The sky is falling! The sky is falling! Buy, buy, buy.

I am looking at the doom and gloom in the marketplace and I think about how in some cases people overreact to bad news. I am going to stay away from the stupid pricing in mortgage bonds and focus on Vale, a.k.a. CVRD. Vale owns the iron ore business. It has the best reserves, the best quality, and a very long life of mine. If they decided to shut down production to Europe, they own enough of the market share to put Europe into a complete economic crash. They also have other assets that are not as nice. The price of nickel is way down as stockpiles grow and demand clearly weakens. Copper is not much better, and let’s not get into the aluminum demand. I am going to focus on the iron ore assets.

You have two forces at play here: The lack of capital is going to suspend lots of projects for the duration, and China has built up inventory because of the slowdown around the Olympics. Independent supply in the iron ore market is just not going to grow. Most of the producers that have production are not leveraged and therefore are going to be much more concerned about profit rather than revenue. China is going to milk its stockpiles as it finally has figured out that it alone was driving up the price of commodities. It has learned that if it takes 1% off of worldwide demand growth, it pays much lower prices for the stuff it wants to import.

So what is going to happen? In a nutshell, we are going to have railroad strikes and mines flooded, and Vale announcing a price rise and then saying it will not ship any product to China until it gets it. Production targets will get lax, maintenance will be done on equipment, and production will go down by 5-10% in the iron ore business. If this were nickel or platinum, global prices would crash, but as this is iron ore, the spot market price will crash, but do not expect the big three to be putting on any inventory reduction sales. The fact is running a mine at 95% of production vs. 102% will reduce operating costs significantly, and it is always much better to cut 7% of your production than 7% of your sale price.

What is going to happen is steel companies are going to get squeezed; the price of steel is going to come down; the price of ore is going to stay high; and we are going to have steel companies doing the dance of the stuck pig. Vale is not stupid. They have no need to ship ore. They can sit on their hands till the customer is begging them to ship. When they do not ship, it costs them $5-10 to idle the tonne of production–to idle a steel mill costs $70. Guess who wins in the waiting game? Vale, and the stuck pig will pay the price.

So what would I do in this market? My gut says buy Vale, as it is trading for the value of its iron ore assets, and the price does not assume any value for anything else. My gut says go short on the steel companies, especially the steel companies that do not have captive iron ore like ThyssenKrupp. There is going to be a consolidation in the junior iron ore marketplace, but the fact is the iron ore production business is going to stay strong because three companies own it and they will treat it well.

Going to be a fun year.

Benjamin

Okay, everyone is coming out with solutions, and I do not like most of them. Let me go over a simple solution. We have to fix two things: Freddie and Fannie, and the existing toxic debt. I have a simple solution to both things in one deal.

We create 10 regional banks that are 100% owned by every U.S. citizen. The banks issue 100% of the shares to the U.S. citizens, one per citizen. They do not trade publicly for five years, and when listed after five years, the banks can only do the listing to take out shareholders who want out, not to raise new capital.

We fund the banks by giving them each the ability to issue $200 billion of U.S.-backed debt that is issued at a term of 25 years at 2.5% interest.

The banks then have the limited mandate of buying only any mortgage-backed securities that they can trade at face value for the federally backed debt. If someone thinks their bonds are worth more than the 25 years at 2.5% in trade, then I would not define the debt as toxic, but I expect that lots of of the bad debt, if not all of it, will get traded.

The banks then rehire lots of the people who have been fired and create a clean regional system to deal with the mortgages. They work to refinance homeowners into 30-year fixed rate mortgages with 80/20 ratios, being willing to write off the equity part needed to get the loans to 80/20. If the homeowners in trouble cannot afford a 80% loan on current valuations at 5-6%, I am sorry to say they should not be in the houses, and the banks will work with them to put the houses up for sale in an orderly manner.

We can be fair and say that these banks can never pay senior management more than 50 times the lowest-paid full-time employee.

