Tuesday, January 27, 2009

Here We Go

The news leaked this evening of the new plan for an "aggregate" bank, or what will be known as a bad bank.

This bank will be government run and will purchase toxic debt off the balance sheets of the remaining investment banks. This was the original intention of the TARP program that was scrapped due to an unforeseen glitch. Let me try to explain:

A bank has a mortgage on its balance sheet that they currently value at $100. The government would then come in and purchase that mortgage at what they would consider fair value. Let's say that they consider that mortgage worth $50 and purchase at that price. Sounds good right?

Here's the problem. There are currently no other buyers in this market other than the government. That means that the price they pay for the asset now determines the market value of that asset. Think of it like a house. If you have a similar house to your next door neighbor, and he sells his house for $200,000, that is now essentially the free market price for your home and what someone would use as a guide to offer you.

So, here's where you run into trouble. With the government's purchase of the mortgage at 50% of the value of what the bank had it worth, that means whatever mortgages the government does not purchase, the bank must now write down the value of that asset by 50%, bringing them down to free market value. This would have sparked trillions of dollars in write downs for the banks, which would have caused systemic risk. (Previously discussed)

This new bad bank has found the "solution" to this problem. They are going to replace the difference in the price they pay for the asset with the price the bank currently has it marked at by buying shares of common stock in the bank.

The government has then justified the purchase of these assets by saying they have the ability to hold them to maturity. This means they will never have to sell the assets. It will just sit on their books until the loans expire.

The second part of Tuesday's news was the Fed's new housing program. Discussed previously in great detail was the Fed's purchases of Fannie and Freddie mortgage debt to help clear their balance sheet and allow them to make new, horrible, loans to home buyers at very low interest rates. (Mortgage rates are currently between 4 and 4.5%)

As I mentioned before, there is still one problem with this program; the people who have already bought homes that cannot afford them. That solution was announced this evening:

The Homeownership Preservation Policy for Residential Mortgage Assets

This new program allows the Fed to start modifying the loans of current mortgages. The Fed will do this by reducing interest rates on the current mortgages, extending the term of the loans, or even accepting a reduction in the outstanding principle on the loan.

The cost of these programs will most likely end up in the multi-trillions. $3, $4, $5, $6 Trillion?

What force is out there to measure and account for all this inflation and debt?

Gold.

The world's last true accountant. It is watching every dollar enter the system, waiting to revalue itself as it has time and time again throughout history.

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