same zero regulation inures to the purchaser of the “insurance” (the credit default swap).
 A fire begins burning in you neighborhood (the economy starts to drift downward). An evil doer or gamer (hedge fund or other party not associated with the ownership of your home) shows up to buy insurance on your house. He does so cheaply (cents on the dollar). He begins to fan the flames by alerting the media to the fire in your hood. With each successive article the winds flare eventually engulfing your home.
 The portfolio and bank begins to default on their obligations. The purchaser, without any insurable interest, has every incentive to short the issuer thus exposing the leveraged liability and non-collateralized risk. The issuer goes bust, the purchaser gets a huge pay-day all with borrowed money … probably borrowed from the bank that got trampled while shorting their stock just to add fuel to a neighborhood fire.

With Executive Order and effective immediately, the President needs to eliminate all speculative credit default swaps. The only CDS’s that would be allowed would be on a fully disclosed and transparent basis by the issuer in an amount not to exceed the value of the portfolio. In the case of corporate default swaps, whereby the swap “insures” the default of the debenture from issuing company, then only the amount of the debenture is allowed to be “insured” to a purchaser of the debenture only limited to the amount of their purchase. This “premium” will be “sold” by the issuer only, and if sold, it needs to be fully collateralized by an appropriate bond issued by a third party regulated insurance operator. The effect will be a reduction of yield to the purchaser of the debenture correspondent to the risk that the insurer associates with the issuer and the specific debenture.

This Executive Order will provide a window of 30 days for the speculative purchasers to receive back their “premium” plus LIBOR. After this 30 day window, all contracts are null and void and without appeal. Those issuers of swaps who issued on a factor of the actual exposure (value of the loans for a CDO or actual face amount of a bond debenture) will pay the government bail-out fund an amount equal to twice the premium collected on the excess premiums received or face the suspension and/or revocation of any licenses or charters such company currently holds.

By doing this extremely important measure of the “Follow Through Plan”, the unknown factor lying in the weeds to dismantle the good faith and money of the American taxpayer will be eliminated. The greatest risk is the element of the unknown or unquantifiable. Eliminating by Executive Order the Ponzi-styled credit default swaps and holding those to the pervasive risk that has lead us to the brink of Depression will be the tonic that turns Wall Street fraud to Main Street elixir. A bonafide relief rally will engulf the enthusiasm of American capital markets and for once Main Street would be the benefactor.

Even though this extremely important part of the Follow Through Plan will be met with loud cries of complaints from the thieves benefiting by this Ponzi scheme, the cries of the thieves will pale by comparison to the tears of the victims if this financial cannibalism is not stripped to its infancy effective immediately.

The remaining issues are less important from an immediacy point of view but of no less importance to the overall effectiveness and sustainability for any forward looking economic plan. These “suggestions” will have large and emphatic political polarities as many interest groups will cling to their parasitic past for all they’re worth. This said, a common ground should be found otherwise a return to a failed economy will soon be at hand with this time a lot less any government can do to reverse the tidal collapse.

5) Capital Gains to Zero

If Capitalism is to survive in any meaningful manner, capital needs to have preference. This is not to say that we should provide venues for those gamers of systems to prevail. Providing preference to capital should be balanced with penalty if the intent is gamed. To accomplish both, some form of the following scale should be considered:

Capital investment for less than 1 year – ordinary income
Capital investment for more than 1 year but less than 2 years – 28%
Capital investment for more than 2 years but less than 3 years – 15%
Capital investment for greater than 3 years – 0%

The result will be a massive influx of capital to our markets which will result in more stability, job creation, increased revenue to the government and, coupled with the next article of the Plan, a collapse of the international tax havens.

6) Eliminate the IRS

I will purposefully refrain from providing specifics to the suggested alternative revenue plans as this could stimulate a protracted debate beyond the scope of this general outline of what needs to be done to maintain a sustainable recovery. Also, given the potential extent of the debates surrounding this issue, there are no illusions from this writer that anything productive on this measure will be prioritized regardless the obviousness of the need.