First problem is then solved, and what we have is 10 new banks that are regional and cannot operate outside of their region that have very nice balance sheets, $200 billion in assets that will yield 5-10%, and $200 billion in debt that will cost 2.5%. They should have $5 billion a year in earnings each, and they should quickly be able to build balance sheets so that they can compete with Freddie and Fannie on standard mortgage terms.

On any new loan, these banks should be federally limited to doing only 80% loan-to-value mortgages. Or for less than 5% of their business, they could provide low-income loans where they do 95% LTV mortgages for first-time home buyers with credit scores above 700. For new loans, they could issue market-rate debt, and it would be federally backed. They would be mandated to issue the mortgages at 1.5% higher than they borrow money at. They also would be limited to only issuing 15- or 30-year bonds that match the maturity of the underlying mortgages.

The U.S. citizens will become shareholders; the banks will not cost the federal government a nickel as they are buying toxic debt cheap with clean debt; and I can assure you that the default rate would have to hit a very high number not to make money on the interest rate swap. Within 10 years everything will be unwound, and frankly the shareholders will make some serious money at the expense of Wall Street.

We then leave Freddie and Fannie around to compete with these companies, but we make a them follow the same rules: 50 times compensation, 1.5% spread, 100% owned by U.S. citizens, only 80/20 mortages or a very limited number of 95% mortgages to first-time buyers with credit scores above 700, only fixed rate products, and only 15-, 20-, and 30-year term loans.

Problem solved.

Benjamin

Valuations are traditionally done in boom times and bust times, and they are done very differently in both times. I am going to go over how to value a mineral property in a full market cycle. I am not going to focus on any one project, but I will draw conclusions that can be applied to most any project.

First off, a mineral property should be viewed not as a discounted cash flow asset, but rather as a set of real options. Let me start by going over what shapes those options and how to deal with them. In this update I want to lay out the variables I think about when I do this type of work: project size, capital costs, and commodity pricing.

Project Size

Size does matter. I know you all have been told that it does not matter how large your asset is, but really the people who do your books do care. A property has a binary valuation depending on the size of it. The question of how small a project you can develop will depend on the capital required to get to a minimum amount of production. To take an extreme example, a 100 million tonne iron ore body that needs a 1,000 km railroad will never be developed. A 10 billion tonne asset such as Serra Sol that only needs a 100 km extension to a rail line to be developed will always be developed.

The issue about size is threshold. If you do not have enough size to support the capital invested, you will never have a mine. It is sort of like a roller coaster at Disneyland–you have to be so big to ride. The old rule of thumb was your needed 30 years of production at an economic scale. If you are a low capital scavenger of brownfield like Portman, this does not apply, but for any greenfield project this is a good test to undertake. So if you want 8 million tonnes of ore production out of a mine, you had better have 240 million tonnes of product in the ground. Not ore, product, and of course the first thing that happens in a boom is people do not do proper conversion of resource to product (processed reserves).

Capital Costs

The amount of capital required for development also matters. Now let’s be precise. If you cannot service the debt from the mine, it does not matter how big the ore body is. A simple calculation is in order here: Take the capital cost of the project and divide by five. So if you have a $1 billion project, you end up with $200 million going to debt service. The free cash flow from the project has to be greater than 20% of the capital required to build the mine.

Now how you get the free cash flow number will heavily depend on the commodity price used. In a bull market that price can be very high, but you have to pick a floor on that number. You have to know the price of iron ore or copper at which the mine will not work. You have to know that the unit production cost is well in excess of the “cash cost” of production. I am not saying that you have to do your DCF (discounted cash flow) on the valuation of a project with the floor number, but you have to understand that if you have cash costs of $25 per tonne of product and the 10-year floor is $15, you must have a decent plan on hedging for that, or else you will go out of business during a down dip.

Commodity Pricing

To develop commodity prices, I like to look at a few different things.

How leveraged is the sub-industry? Leverage adds to volatility because with leverage, people have to produce in a full market cycle. You do not shut down if you have a bond payment to make. A highly leveraged industry will work for the debt holders. Even if your own project is unleveraged, you will be working to the tune of steady production and not steady pricing, a tune that will be set by your most leveraged competitor.

