Its a week or so old, but I haven't gone into detail on it before, and commentary this morning from Dubai about how Citibank may need more capital is one of those "things that make you go hmmmm...."

"The securities in the VIEs may be worth as little as 27 cents on the dollar once they're put back on balance sheets, according to David Hendler, an analyst at New York-based CreditSights. Hendler based his estimate on the recent sale of $800 million of bonds by E*Trade Financial Corp.

Predictions for losses vary widely because banks aren't required to specify the type of assets being held in the VIEs or how much they are worth, said Tanya Azarchs, managing director for financial institutions at S&P.

'The disclosure on VIEs is hopeless,' Azarchs said. 'You have no idea of the structure or how that structure works. Until you know that you don't know anything. It's like every day you come into the office and another alphabet soup has run off the
rails.'"

Oh we learned a lot from ENRON didn't we?

The amount of money involved here is staggering, dwarfing the equity in these firms. Citibank, for example, has $120 billion in market cap (equity value.)

Bank "regulatory capital" or "Tier Capital" requirements are controlled by the government (OCC/OTS/FDIC/et.al.) But under Basel, the amount of capital you must have for a given financial instrument is linked to its risk - expressed as, you guessed it, the credit rating of that instrument.

Now here's the problem - these "VIEs", some of which are the famous "SIVs", are off-balance-sheet for the explicit purpose of not making available to those who wish to look inside the kimono (like investors, for example) the composition of risk that these banks are taking. And since reserve requirements against instruments are controlled by a given instrument's credit rating, and we know that Moody's, Fitch et.al. would never fail to downgrade someone until after it has already blown up......

Bernanke this morning is urging banks to write down principal balances on mortgages that are in trouble, warning that the "potential for losses is larger than recognized so far." No kidding?

The "money quote" in his speech is that losses today on mortgages that foreclose are typically running 50% of principal balance!

This is a horrifying deterioration from historical norms - but it is exactly what you'd expect when you go from a world where people put down 20% to one where people put down 0%.

By giving homebuyers effective infinite leverage (0% down = infinite leverage) the bank has taken a 70% recovery rate on a potential foreclosure and turned it into a 50% one, and that's without the impact of declining home prices!

Now bundle these mortgages into leveraged instruments and hide them off balance sheet and you have the potential for a nuclear device blowing holes in your balance sheet.

Ben's solution?

For banks to write down principal.

Banks do not need anyone's permission - such as from investors - to do this. They simply buy the loan out of the pool exactly as if it was refinanced traditionally. They then either write a new loan or find someone who will and pay the deficiency in cash. You now have a new, clean note. Properly underwritten these notes will have all of the following characteristics:

• 20% equity in the house
• 36% back end ratio
• 30 year fixed term

In short, they will be sound mortgages.

Now clearly, not everyone will be able to be helped in this fashion. For those who bought at the top or HELOC'd out to the max during the bubble years and are 40% upside down in a declining market, there is no help for them. If you can't get somewhere near 20% equity at today's FMV of the house, that loan can't be "fixed", and ditto if the DTI won't qual. No bending the rules here, as the goal is to do this exactly ONCE.

But a huge percentage of those mortgages that are due to reset can be fixed under this sort of plan!

Do you folks have any idea what that sort of change would do to the banks? Such a policy, were banks to actually adopt it, would force the hit onto the banks who made the bad loans! By effectively buying down the principal and refinancing the resulting balance the CDO and other MBS security folks are protected as the original note is paid off but the banks take an immediate and severe hit to their balance sheets as they are forced to "eat" the difference in principal.

In bubble areas this hit could be well north of $100,000 a house!

Here's the interesting part of this - from what I can see this is the first real proposal that I've seen come out of The Fed to deal with this problem, and it puts the economic impact squarely on those responsible for the loose standards!

The best part of this is that Bernanke can actually force this if The Fed so chooses.

Now let's analyze the impact of this were it to come to pass.

First, it will******the banks. Hard. They will basically eat the phantom appreciation in house prices caused by their unsound lending. The loss goes where it belongs, instead of where it doesn't. The MBS holders have their loans bought out by the banks as the loans are reissued with the principal buydowns, so they remain (mostly) whole.

