How to Clean Up the Financial Mess

I've got a plan, says one hard-asset investor...

The FEDERAL RESERVE and US Treasury just announced a further plan to buy up to $800 billion of mortgage backed securities, notes John Lee of GoldMau.com.

This comes in addition to the $700 billion financial bail-out package announced in September. So in just past 3 months, more than $1.5 trillion has been committed to help US home owners and try to solve the ongoing financial crisis.

But let's get this right: Countrywide (now Bank of America) lent people – let's call him Bob – up to $1 million for a home that's now worth $200,000. The genius AIG then came in and insured this mortgage, collecting a premium from Countrywide.

Now that Bob can't make his credit card and house payments, troubled American Express gets a $20 billion help out, AIG gets a $150 billion bailout from the insurance obligation, and Countrywide gets to sell Bob's non-paying mortgage to the Fed.

What does Bob get from this rescue exactly? Nothing. Don't be fooled by Mr. Paulson. The case above is not an over simplification; it is exactly what is happening across the US economy.

If you were to ask a libertarian like Ron Paul about who the government should rescue, he will say, "No one". In normal circumstance I would agree; however, we are living in unusual times. We had over 25 years of massive credit expansion so the current debt implosion, with no intervention, will cause a spiral of asset price deflation, social chaos, and leave several tens of millions of Americans on the street.

If Mr. Bush really wants to help, the government is much better off giving money directly to the homeowners in trouble. And it can be done: Of the total $10 trillion US residential mortgages, upwards of $3 trillion are non-performing. It will cost a mere $150 billion to pay the interest on those $3 trillion mortgages for one entire year at 5%. This would immediately alleviate foreclosures, and temporarily stop the bleeding in the values of mortgage securities.

To those who faithfully made their repayments, meantime, they could deduct 200% of the interest payments from their tax returns. This "tax cut" would likely cost another $200 billion. And for those savers who are mortgage-debt free, waiving capital gains tax would help generate interests in making new investments.

This plan would also have the pleasant side-effect of generating housing demand from folks taking advantage of their interest tax write-off and zero capital gains tax. And the total cost of such a proposal would be well below that of Mr. Paulson's scheme.

I can't find any rationale to bail out toxic mortgage investors, however. I am still waiting for a bailout from last night's black jack losses. So what about the ailing banks? Who should rescue them?

Banks are like airlines; however badly managed, they must exist for the economy to function. However, I would not rescue Citi, which would solely benefit Citi's shareholders (including Saudi Arabia's wealthiest prince and the Singaporean government). Instead, the US government should only buy viable assets from Citi and other failing banks – assets including buildings, machines, and banking networks.

Next, the government should institute a new federal bank – starting with a clean slate – to resume residential and commercial lending. The new bank would have oversight by independent audit firms and a reasonable salary scale. After the crisis subsides, the new bank can then seek a stock-market listing and replenish the US Treasury with the proceeds.

The idea of nationalizing banks may sound anti-capitalistic, but it is exactly what we are doing right now anyway. In fact, we are doing worse – as we are leaving the good assets to the bankers and bank shareholders, but buying the worst toxic waste from them. This makes no sense at all.

And while we are debating where the government should spend its bailout money, the funny thing is, the government doesn't have the money! The 2008 federal deficit is over $500 billion, and if the bail-out programs come into effect, the federal deficit could easily top $1 trillion or even $2 trillion in 2009.

Where does the money come from? More to come...