THE OBAMA PLAN: WILL IT SAVE THE ECONOMY?

I watched Steve Forbes being interviewed at the World Economic Forum in Davos, Switzerland. His simple, straightforward cure for the financial crisis is the same that I have been preaching since last summer, suspend the "mark-to-market" accounting rules. I have added that the rules are not being followed anyway. The so-called "toxic assets" or mortgage based assets have no market, thus if mark-to-market rules were strictly followed, they would be marked to zero. But that is not what is being done. They are being marked to notional markets that may or may not reflect the actual value of the asset.

I have called for valuing these assets to their long term or maturity value instead of what they bring at sale in today's market. My reasoning here is that, since you cannot sell it, you continue to hold it. The assets do not vanish.

More importantly, I have noted that the actual default rate on mortgages in 2008 stood at 6% and the foreclosure rate was just over 2%. My argument was that the underlying asset, i.e. the mortgages themselves, were still performing well enough to value them to their maturity value.

The problem lies in the fact that when the holder of the toxic asset devalues it to a non-existing market or a notional market based on fear of massive foreclosures, it sharply reduces its value on the holders books. This leads to not having sufficient reserves to lend or borrow. Thus the failure of our financial sector, the so-called "financial crisis of 2008."

But we are now beyond the "financial" crisis. The crisis has now spilled over into the so-called "real" economy which means actual output of goods and services. In essence we have less credit, thus less demand, thus less production, thus lower employment or higher unemployment. Unemployment is now putting more pressure on ability to pay debts, most importantly mortgages. The default rate has now grown to 7% and the foreclosure rate to 3%.

Much of the debate over the new Obama plan to revive the economy revolves around the proper valuation of the "toxic" assets to be purchased by the Feds and housed in an "Aggregate Bank" (popularly being called the "Bad" Bank). The theory here is if the Feds buy the "toxic" assets they will establish a market for these assets and thus raise their value on the books of those still holding them.

This is good but a bit late. We don't have time to wait for establishing the market. Thus I insist, as does Steve Forbes, that we suspend "mark-to-market" rules. Valuing the assets at their maturity value would reestablish balance to the books of those holding the assets to a level where they can borrow and lend again, immediately.

As for the rest of President Obama's plan, we have let the financial crisis cause so much damage, we need to do more than simply reestablish credit channels. We need to put people back to work and keep the "real" economy moving. The plan will do this, no matter how the funds are spent. Build a bridge, build a road, refit a classroom, improve energy efficiency, spur research. All of these put people back to work and thus provide funds for them to buy and spur production of all goods and services.

Of all of Obama's plan I am most pleased to see the block of funds going to state and local governments to help them out of financial crisis brought about by the other end of the real estate decline, rapidly declining revenues from property taxes. It is no surprise that foreclosures for failure to pay taxes are running more or less the same as foreclosures for failure to pay mortgages. The Fed fund here will more than cover the anticipated shortfalls in state and local government budgets.

Most importantly, no matter how the drama is played out, we have a "New Economy" in which the Federal Government plays a much larger role than before. No longer is it just the main consumer of our output of goods and services, the Federal budget equals 20% of our GNP, or the rules maker and central banker, it has rapidly become the single largest share holder in our private sector - banks, insurance companies, mortgage companies, auto markers and more. Our economy will now be seriously affected by how the Federal Government acts as a share holder, a whole new dimension for government involvement in the economy.

Even more interesting is that the Feds are buying up the private sector with funds borrowed at no cost, i.e. Treasury Bonds or "T-bills" are being sold with interest rates less than the inflation rate. In other words Uncle Sam is buying these assets with today's dollars that he will pay back in the future at devalued dollars. All investors should have this situation.

And if you think the Feds have acquired a massive stake in the private sector so far, what would it be if they take the step being advocated by many to take over all the banks, i.e. "nationalize" the banks? I don't believe we are at that stage yet but who knows?

Leo Cecchini
January, 2009