• By eliminating the IRS and the current diabolical tax code, the obvious first savings to the government is the wasteful employment of thousands of revenues agents removed from the government’s payroll along with the massive maintenance costs supporting the buildings, etc. responsive to this waste.
• Establish a flat tax or consumption based tax with appropriate rebates or adjustments for lower strata wage earners.
• National Consumption ID.
• Future elimination of cash as we migrate to a complete electronic medium of transfer.
• Massive penalties for fraud, fraud attempts or circumvention of either a consumption or flat tax system going forward including loss of citizenship or deportation.

By shifting to a flat system, without loopholes and without the need to “overspend” to either attempt to game the system or maintain conformity, business will now be able to construct models that are independent of tax considerations. An explosion of economic activity would result along with a simultaneous collapse of the tax haven communities hoarding money outside of our capital markets.

7) Eliminate Public Reporting on Quarterly Basis

The capital markets have been reduced in large parts to a casino. Capital formation and longer term deployments of capital have been surreptitiously doomed by the participants request for “transparency”. In the name of “transparency”, corporate America has been asked to report on earnings, revenues, EBITDA, sales, etc. If the reporting is not up to some analyst genius’ super secret whisper expectation, then the stock of said company gets trashed. Sometimes the trashing takes place even if the hermetically sealed in a mayonnaise jar numbers are achieved. After a few Pavlov whippings, corporate America has been conditioned to release numbers largely inline with expectations with every bold attempt to beat the most secret of expectations regardless of the antics involved in eclipsing these worthless projections. I say worthless because if they had any value at all then the penguins disguised as balance sheet wizards would be consistently advising clients to buy at market bottoms and sell at market tops … stock by stock. The reality is nearly 180 degrees from this mythology.

I submit that the Enron’s of the malfeasant corporate public America would have never occurred, or if so, blown out long before if the practice of quarterly lying (oops, reporting) was not in practice. The short-term planning and accounting tricks responsive to this behavior mechanism needs to be replaced by a longer-term emphasis.

Management compensation is a key factor in how to achieve this important move from casino markets to capital markets. By shifting performance related bonuses from year end spiffs and generously striked stock options to the issuance of 144 stock only, the incentive of management will be forever altered and true transparency will begin to be apparent. I would even go further and advise lengthening the hold and redemption period of the 144 stock to the capital gains periods described above.

The implementation of these suggestions would allow companies to invest or divest of assets with true economic long-term viability. More importantly, it would reduce the tantra of massive debt encumbered acquisitions that have little probability of success without a equally massive dislocation of the acquired companies employees, vendors and geographic representations. Gone with these acquisitions are the benefits of competition and decentralized risk. The later, decentralizing risk by increasing participants and restricting the concentration of exposure (either to capital, market share or risk premia) to a few super companies is largely the reason for the systemic failure of the mortgage/financial industry. This failure to decentralize, and thus reduce systemic risk, will also be viewed upon in years to come as the tacit failure of the various TARP programs. This failure will be repeated with the bailing out of the US big three car makers.

We, these United States, have allowed corporate America to privatize profits while they require the taxpayer to socialize their losses. In the parlance of a trading house I believe the most liberal regulator would classify that as a bucket shop. Winning trades in corporate America’s account and losing trades to the taxpayer plus interest. This spurious theology of corporatism transfluxed through our previously esteemed capital markets needs to be obviated whilst the participants shall never prolong confidence in paper assets. This confidence game or the lack thereof, is the harbinger for the failure of fiat currency … a subject that is the center of another meaningful discussion.

8) The Prosecution of the Culprits

Last but no least is the indictment, prosecution and sentencing of the guilty profiteers and enemies of the State. The list is long and slashes at some of those the media holds as disciples. Again, a dissertation at length, I will refrain from developing the case here so as not to offend the innocent whom may be unfairly painted onto the same canvass. I believe that holding the guilty parties responsible to the American public for operating outside of the law or the intent of the law will be a prominent move restoring the faith of the American public at large.

Separately, I will devote an entire article to speak against the plethora of government statistics that are at best misleading and more directly, intentionally manipulated to disguise the real output of the U.S. economy.

Ronald M. George
Director of Trading
Highstreet Financial Group, LLC