Washington Dithers, Dow Drops

Washington is AWOL right when we need them, Cramer said Friday. Will more banks fail? Will they be nationalized? The Dow reached new lows today because Wall Street didn’t have the answers to those questions. Instead of worrying about climate change, or even the war in Afghanistan, President Obama needs to focus on this financial crisis. Otherwise, Dow 6,000 is a very real possibility.

The new administration has failed to act quickly and decisively, and as a result the damage has spread far beyond just the banks. All across the market, large-cap companies have shrunk into mid-caps, and mid-caps to small-caps. Just a year ago, the 100 largest companies were worth $8 trillion. Now they’re worth $5 trillion.

But, yes, the banks are at the center of this storm. Citigroup’s market cap has plummeted to $13 billion from $125 billion, and Bank of America to $24 billion from $197 billion. Yet still we don’t know the government’s plan for saving this sector. Market opinion swings between an expectation of nationalization and the exact opposite – letting institutions fail a la Lehman Brothers on principle. For the latter group, it’s a question of moral hazard. This “Chicago trader school”approach, as Cramer called, also said that overextended homeowners – those people “underwater,” whose mortgages are worth more than their houses – should be cut loose, too.

Here’s the problem with those two theories: Nationalizing banks would wipe out their common and preferred stock, as well as their bonds. And that in turn could mean the failure of some insurers and issuers of annuities because these companies hold their money in the very preferreds and bonds that would be wiped out. Americans would watch their net worth, their nest eggs, disappear.

On the flip side, the moral-hazard approach doesn’t work either. History shows that attempts to punish the “bad guys” rather than save the system have disastrous consequences. Because that was exactly Herbert Hoover’s intent, and it landed us in the Great Depression. We can’t risk that happening again.

So what to do? Cramer, of course, has a plan: The government should offer 40-year, 4% fixed-rate mortgages or refinancings to everyone – not just those overextended homeowners. Those mortgages would be valued at current market price so no one is underwater, and in return the lending banks would get Equity Participation Certificates for the excess principal left over after the revaluation. The banks would then use these certificates as money for regulator capital, with no mark-to-market rules so they can work out their problems themselves. If the homeowner sells their house at a profit, the balance would first go to the banks, and any remaining money would then go the seller.

The keys, regardless of the plan Washington puts in play, are to keep people in their homes, save the banks and create jobs. Until Obama and his team step up, the market’s down days will continue.

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