How elastic is the demand? Can people live without the commodity? Copper is one such thing where people start to figure out how to live without it. I have written in the past of substitution of copper for aluminum in wiring. I expect at $3 and more per pound, thrifting has to continue. The question is, just how much can demand decrease?

Let’s take the elasticity of demand of oil. If the price of oil goes to $6 per gallon in the U.S., I can assure you that demand will drop. Heck, at $4 demand dropped. When you build your model, you have to figure out if demand will fall apart at a certain price.

My own theory here is that you have to figure out the ratio of the input cost to the end product’s price. So to take an extreme inspired by the fact that I am sitting at an airport, if the price of gravel doubled, people would still expand an airport if there was demand for the airport. The gravel is required for strong foundations, and it is not priced very highly as a percent of the cost of the project.

The more that the product input cost affects the end product and the more nonessential the product is, the more elasticity of demand. So if the price of a one carat diamond went to $15,000, I can assure you that demand for the stones would drop. If the price of a one carat diamond went to $1,000, the demand would spike. In contrast, if the price of gravel went to $2 per tonne, about the same amount of gravel would be used as if it went to $20 per tonne.

How elastic is the supply? This is the next thing that I take into account when I figure out how to value a mining project. I like things like potash where starting new mines is a $2 billion or more concept and not every Tom, Dick, and Harry can start one. These make for excellent assets to own. The problem, of course, is getting the $2 billion, and that creates a barrier for most junior players that is insurmountable. We will cover access to capital later on.

How concentrated is the industry? Now here is something interesting. I do not like industries with one major player and lots of smaller fish. I like strong oligopolies rather than an industry structure with a 50% market share player and lots of 1-4% players. The thing is, the small players do not really care about cleaning up after themselves, and they will make a real mess if it helps them in the short run. I also like real fragmented markets where everyone has to work on their own and no one party can mess with the game.

In markets where there is one almost dominant player, that player rarely can effect enough market control to stabilize prices, and everyone else is in the business of taking from that dominant player. An example of such a market and player would be platinum and Anglo Platinum. Anglo Platinum should own the business, but they do not because they are dancing for every little guy.

Once you have commodity pricing, capital costs, and project size, you can start to build out valuations. I am going to write another update on stages, but let’s sum up a conclusion here. When you start to figure out how to value a project, work out on a worksheet the questions that I have laid out above, then make a decent bet around the project.

The Herald Sun: Whole new ball game

A key note to the Guinea government: Next time you want to nationalize something, wait for the rail line to be built. I mean seriously, if you are going to take Rio Tinto, do it right. Get them to invest at least 1-2 billion in capital and get some extra added value. Taking a project after a resource has been established and a feasibility study is done is rather short-sighted in these trying economic times. It is much better to let them sink some capital into the project first, as once you have nationalized the asset you have to come up with the money to develop it. Or maybe you already have another deal. China and Mittal both come to mind as groups who would be willing to follow in Rio Tinto’s footsteps.

When you discount African or Russian assets, discount with a huge margin. But then again, with Obama coming to power, if you own American resource assets, you could be facing partial “nationalization” in a windfall tax. If I am not mistaken, everyone wants to take from the rich resource companies and give to themselves.

Isn’t greed great?

Does government have a place in business? This is a question that I have been debating for awhile. Orderly markets require regulation, and regulation has to come from government. Too much regulation and you end up messed, too little and you end up fried. This is sort of like cooking a frog.

Now government has to figure out the rules that we all play under. Government has to not be corrupt, has to enforce the laws it puts on the books, and has to be willing to admit it when it makes a mistake. Government has to understand that it will build a set of rules and the market will mess with them till they work for the market.

Some rules, like the Sarbanes-Oxley Act, have to be changed and partially discarded. The American stock exchange will get killed by SOX. The fact is, the American stock exchange has a good market-making system, a good amount of liquidity, and no ability to compete with AIM or TSX venture exchange because no one in his right mind–myself included–would willingly undertake to implement Sarbanes-Oxley, no matter how cheap the market is to access. Bankruptcy laws should make sense. Some debts should be clearable, others not so.

