Unclog the Cash Pipe – Anyone Know a Good Plumber?

Credit is based on a cycling of cash. Banks lend and sell the loan. Sallie Mae buys it, bundles it and sells it to investment banks. They rate them, package them and sell them to investors. Investors trade them at the monthly auctions – - SCCREECH – wait the auctions are gone.

“Hold one now, Mr. Columnist Guy. Are you telling me that I can sell my fake Gucci on eBay to someone in Russia but sophisticated investors have nowhere to sell billions of dollars in professionally rated securities to others who might want them?”

Yep, that is the problem.

“Well what idiot would buy stuff he or she can’t sell or even use?”

Precisely.

When the natural flow of anything is clogged, either the system stops or, as in this case, it backs up and spills icky stuff all over the place. The solution is so simple – restart the ARS auctions. At these auctions, the securities will be purchased and sold. As always, some will not sell. The government can purchase those that don’t sell just as the investment bankers once did and offer them for sale the next month. The clog will be cleared and the cash will flow again. Values will go up. Banks will loan money. Fannie Mae will not be broke. Investment banks will not be broke AND it will NOT cost $700,000,000,000.

How it Used to Work
Decades ago, shares of stock could only be purchased in large blocks, effectively excluding ordinary people from entering the markets. Mutual funds and even money markets were a thing of the future. People deposited their money in savings accounts at a bank or savings and loan. This money was then insured by the FDIC. The institution loaned that cash to customers to buy homes and start businesses. This was a local process and quite limited.

As higher return on investment options for smaller investors grew, people began to place a lower percentage of their wealth in bank savings accounts. Since this cash was the primary source of lending, the government had to create a mechanism to allow banks to turn loans into cash they could lend again.

Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac were born. Their mutations over the years were designed to continue to facilitate liquidity as financial behavior changed. Anyone can buy stock in today’s world. There are many creative and effective vehicles, with varying levels of risk and return, into which people of all levels of wealth can invest. As a result, savings accounts no longer effectively support lending. Lending is now driven by liquidity.

Liquidity is created and lending is facilitated in the following process:
1. A bank makes a loan.
2. The loan is purchased by Fannie Mae for cash.
3. Fannie Mae needs cash to buy more loans, so it has to sell the ones that it has purchased. It bundles these loans into securities rated by Standard and Poor’s and others (ARS) and sells them to investment bankers.
4. Investment bankers need cash to buy more ARS, so they sell them to investors.
5. Up until a few years ago, investors then traded these assets in monthly auctions. These auctions supported the value of the ARS by keeping them liquid.
This cycle kept cash moving through the system so that loans could be made to you at the front end.

What is Broken?
When you clog up the pipes the whole system backs up, and this is precisely what has occurred. The auctions for these ARS dried up due to stupid Federal Reserve policies (see my prior blog).

These auctions allow investors in ARS to buy and sell them. Liquidity is a critical part of value. According to Carl Jenkins, an expert in securities valuations with UHY Advisors in Boston, MA, the inability to sell an asset can reduce its value by as much as 30%. These are fairly tight margin investments and the only way they make sense to an investor is if they can be sold easily. When the ARS auctions failed, investors not only stopped buying ARS but also demanded their money back and got it from investment banks.

If investment banks cannot sell their ARS to investors, they have no incentive to purchase them from Fannie Mae. If Fannie Mae cannot sell its bundled mortgages and bank loans to investment bankers, it has no cash left to purchase mortgages and bank loans from banks who make them. If Fannie Mae cannot purchase the loans, the banks cannot make them because they have no cash to lend. If the banks cannot make loans, the economy screeches to a horrible stop.

And that is what has happened. Start the auctions. Unclog the system. Let the money flow again and all will be well with the world. By the way, if the government starts the auctions and gets the cash flowing, private players will take the auctions back and the government can get out of that as well.