Second, it will******anyone who is paying but purchased in the 2005-2007 years. This sort of change will almost certainly produce a wave of intentional defaults as people simply refuse to watch their neighbor get $200,000 in "free principal" while they do not. That will add to the pressure on those banks.

Third, it will adjust the real estate valuations more rapidly than would otherwise occur, which will shorten the length of time that we suffer economically in a very material fashion.

Fourth, it will likely prevent a re-run of the 1930s, as by NOT attempting to sweep it all under the rug and shift the default costs off on someone else confidence will be restored in the system. We will actually see those who were responsible for selling financial "instruments" with 100,000+ pages of paper you'd have to read to understand them (clearly impossible) eat the costs of their intentional mispricing, just like they got the profits during the "boom years."

Fifth, it will be the absolute end of zero-down and "liar loans", unless you like paying credit-card style interest rates. There's no way you're going to get a bank to do this again once they take this sort of hit. This is a huge net positive for the stability of our economy and financial asset base going forward.

Sixth, it will result in all of the following in terms of actual pain:

• The banks will take 25% write-downs instead of 50% ones (Bernanke said today that recovery on foreclosures was 50% or less.) While some of the investment banks will fail anyway under this scenario not all will and those who survive will operate in a less-competitive market.
• The mortgage bonds, CDOs and CDO^2s will not blow up. This means your pension fund doesn't blow up, for starters. It also means that the other banks and investors who bought this paper don't blow up.
• Leverage will be cut way, way back across the board. This will blow up a lot of the hedge funds, especially those who bet "short" on these financial instruments.

Seventh, there will be no government bailouts. No taxpayer money gets spent. Instead, those who did imprudent things eat them.

Eighth, we clear the debt market within six months to a year, and our economy restarts. We get a nasty recession but not the "D" word.

I think I just saw a pig fly by my window..... amazing.

Is it perfect? Hell no! But let's be straight here - if I have to choose between the government bailing out people via a RTC-style buyout of mortgages or this sort of "you made the mess, you eat it!" solution, I choose the latter.

Yesterday morning on CNBC Warren Buffett was commenting on these CDOs and similar instruments, noting that you'd have to read hundreds of thousands of pages of documents to actually understand what's in a typical CDO and where the risk lies. Of course nobody can actually read hundreds of thousands of pages of documentation before making a purchase, which means that these instruments are intentionally impossible to understand in detail.

Yet it is those details that are critical to understanding the risk they pose. How many of the loans in a given pool were "liar loans"? Exactly what zip codes are these loans in (so we can get a handle on the market's performance there)? There's a tremendous difference between a home in San Diego and one in Witchita!

The danger here should be obvious and on everyone's radar, especially small and medium-sized businesses, and less-sophisticated investors and individuals such as retirees who often take banking relationships for granted.

If you are over FDIC limits at any banking institution do something about that right now.

Finally, six months after I started talking about it, we're seeing estimates come down on the S&P 500 and companies in general. Duh; in a recession earnings GO DOWN!

Beware "multiple contraction"; this is the major rapist of equities in a recession. It is not the contraction in GDP that usually gets you as in general GDP doesn't decline that much in percentage terms in recessionary times; it is the contraction of earnings multiples as a result of overly-optimistic estimates that leads to the lions share of losses!

Oh by the way, we tasted the closing levels in the S&P 500 from January (1309.50); the key item now is whether it holds, or whether we're going much lower - a break here, which is more than a bit likely, targets 1220 at a minimum and the bad news is that on the way we will trigger cascading Head-And-Shoulder patters, which leaves open the potential for a waterfall-style collapse.

Of course that prompted a double pump by Charlie Gasbag reporting the very same rumor that has been flying around for two weeks on Ambac, and which was (again) good for an instant 20 handles on the SPX.

You have to wonder about these people....... how come there's no news on reality? What's reality? Simple - all the prime brokers are pulling credit lines from their Hedge Fund customers by increasing margin requirements. Why? Again - is this a choice or is it forced by capital requirements and if the latter, what does it say about the big investment banks' health? This is NOT a small matter and it WILL force a "market event", but the gasbags on CNBC have not and will not report this because it would result in 20 handles coming OFF instead of going ON.

Buckle up folks - the ride is about to get a bit bumpy......

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