Thoughts on the Chicago Tea Party

Highlighted stocks include The McGraw-Hill Companies, Inc. (MHP - Analyst Report), Moody's Corp. (MCO - Analyst Report), JP Morgan Chase & Co. (JPM - Analyst Report), Wells Fargo & Company (WFC - Analyst Report) and General Motors Corp. (GM).

Yesterday on CNBC, Rick Santelli went on a rant about the unfairness of the Obama mortgage relief program. It has gone viral and has been replayed on virtually all of the network news shows.

Clearly he has touched into a deep nerve. However, while he makes some valid points, I really don't agree with him.

In war, there is inevitably "collateral damage," which is a nice euphemism for the fact that in any war, innocent civilians get maimed and killed. What separates a good professional Army from a bunch of storm troopers or war criminals is that a good professional Army will do what it can to minimize collateral damage, storm troopers don't care, and war criminals actively cause collateral damage.

However, even the best, most professional army in the world cannot be held to the standard that there will never be any collateral damage. The mission has to be accomplished and the war must be won, but it is a matter of honor and integrity to do so in a way that best minimizes collateral damage.

The current financial situation presents the flip side of this. The losses that have been sustained by the decline of the real estate market, and now the equity market are so huge, approaching 100% of GDP, that something has to be done. If we stand by and do nothing, the economic system will go into total implosion mode, and the early 1930's will seem like the good old days by comparison.

In other words, this is, simply, a war that needs to be fought. If the losses were to be borne entirely by the household sector, vast numbers of people will be totally wiped out. Dreams of being able to retire eliminated, people living in the streets, and real poverty will become common in this country.

It will not just be the people who got over-extended who will suffer. Spending will get cut back, and as that happens people will get laid off, and then many of them, who previously were able to pay their mortgages, will end up defaulting and we will spiral into the abyss.

On the other side of the trade stands the financial system, most notably the banks. If loans are not reworked somehow, then as people swim away from their underwater properties or get foreclosed on, the banking system starts to bear the losses.

In many ways this is even worse for the overall economy. Even a good conservative bank will have about $10 of loans outstanding for every dollar of equity. At the investment banks during the heyday of the bubble, it was more like $35 worth of loans (both whole or packaged up into securities) were supported by a dollar of equity.

These losses hit the equity of the financial system directly, so the banks are forced to cut back on the extension of credit, or even call in loans. Of course, the decline in the real economy due to the losses already borne by the household sector means that there are fewer creditworthy borrowers available, as well.

Now, there is plenty of blame to spread around here. However, just because most people played a role, that does not make them all equally culpable. Yes, there were speculators that took advantage of the lax lending practices. There were people who were flipping homes, claiming multiple houses as their primary residences, and inflating their incomes to qualify for the loans.

More common were people who looked at the long history of housing prices going up and fell for the realtor's advice to "buy now or forever be priced out of the market". Or people who assumed that their incomes would increase at, say, 10% per year, but who now find their wages cut up 10 or 20%, or those who have seen one spouse become unemployed.

Or people who assumed that because they were paying a mortgage broker thousands of dollars, that he was actually under some obligation to look for the best deal fro them, rather than free to steer them in to the worst possible mortgage, which just happened to pay the mortgage broker the highest up-front fees.

Or people who wanted to get their kids into a decent school system. Yes, it is easy to say with 20-20 hindsight that they should have just rented and saved their money. However, rental properties are not evenly distributed, and they tend to be concentrated in areas with poor school systems.

Many financial firms actively encouraged bad behavior. Remember the "lost another one to Ditech" -- a division of GMAC, partially owned by General Motors (GM) -- which made fun of the stack of papers people had to sign in getting a mortgage. Well, that stack of papers is known as documentation -- the very stuff that would have prevented the liar loans and mortgage fraud.

However, since the lender would immediately package up and sell off the loans, and the Ratings Agencies like Standard & Poor's (a division of McGraw-Hill [MHP - Analyst Report]) and Moody's (MCO - Analyst Report) would slap a AAA rating on 95% of the packaged-up loans, almost without regard for the quality of the underlying loans, there was little incentive on the part of the lender to do their due diligence.

Big banks such as Washington Mutual and Golden West Financial (now parts of JP Morgan [JPM - Analyst Report] and Wells Fargo [WFC - Analyst Report] respectively) pushed option arms with catchy titles like "pick a payment" which actually had the mortgage balances increase over time because they could report those increasing loan balances as income.

Also remember that the bankers were the professionals, the ones who earned the big bucks, the ones who were supposed to understand the risks, the ones who had a fiduciary duty. Who then bears more responsibility, the borrower or the lender?

The new mortgage bailout program uses $75 billion of already appropriated TARP money, and is focused on people who owned a single home, not mini real estate moguls who were trying to flip 4 or 5 houses. It is focused on conforming loans, which for most of the country means mortgages of less than $417,000. This is relatively small change compared to what has already been spent to bail out the banking system, between the first round of TARP money and the trillions in guarantees, back ups and asset purchases by the Fed.

Not all underwater homeowners will be saved, but there will inevitably be some collateral benefit to those who don't deserve it. And yes, those who were conservative, and didn't do cash out re-fi's or stretch to buy a big McMansion will be hurt, since it eventually comes out of everyone's tax dollars. However, this pales in comparison to the "collateral benefit" of Merrill Lynch paying 7-figure bonuses to over 700 of its employees, effective using TARP money to do so as it posted some of the largest losses ever seen in U.S. corporate history.

It strikes me that the Obama plan is more akin to that of a good professional Army. TARP 1.0 was handled, at best, like the storm troopers. Thus, if the focus of Santelli's Tea Party is individual homeowners who get an undeserved benefit, and not on the actions of the banks, rating agencies, and real estate professionals, I will not be attending, even though I am based here in Chicago.

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