Picking Up the House of Cards

Today's announced action to address the root cause of the crisis, answers long-ignored calls from voices like ours to address the illness and not the symptoms. It's about time!

(Article interests AMEX: XLF, AMEX: DIA, AMEX: SPY, AMEX: SDS, AMEX: DOG, AMEX: QLD, Nasdaq: QQQQ, NYSE: NYX)

Recalling the Reasons

Clearly, the root cause of market demise can be traced back to housing value decline, which followed a period of unnatural appreciation. As homes suddenly dropped in value, negating home equity in many instances, mortgage holders began defaulting for this and other reasons. As a result, a great deal of derivative instruments were left hanging in jeopardy as illiquid pariah nobody wanted to buy or hold anymore. This compounded the housing collapse and set catastrophe on track.

Accounting rules require securities be marked down to reflect value, and the whole house of cards fell apart as financial institutions' capital sources dried on fear of diseased assets and generally declining business activity. The disease quickly spread to other facets of debt financing operations, including the insurers of debt. Other debt was also taken down in the process, due to the distressed secondary markets. Mortgage backed securities, which were ironically created to promote home ownership (and to profit creative investment designers, investors and traders), took down housing in the end. Thus, the American dream was destroyed by human greed, and our homes proved made of cards.

Fixing the Mess and Addressing Those at Fault

Clearly, the best way to fix this mess would have been to slow the bleeding in housing; a bubble is a bubble though, and it will pop if it's excessively inflated. Unfortunately, that became a given in real estate when regulators took their eye off the ball. But afterward, we still needed to slow the bleeding. While much blame is directed to Alan Greenspan and his hearty rate cuts, we could have limited this mess by actually regulating the mortgage industry in the first place and actually holding the rating agencies to higher standards. At this point, rating agencies must be held accountable for their mistaken rating of these securities. Certainly, banks are partly to blame as well, and have rightly suffered at the fault of their own poor decisions.

So, it seems clear to me that these regulators should not only be absent from their desks, but perhaps jailed for negligence. It seems equally clear that the rating agencies including, Standard & Poor's (NYSE: MHP), Moody's (NYSE: MCO) and others should receive major penalty. Their operations need to be reviewed closely by the government for their internal processes, and I believe the process should be made government responsibility. If the government should take control of anything, it should take the rating of non-sovereign credit under its wing.

Rate & Inflation Control Also Critical

Keeping long-rates low is also of critical importance, so as to offer natural incentive for renewed home demand and thus price support. We need to insure that natural demand consumes the excess inventory that still floods the real estate market. The lower the long rates, the greater likelihood of treating the illness from its core.

In January, in regard to treating the root cause of crisis, The Greek said, "As we said, lower rates treat the illness, which is better than treating the symptoms if you want cure. Let's get these bad loans refinanced, strengthen the underlying paper. Do that and the derivatives become more viable as well. Problem solved."

In retrospect, that statement as a standalone was naive and inconclusive. These folks can't refinance, because home value decline eroded equity, and in too many instances mortgages ended up greater than home value. Thus, refinancing might require more collateral, which many weakly qualified home owners just don't have. But, supply and demand drive price, and lower long rates should support demand, and thus price. Eventually, this will restore equity to many borrowers. Meanwhile, the government and banks have been helpful in aiding borrowers like these for the sake of limiting the flow of foreclosures flooding housing inventory.

Also in January, in addressing the illness of the crisis by targeting long-term rates, The Greek wrote, "If this happens, while the spread between the 2-year and 10-year treasury yields could widen, we expect long-term rates would still fall. This could be perfect medicine for the mortgage market by allowing burdened borrowers more opportunity to renegotiate into more amicable loans. We believe this would directly treat the illness, not the symptoms, and thus better solve the problem within credit markets."

Today's Action Recognizes Government Limits

Finally, instead of throwing limited dollars at treating symptoms and taking conservatorship of a mounting number of companies, the government seems on a better path now. If this strategy had been considered earlier, perhaps Bear Stearns (NYSE: JPM), Lehman Brothers (NYSE: BCS), Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE), Ambak (NYSE: ABK), MBIA (NYSE: MBI), AIG (NYSE: AIG), IndyMac (NYSE: IMB) and Countrywide (NYSE: CFC, NYSE: BAC) might still exist as they did pre-catastrophe; but the fix would still have been expensive.

In any event, this should offer stability to the financial sector, and explains the group's rise today. The Financial Select Sector SPDR (AMEX: XLF) was up 13% at the hour of publishing. We really were at risk of economic depression as the system came frighteningly close to complete loss of confidence and collapse. The government will burden itself with sickly securities, allow these companies to shed their illness, and support future growth. Thus, assuming this is fast-tracked through government approval, I believe it's time to go long the financial sector.

The government gets that it's not too late to stave off future failures, and perhaps economic failure as well. Naked short sales and the shorting of stocks on the basis of fraudulent rumor mongering have played a role as well, but those have been addressed already. The SEC action to temporarily stop shorting of financial stocks altogether adds unnatural support as well today, and keeps us from shooting ourselves in the name of capitalism. The government also took action long ago to prevent future mortgage brokers from issuing loans to unqualified borrowers and from other deceptive practices.

As we've discussed often, the fact that this is an election year, leading both Democrats and Republicans to aggressively seek spotlight as economic saviors, is driving intense action and possibly saving us from the worst case scenario. It's sad but true that if this was 2006 folks, we would be in greater danger of depression.

That said, I want to reiterate my statement from two days ago, when the market was down 300 points and the headless chickens ruled the street. This week should mark a long-lasting bottom, and I believe stocks can be purchased here with a greater level of confidence.

Please see our disclosure at the Wall Street Greek website.