See Thru Shorts

The mortgage mess, messy shorts and subsequent bank failures all seem to share a common theme. What is driving the current down cycle in the American economy is lack of clarity of ownership.

In the housing industry, we find that the very structure of the mortgage system clouds ownership. In the mortgage system the lender and borrower do not share the risk. The mortgage system, a homebuyer ends up with two two offsetting financial instruments. They have a deed to the property, and a loan from the bank. The value of the property is ruled by the local realty market. The loan is ruled by global money market.

The fact that these two financial instruments are ruled by two separate segments of the economy muddle the ownership of the property. This false economy creates artificial and destructive business cycles.

When people believe that values in the housing market will rise at a rate faster than the money market, people fall into a gambling spirit and buy more property than they need (in many cases they buy more than they can afford). The false economy creates a state of crisis when prices start falling.

The banks end up repossessing the properties that were leveraged in the boom. They are then left to dump the properties during a falling market magnifying the disconnect between the value of the property and global money market.

The short market muddles ownership in a more direct way. In the short process, a person sells a stock they do not own. In the last few years, it appears that many hedge funds have financial instruments that take long term or even perpetual short positions. These long short positions are diluting the ownership in a stock, and are adversely affecting the ability of companies to raise capital based on the market value of their business.

Pundits on TV are demanding greater transparency in the financial industry. I contend that the transparency problem is not simply a political problem. Our financial institutions have taken extraordinarily complex positions with derivates, mortgages and reinsurance that are simply too far removed from the underlying equities that support the securities.

Our financial institutions have built up an enormous house of cards that is logically detached from the real day to day economics that rule our lives.

The problem is not with a lack of transparency. The problem is that when we look at the complex financial arrangments of our banks in the light of a down market, we see that the complex financial models behind these institutions are divorced from reality.

A year ago, the big financial institutions thought they had the right mix of derivatives and reinsurance to handle any financial storm. They failed to realized that the derivatives and insurance programs we create to avert risks create a new layer of unforeseen risks.

My solution to the financial crisis is to replace mortgages with tools that create greater clarity of ownership, and to simply can the short industry which has proven itself to be something that magnifies the depths of a down cycle.

Yesterday, the SEC temporarily halted the shorting of financial stock (see PDF. That action reversed the spiraling crash of the financial sector.