Recently Morgan Stanley, Merrill Lynch and Goldman Sachs were in the news for stating that they had reserved $20 Billion to pay themselves their bonuses. This came after the government announced its bailout. http://www.bloomberg.com/apps/news?pid=20601087&sid=aRDImphnW84Y&refer=home

So we know part of the bailout is being used to protect Wall Street bonuses. Does that help the economy? Is that fair? Should that make us furious? Why is it that the same institutions and same people who profitted handsomely from creating this mess are getting bonuses?

Well how should the money be used?

As Einstein would say the best solutions are the simplest. We have also been down this road before. Let's review the fundamental reason why we are in this mess.

Housing.

Seems like we have quickly forgotten how we got into this mess. Starting with 9/11 and the low interest rate environment regime it fostered the market sent a very strong signal to build more housing. Initially the demand was real. Real people needing housing. Housing is after all a fundamental human need - food, air and shelter.

In this low interest rate environment, credit became outrageously easy to obtain. People who should not have qualified to get mortgages were given them. Wall Street aided and abetted by Fannie Mae and Freddie Mac helped disintermediate the role of the loan originator from the loan provider. Underwriting standards were thrown out the window. What standards remained were based on the ability of the buyer to make payments during the low teaser rates and introductory period. New loan products especially the sub-prime negatively amortizing loans were created and marketed furiously. These products made billionaires out of people like Mozillo at Countrywide, and the fixed income traders at Lehman and Bear Stearns.

But how did the loan orginators and their investment banks convince others to buy these loans. That is where companies like AIG come in. AIG the insurance company, started collecting premiums in case these loans went sour. For the first few years, while people could still afford the low teaser rates, these policies generated tremendous premiums with no payouts. Pension funds, foreign investors, endowments all bought these mortgages believing that with the AIG backing and with the rating agencies (S&P, Moody's, Fitch) giving them the highest rating that their money was safe.

Not surprisingly when this introductory period ended, default rates soared. Demand which had been real, was at this point purely fueled by speculators. Meanwhile, new supply was flooding the market as builders who broke ground (including planning and permitting) were now selling their finished units.

A perfect storm was unleashed - huge supply coming into the market, plummeting demand as speculators left the market, and a credit market that tightened.

Housing prices have therefore plummeted. The basic laws of economics still apply and this is a natural reaction. Falling prices feed into a cycle of further credit tightening and the inability of people who cannot afford their mortgages to sell to someone who can. The cycle intensifies.

What to do now?

Well if you disentangle the history lesson above the key to this mess is housing. We have to get the supply and demand in housing back to a point where we can hold certain price points. This puts a floor in the market and the paper instruments have a way to be valued. The markets would then adjust and we can move forward.

Put simply - we should buy houses with the $700 Billion (or what's left of it after paying Wall Street bonuses). At $200,000 per house, and assuming that $400 Billion is left - that is enough for 2 Million homes. That is about the number of homes that are in foreclosure. The homes should either be destroyed, or boarded up or used for affordable housing for people who are now homeless. The point is that the supply should be taken out of the market.

Is this a radical idea? No! This is exactly what we did when the S&L crisis hit in the 80s. We created the Resolution Trust Corporation to buy homes and other real assets and we were able to profitably sell the assets over time. This is also what we do for farming. We recognize that sometimes when weather conditions are perfect that we get bumper crops. We then either store the crop or we burn it. This helps farmers stay in business and it helps us when weather is bad so that we have a reserve.

Well if shelter is a basic human need - food, air and shelter - then we should support this market as we do farming.

Hillary Clinton proposed this idea during her campaign and Jim Cramer is supporting this idea as well. He also had the additional idea of letting more immigrants (legal and illegal) stay in the country. This has the effect of lifting demand which is also critical.

Let's hope that our politicians get this right. The root cause of our economic crisis is housing. To fix the crisis we must fix housing. Let's get to it!