Other rules have to be changed and enforced. It should be a crime to knowingly give people credit when you have statistically less than a 50% chance of getting paid back. Interest rates should be capped at 24%, and that should include hard-money men and payday-loan nasties. The fact is, we need to go to some common-sense laws that take financial predators and feed them to the lions at the local zoo.

On the whole, the presidential candidate that will go through and clean this up, I will vote for. You, however, cannot, in the process of cleaning it up, make America a harder place to do business. The candidate that says we will cut 50,000 pages of regulation, cut the bankruptcy code to 10 pages, and cut the tax code to 500, will win. Let’s open America up to fair business, because until then no one in his right mind will open up new shops in the United States when there are other choices.

I fly out of the country every week. I take a domestic business trip less than one time a year. That does not make sense. We need to rebalance the U.S. government’s regulatory role to encourage, not discourage, fair business in America.

Chicken Little, the sky is falling. Did you not notice the sky is falling? I mean, everyone knows the sky is falling. Do you not watch TV, read a newspaper, own a house, have a mortgage? Do you not know that the sky is falling is the flavor of the day?

Do not worry. Next we will have the perpetual boom. Everything will be great. Every kid will be above average; the stock market will never go down again, ever; and the price of Starbucks will go up enough that they’ll never have to close a store again.

Then the sky will fall again.

The question I like to ask is, do I mind the sky falling? Does it really affect me? Do I care? Well, yes. This sky-falling business has cost me millions. You should have seen the look on my mother-in-law’s face when I told her I lost at least $500,000 in the market since November. And of course I underestimated—it never helps to tell your mother-in-law that you lost at least $1 million or more. The question, however, that the loss presents is the better one: Is the house I bought, or the stock I bought, something I’ll be happy owning in five years?

Now understand what I mean. If I put the house, or the stock, or the art in a closet and did not look at for five years, when I brought it out again, would it represent value and would I be happy with it? In figuring out my answer, I assume that there will be no earthquake, or fire, or other natural disaster during those five years. And the fact is, if the asset does not meet the five-year test, then into the dustbin it goes.

What is good about the sky falling is this: Into the dustbin goes the junk. Everyone cleans house. The stupid investments are sold. The shaky stores are shut down, and then the mall operators are forced to find new tenants. This type of house cleaning is good. The thing is, to properly clean house, you have to have the eye of a collector and not a demolition man. Get rid of the ugly shoe art from the 1980s, the stupid Starbucks in the bad location. Get motivated, focused, and directed and get some real wealth creation going. When the sky falls is when you make the choices that will make you money when the sun is shining.

An investment gets trapped in Kremlin’s vise

Very scary article on Russia. As resource prices go up, expect more and more to be taken back by the locals. Russia is ahead of the curve, but just you all wait, others will catch up. At least this guy is out and is not spending his time in Russian jails. I am, of course, not sure who is right, but this on top of BP’s troubles, points to a clear case of nationalization. Heck, you all know what comes next.

Reuters India: Russians, Japanese vie for CSN unit

Ok, well, not unknown, but we are not certain who they are. There are a couple separate lists provided by different people, so I tend to not trust them. The valuation numbers are more interesting. We are seeing a $10 billion price tag for the whole project or $6.7 billion for two-thirds. Of course if you read my blog, you would have already known that. (See this post.) I called $7.2 billion for two-thirds, so I was a bit off. Let’s see where it ends up. The liquidity crisis we are under right now is going to lower the number of bidders because anyone who would be bidding with borrowed money–JSW, Tata, and others–is not going to be able to make a bid. I expect that the Chinese or the Japanese have the least need to go to the banks, and that might make them the winner.

Sorry I have been writing less. Now that we have the top 10, I am going to aim for one to two editorials a week. I am not going to find short news articles and write about them in the quick blurb style as others are quicker and funnier at that.

