How To Stop The Contagion HERE

Posted by Karl Denninger from The Market Ticker:

This is an unpopular set of prescriptions.  Nonetheless, it is the only thing that will work, and either our President grows a set of clankers between his legs and forces this through one way or another or we will suffer a self-fulfilling collapse when our turn comes – and it will.

1. ALL derivatives must be placed on an exchange and backed nightly with CASH margin.   Give everyone 30 or 60 days to do it, including de-constructing the "custom" derivatives to one or more "standard" and thus tradeable contracts.  All positions must be marked nightly to the market and cash margin posted by the underwater side – period.
    
2. 30 or 60 days hence all derivatives not so exchange-traded with cash margin proved behind each one are deemed canceled.  End of discussion.  Argue over "sanctity of contracts" if you wish, the inability in aggregate to perform is sufficient to void them.  Yes, I know, this will produce howls.  I don’t care.  That which must be done must be done.  If the GM bondholders can take this one up the chute so can the banks on these derivatives.
    
3. All banks and other backstopped institutions are required to sell 5% of their retained virtual portfolios to non-bank entities and mark their virtual portfolios to the market – no exceptions – including all off-balance sheet entities.  The "mark to fantasy", "extend and pretend" and similar games must stop right now.  We gave the banks the right to lie for a year and demanded they recapitalize and get rid of their crap.  They laughed at the government and bonused out over $100 billion instead.  These institutions and individuals abused the "pass" we gave them – this has to end as the crisis was and is REAL!  The mark-to-market requirement must be immediate, continuing and permanent.
    
4. All banks and other backstopped entities are required to adhere to "one dollar of capital" behind each dollar of unsecured lending at all times, plus six percent regulatory cushion, all in either cash or short-term (26-week or shorter) T-bills.  No ifs, ands, buts or exceptions.  Give the banks three months to sell off whatever they must (or to raise additional capital on whatever terms they must) to meet these requirements.
    
5. The government must cut back spending to what it can support with current tax revenues at all levels – federal, state and local.  Yes, I know this will mean big cuts in state, local and federal jobs and budgets.  It has to happen.  Give the public sector unions a choice – either they accept 20% across the board cuts or they’re all fired and replaced.  Reagan did it with PATCO and we need to do it across the nation.  It doesn’t matter what a judge says if the unions sue – if there’s no money the check bounces, and that’s that.

   
    

6. The banks that are rendered insolvent by (1) – (4) above are closed.  The assets of those institutions are sold off and the capital structure takes the hit, with both bond and stockholders bearing all loss until they are both exhausted in their entirety.  At that point if the FDIC needs to step in to make depositors (and only depositors!) whole they do, borrowing on the credit of the United States Government if necessary. 
    
7. IF this leaves us with insufficient capital in the banking system as a whole to support the proper and necessary clearing functions for payments then the Federal Government charters ten new federal banks with $10 billion in capital each.  These new banks can then lend $100 billion each, or $1 trillion in aggregate, in new credit into the economy.  However, they remain constrained as do all other financial institutions post this change, to the new rules.
    
8. The Fed is DIRECTED to bring credit aggregates in line with long-run GDP within the next five years.  This requires massive withdrawal of credit liquidity to the level of stable utilization, which was found in the 1950s to 1980.  That is, total systemic debt to GDP ratios of 125-175%.  I am well-aware that this means the withdrawal of more than half of all outstanding credit.  This is The Fed’s actual legal mandate –  the Executive and Congress must demand that either The Fed do this or The Fed as currently constituted must be dissolved and replaced with an institution that will!  We must also amend the Federal Reserve Act to provide for criminal penalties for future violations.

I fully understand that doing all of the above would cause an immense amount of economic pain.  It would end the games of "pulled forward demand", asset prices that are supported not by production but by stratospheric and pyramided debt, government deficit spending with all that entails and the age of "entitlement."

But it would have been less painful two years ago to do this than now, and if we don’t do it now it will only get worse!  If we wait for the collapse to come here the contraction will not be to 125-175% of GDP for outstanding debt, it may be all the way to zero in terms of available debt on reasonable terms!

There is no way to escape what has to happen here folks.  We are only choosing when we accept that which must happen – the removal of excess leverage and fraud from our financial system and economy.

The longer we wait to do it the more damage will accumulate as a direct and proximate result of continued attempts to paper it over and lie to the American public.