After last night’s vote on the Government’s Wall Street Bailout (a.k.a., “The Economic Rescue Plan”), I am compelled to now take the conversation to a different level. I am going to attempt to explain why this bill will make no difference in credit availability to Main Street, regardless of the repositioned marketing efforts designed to sell you otherwise.
The old way lending worked was that the bank or financial institution that made the borrower the loan, owned the loan. If you made a mortgage application to Bank of America, they analyzed your credit, approved the loan and kept the loan on their books (on balance sheet).
These were the days when you got your billing statement from the same bank that gave you the loan. The bank billed the customer, collected payments and most importantly collected on the delinquent loans. Collections include calling delinquent customers, foreclosing when they weren’t paid, selling the property and (this is key) writing off any losses (charge-off).
Since the bank owned the loan and had to take any losses from the loans they made, they had to set aside money to pay for those losses. This money that had to be set aside for losses is called “loss reserves”. These reserves had to stay in reserve and could not be used for any other purpose. The money couldn’t be used to make more loans (i.e., pay operating expenses, more loans). It was set aside to pay for potential losses.
This changed in the 1980s, as a Wall Street tool called securitizations came into play. I’m not going to go into detail on this, you can find it in my upcoming book, but the end result was that the bank that made the loan could sell the loan to private investors. The investors were now the people responsible for the losses.
As an example, let’s say a bank made five $200,000 loans for a total of $1 million dollars (5x$200,000) and their anticipated loss rate was1%. The bank would then have to set aside $10,000 ($1,000,000 x 1%) to cover those losses.
Once the loan is sold, the bank is paid for the loan and is no longer responsible for the losses. Since the bank is no longer responsible for the losses, they didn’t need to keep loss reserves for the loans they made. Using the same example, the bank makes $1 million in loans, sells the loans, collects their money from the sale and never puts anything in loss reserve.
This very fundamental difference in lending is the primary reason we are where we are today and why credit is going to be severely restricted in comparison to the last 10 years.
Let me explain.
The first issue is credit underwriting, which is the criteria the lender applies to say who gets a loan and who doesn’t. The reason so many loans were made to people who couldn’t afford them is because the lender, making the credit decision, is no longer responsible for the losses. The more loans they make and sell, the more money they collect (more profit). It is important to note again, this model does not require the lending institution to set aside money for losses.
The game then becomes to make as many loans as possible, good or bad, which is exactly what happened. In the period between 2001–2007, $19 Trillion in mortgage loans were originated. For those that pay attention to the numbers, the reason this amount exceeds the current mortgage loans outstanding of approximately $14 trillion, is pay-downs and the large numbers of refinanced mortgages in the $19 trillion.
The second issue is that these loans are made and the loss reserves that are supposed to be set aside in the banking system do not exist. This is what the now roughly $1.5 trillion in tax payer bailout (if this ridiculous bailout bill goes through) is paying for.
The reason all of this spin telling you the “bailout” has to be approved or you, Main Street, won’t be able to get loans is completely misleading is because credit is going to be severely restrictive moving forward in comparison to the past 10-20 years, regardless of this bailout.
The only way to keep our system safe from these problems moving forward is to require lenders to set aside the appropriate loss reserves for the loans they make. The lender must be responsible for their losses. This has to happen and must be the primary demand of the public to our regulators or the problems we have now, will just continue. If the lender is again responsible for those losses, they will make better (read tighter) credit decisions. This resolves the massive moral hazard we have built into the game.
If these loss reserves have to be set aside by the lender, it means less money to lend to borrowers; less money to lend because they own the results of their decisions, and less money to lend due to loss reserves.
There are other conversations about vehicles to help resolve the problem, such as covered bonds, but none of them can get around these banking basics.
If you want to go along with the bailout of Wall Street, go ahead and line Warren Buffett and other’s pockets who are taking advantage of this situation, that’s certainly your prerogative. Don’t do it because you think it will change your ability to get credit now or in the future or actually solve the issue at hand.
I UNDERSTAND!
Great explanation. I now get it!
Posted by: Lewis | October 14, 2008 at 06:27 AM