At some point, inflation is going to hurt everyone, but it hurts people differently. This is because inflation is in essence measured alongside a basket of goods and services. From country to country, people spend different proportions of their income on raw materials, processed goods, and services. The question I want to look at is, what is the cost of raw materials as a percent of GDP, and how does that impact the consumer?

In America, people complain if gas prices go up $2 per gallon, and I understand their pain. I am feeling it every time I fly. My wife feels it every time she fills up our van’s gas tank. Putting aside the flight costs for the moment, let’s look at the math of how gas prices are affecting people like my wife who drive a lot. She drives a van that gets 20 miles per gallon about 20,000 miles per year. So my wife uses 1,000 gallons of gas a year driving around the kid-hauler. She buys regular gas, and she is now paying on average $4.30 a gallon. Assuming gas prices stay at $4.30, she’ll spend about $4,300 this year on gas. Last year, gas prices were a high $2.40 per gallon, so she would have spent $2,400 on gas if we had not lived in Israel at the time. So this year she is spending an additional $1,900 for the privilege of not staying home and going stir crazy.

Now let’s apply that cost increase to a family with an income slightly above the American average, say $60,000. On a take-home basis, that family is losing an additional $158 a month to gas costs against a gross income of $5,000 a month. On net income, it is probably a bit worse. That family is losing 3-4% of their net income to gas.

Now let’s flip commodities and countries. In China, they consume probably 275 kg of steel per capita per year. That translates to 440 kg of iron ore. Now the price of ore went up around $40 per tonne in China. So that mythical Chinese person is losing $16 in purchasing power to get the same steel. It takes 250 kg of coking coal for a tonne of steel, and the price of such coal went up $200 per tonne, for another $50 in lost purchasing power.

Now you might say, so they lost $66 per person, that does not matter, but that is 9% inflation on steel raw materials alone. And that is without freight or fuel. When you add in the freight jump it is worse, and with the fuel jump it is even scarier. The total inflation gets to be a bad burden when you figure that it affects everything a person consumes: raw materials, fuel, food, and everything else.

I do not notice when rice doubles in price. Not that much of my caloric intake comes from rice. And not that much of my income goes toward food, relative to my other expenses. If food goes up in cost by 30% on a macro sense, and as an average American I am spending 6% of my budget on food, the percent of my income I spend on food only will go to 7.8%.

However, if you were in Asia and spending 30% of your budget on food, an increase of 30% in food prices would be a much bigger problem. Suddenly, you would be looking at your food bill taking up 39% of your budget, a significant increase.

As I said before, inflation is in essence measured by a basket of goods and services. The American basket, with 6% of our money going to food, and x for fuel is completely different from those of people in the rest of the world. The reason, of course, is simple. People in other parts of the world spend a lot less on finished goods and a much higher percentage of their money on the basic raw materials that form a life. We in America do not, on the whole, buy rice. We buy rice mix. We also make a whole lot more than most other people in the world, so rice mix costs us a lot less, relative to our income, than rice costs the poor guy working in Shanghai with a wheelbarrow to make a living.

So what is the issue that I see here? At some point, inflation is going to bite the emerging market expansions in the rear and cause people to curtail basic spending. If we’re lucky, a feedback loop will take care of the problem: People buying fewer items will be enough to just slow down inflation and growth. But if we’re not lucky, spending will decrease so much that growth will nearly grind to a halt. That would be a hard landing.

I think my wife at this point can afford the gas she spends to drive. I worry a lot more about the rice bowl in China and if is it staying full. And I worry even more about the bowl of food in Africa, where a lack of food can cause political instability and war. If you cannot afford to feed your kids and they go hungry, you probably will do anything to put food in their mouths.

People will not riot for lack of gas for the car, but they will kill others to feed their own kids. Let’s hope that the feedback loops will avert that from happening. In the long term this is not a zero sum game, but it can sure feel like one in the short term.

