President Obama has re-nominated Bernanke:

Bernanke “has led the Fed through one of the worst financial crises that this nation and this world have ever faced,” Obama said in remarks prepared for delivery today at 9 a.m. in Martha’s Vineyard, Massachusetts, where Bernanke is to join him.

“As an expert on the causes of the Great Depression, I’m sure Ben never imagined that he would be part of a team responsible for preventing another,” Obama said. “But because of his background, his temperament, his courage, and his creativity, that’s exactly what he has helped to achieve.”

I suspect that these words will come back to bite our President in the future, perhaps dramatically so.

Here's the problem, in a nutshell: We still have "mark to fantasy", but the basic principles of accounting have not and cannot change: Assets - Liabilities = Capitalization.

Now add to this what I wrote about yesterday:

Delinquency cure rates refer to the percentage of delinquent loans returning to a current payment status each month. Cure rates have declined from an average of 45% during 2000-2006 to the currently level of 6.6%. It is important not only to observe total roll rates, but delinquency cure rates as well, according to Managing Director Roelof Slump.

Got that?  It bears re-emphasis, because it changes literally everything about loss assumptions.

Let's do a bit of math.

We have a mortgage for $500,000.  The underlying asset (the house) is now only worth $400,000  (a 20% "underwater" status.)  The homeowner is behind.

What is the loss to be expected?

It's binary: either zero (if the delinquency cures) or about 25% (if the delinquency does not), with the latter including the fact that the $400,000 "value" also has to have deducted from it rehabilitation and sales costs.

But if you have 1,000 of these loans then the outcome is not binary; it now becomes a statistical issue.  Here's the difference:

$500,000 x 1,000 = $500 million "face value".

Recovery value per home: $350,000 ($400k - rehabilitation and sales costs) = $350 million in "recovery value."

If cure is 40% then the value of this pool is $500 million less (150 million X 60%) = $410 million.

But if cure is 6% then the market value is $500 million less (150 million X 94%) = $359 million.

That's big - we're talking about $51 million bucks on the entire pool, or a 10% difference in valuation across the entire pool from its ORIGINAL value, and a difference in loss severity of about 57% (!)

Now consider that banks typically have just a few percent in capitalization against their loan assets, and you see the problem - this change in recovery values is sufficient, all on its own, to either severely dent or even wipe out the bank's capitalization.

Now consider that the "recovery rates" for many of these homes are hopelessly optimistic.  In bubble areas such as SW Florida and California recovery rates are in the 40% range or less on many of these properties: today, with cash, you can buy what was a $250,000 house in SW Florida for under $100,000.  That's "the market" and unfortunately that's where recovery value lies. 

It is this dramatic change in recovery (market) value that has in fact caused the drop in cure rates.  People have come to the realization that if banks are going to be permitted to lie about asset values and solvency and get away with it then there is no reason for individuals to do anything other than make a business decision - and they are.

I get anecdotal reports of this every single day: People who have not made a mortgage payment in a year or more, yet have gotten only a letter in the mail notifying them of their delinquency.  Some have decided that since their credit is going to be trashed anyway they will charge their groceries and everything else on their credit cards and stop paying those too, stashing all their cash "somewhere else" and waiting for the inevitable - bankruptcy.

Yes, hiding that pay is a crime.  And?  So is accounting fraud - in theory.  So is making claims of solvency when you're in fact bankrupt - in theory.

This is the outcome of "moral hazard" - it becomes "mortal hazard" to any potential economic recovery, and yet we've seen exactly ZERO intent from either the Bush or Obama administrations to address it.

How do we address it?

Simple: Every financial institution in the country has the examiners show up and marks to the market every asset.  Then capitalization ratios are recomputed and those institutions that fail are closed.  The assets are sold off to mitigate deposit insurance claims and the deposits are transferred or sold to sound institutions.  In the case of large regional or the huge monster banks the deposits are split off to the various communities served across the country.

We decentralize what was agglomerated over the last thirty years by doing this, spreading the employment and benefits to the local economies instead of concentrating them in New York.

We put Glass-Steagall back in place at the same time, stopping institutions from gambling with taxpayer money.

Will this be popular?  Not with Wall Street! 

But can we "stabilize" the banking and housing markets without doing this?

No.

Accounting fraud, legal or not, can only cover up insolvency.  It cannot fix a cash-flow deficiency, which is the root of the problem, and that cannot be addressed with games and obfuscation.

As long as cash-flow deficiency persists (that is, people not paying) there are only two alternatives: either declare those loans busted that are busted or paper it over and pretend by "making up" the cash flow to investors in those securities out the back door by siphoning off government largesse and otherwise-earned income.   The former forces the truth to be told and clears the market, allowing economic growth from a stable, sustainable base, the latter severely damages GDP and private economic activity going forward.

We've done the latter for more than two years and have continuing unemployment, capacity utilization in the ditch and a dysfunctional credit market to show for it.

It is time to do the former and confess before we are forced into it when the electric bill cannot be covered and the lights go out.