Cleveland-Cliffs and Alpha Natural Resources to merge, creating Cliffs Natural Resources, a leading diversified mining and natural resources company

Now, finally, Cliffs is out spending its seed corn. The question is, will it get returns from it? What has protected Cliffs in the past from takeover is its horribly structured off-take contracts. Why would Mittal, for example, want to buy out someone who gives it cheap ore already? That protection will have less value as the iron ore business becomes a smaller part of the whole, so the question I ask is, is this a clean up to get taken out by the Russians, or maybe Xstrata? At some point, the combination represents a real chance for someone to get a nice slice of two business groups that represent value.

Xstrata and Anglo both have to grow or else be eaten, maybe some North American iron ore and coal is what’s for dinner?

Benjamin

PR-Insider.com: Cleveland-Cliffs updates 2008 iron ore revenue-per-ton guidance; provides commentary on 2009 North American iron ore pricing

Reuters: Cleveland-Cliffs buys out minority holder in Minnesota

What is 30% of 5.2 million tonnes of U.S. pellet production worth? Apparently a whole lot of money. Let’s break down the math. Cleveland-Cliffs bought 30% of United Taconite from Laiwu for $100 million + 1.5 million shares + 1.2 million tonnes of seaborne pellets. That’s $100 million in cash, $167 million in shares, and $168 million in pellets (assuming the pellets are from Wabush and worth $140 per tonne). So, the total price Cliffs is paying is US$435 million.

Now United Taconite has 5.2 million tonnes of production, and 30% of that is 1.56 million tonnes of production. Cliffs is estimating North American Pellet prices to be $85. (I could devote a whole blog to the silly North American pricing model.) Costs are $56, so the margin per tonne is $29. The earnings from this stake in United Taconite pre-tax are US$44 million. So Cliffs paid 9.9 times the pre-tax earnings of this stake to buy it. This is a very good price considering that Cliffs trades for a price-earnings ratio well in excess of that.

The interesting bit here is not that Cliffs bought this, but that the Chinese sold out. Apparently they felt that they could get better returns elsewhere. I can understand the attraction of the cash to the Chinese. This is hard currency that is outside of China, and it probably can be reinvested outside of China into other things without government control. I would expect to see Laiwu go out and buy something now. The question is, just what? They can leverage, so I would expect something with a US$1.2 billion price tag—could be a mini mill, a coal mine, or maybe some ships.

Advanced Explorations Inc. to earn up to 70% interest in Roche Bay Project

Sinosteel gets control, but likely to have company at Midwest

Okay, they have more than 50%, but they are probably not going to get 100%, and that sort of makes their life hard. They are going to be stuck in never-never land like Portman. They’re going to have shareholders whom they are going to have to take care of, and a stock market listing that they are going to have to maintain. The real interesting bit is going to be seeing how Sinosteel deals with having a listed company. Can they deal with the regulations and the paper work?

This, however, leaves them with a stock market listing where they could maybe stick other assets and raise money if they wanted to. I am just not sure if the Chinese have a need like the Indians do for capital. If it were an undercapitalized Indian company gaining control of Midwest, this listing would make a lot of sense to keep. However, it seems China has lots of capital to place, and not enough places to put it, so the public company will probably have less value than it would if they were short on capital.

So Sinosteel now has an iron ore resource in the hinterlands of Australia. It has to deal with Murchison, Mitsubishi, and the Australian government, not to mention a few remaining shareholders, before it can develop it. It’s going to be quite a mess and good fun to watch.

Benjamin

Drill, drill, drill.

Sounds so simple, right? If you drill, you end up with oil. And if you end up with more oil, you will drop the price, right? The reason to drill has to do more with what people think than reality. What I mean by that is the drilling will cause people to think about the supply increasing, and you know what they say about a 1% oversupply to a market, even an illusion of one.

The question is, does drill, drill, drill really work? Can we get more oil? Are we going to end up with lots of extra reserves? Obama does not think so. He thinks oil is a zero-sum game, that there is only so much in the ground. But Obama is not an oil economics guy.

The quantity of reserves are calculated at a cut off of production cost. I do not know what that number is, but I doubt that it is over $35 per barrel. The thing about oil that then sells for more than $100 per barrel is it opens up a free market for capital, and for people to do stupid and risky things. Heck, Freeport is drilling 32,000 feet and going, and in only 70 feet of water. If you can get capital when you define a reserve at $80 per barrel cost, you might be surprised at what is found.

The Wall Street Journal: A famed dry hole gets a second shot (A WSJ online subscription is necessary to read the whole article.)

Stupid, risky things pay off in this business; rarely, but enough times to make the bets happen. And frankly, high oil prices will force the bets. People have to understand that if they hit a well at 35,000 feet, and it pays out, then the whole coastline will be dotted with rigs that will do the same thing, and that will change the supply dynamic.

Now the other option is to force high oil prices via taxes. That does not increase supply, but reduce demand. If this is the approach you take, the question is, what should the government do with the taxes? I would be willing to pay a $1 per gallon tax on fuel if 100% of it went into researching alternative forms of energy production. If you pour money at a problem, you will find solutions to something. Of course, the solutions may not be to the problems that got you researching in the first place. A research initiative into alternative energy production could, like the space program, completely change the world with the side effect inventions that come out of it. You cannot be sure that the solutions will solve the energy crisis, but 10s of billions of dollars per year being forced at research and development with a clear goal in mind would be interesting watch. I would want it to be a five-year program with a clear sunset.

For now, to get the rigs out looking, there is nothing like high prices to just raise the cash and get the drills turning. But Mr. Obama, if you want to sell me on changing energy policy, you’ve got to treat it like the space program and make it a war effort, and you might find some stuff. Just do not be surprised if you find a cure for cancer, or a 20-times-faster computer chip out of the spending, rather than a cheap form of renewable energy. If, however, you treat the new gas tax as a way to pay for social programs, I will be significantly angry.

Without ground rules to play with in the financial markets, people will make stupid bets for short-term profit that cost everyone 100 times over in the long term. The U.S. had–I stress had–the best mortgage system in the world: 30-year fixed paper at a decent rate, with 20% down. This was a bet that created a whole middle class in America and let everyone build some equity. The kicker was it was pre-tax dollars, so the real effective interest rate was even lower. The question is, what is the harm in messing with a system that works? The answer is clear. Now not only do we now have the new alternative mortgages (which look a lot like a standard UK or Aussie mortgage), but we have messed up the standard American mortgage that created the American dream.

Now the question is, how do you, as a government, fix this mess and make it go away? The first solution is to create a clean new bond deal. Any bond or mortgage on an American piece of real estate should be tradable to a new government entity that will swap it for a 2.2%, 20-year bond that will be backed by the government. The deal, however, is it cannot be a secondary swap contract, or an insurance policy, or anything but a primary ownership of a loan. This new government-backed company will then have 20 years to clean up this mess. The first step needs to be to freeze foreclosures, just stop them. The fact is banks do not rent homes, so rents are going up, people are losing houses, and then the houses are sitting empty.

Next, the company would sit down and renegotiate one by one with borrowers. If you have to foreclose, create a group of investors in which no one is allowed to buy more than three homes. Offer these investors a 20%-down mortgage at fair value for the house. Give it a 20-year interest-only term with an interest rate set at 5%. To become an investor in this group, you will have to pass a basic knowledge test on real estate and finance. Trust me, if you spread it out and create a whole new group of people who own three rental properties, the market will stabilize. The mortgages have to be able to be supported by rent, but that should not be hard.

If people want to stay in their homes after renegotiation, the second step has to be create a required course at every community college that people have to take and pass if the government owns their mortgage and they want to stay in their home. Get people to learn basic finance. Heck, make finance a required course to pass high school. Let’s make people financially literate and understand the bets they are making. Then we might end up with less of a mess.

The basic point is if people are willing to take 10 cents on the dollar for real assets, why should the government not offer 100 cents on the dollar at a below-inflation rate of return. Get the underlying paper off the market, and the rest will clean itself up. An interest rate of 2.2% is not a bailout; it is a fire sale. I can promise over the next 20 years this bet will return 10s of billions of dollars in profit.

The underlying real estate is good, trust me. People will still need a place to live.