The banking system is a wreck. Credit is not flowing. Trillions of public dollars have been used and are at risk with no planning and no oversight. Governments attempts to leap frog the constitution and fix the “Too-Big-to-Fail “ problem with tax dollars have created entities twice as large as the ones they said they were “fixing”. Foreclosures are at record highs, housing prices continue to decline and there is no end in sight at this point.
The banking system, the banking model, as we have known it for the past two decades, is dead and the lack of careful thought given to how we address the problems, before we spend public money at an unprecedented pace, is nowhere to be found. Only now are there a few ideas from a few individuals and biased constituencies coming to the surface. We can put a man on the moon with billions in public funds because we assemble teams of very smart people to work the issues, but we can’t seem to muster the management discipline to work this problem.
The Fundamental Issue
The very heart of our problems today is asset securitization, the synthetic securities created from them, and the use of these uncollateralized synthetics in “hedging” (add gambling) risk. The final large layer of plaque in the arteries is the use of these mechanisms by government created behemoths like Fannie Mae, Freddie Mac and Ginnie Mae. These public policy driven and government supported entities exponentially increased the risk and finally the heart attack to the patient.
The primary reason these structures have seized the heart beat of the patient is that the lenders making the loans passed along the risk to others and took fees. Since they didn’t own the risk and wanted to increase their fee income, they loosened credit standards and made loans to people who shouldn’t have received them.
Since this many bad loans had never been in the system before, investors working off of old assumptions and with assurances from the credit rating agencies bought them up as fast as they could. This brought trillions of dollars into the mortgage market making even more loans available, driving lenders to make even riskier loans, with more exotic products, driving up home values and increasing investor appetites.
A great deal of this money came from outside the United States, it had an upward leveraging effect on our economy. We didn’t have to produce all of the capital to fuel consumer spending. It also meant that the banking system never put away the reserves to cushion the system against losses, because these were passed along to others.
This created massive excess credit availability, and inflated home values, and everything else… for decades. Credit expands economies. It increases purchasing power, fuels business creation and jobs, stimulates the inflation in the values of almost everything, and it has gone on for a long time. This is why all of the money being pumped into the system is not having an effect. The balloon is deflating and will continue to until we arrive at a systemic solution that ties the risks back to the lenders (as it once was). When we know what that solution is, we may then calculate the bottom and the massive costs it will take to arrive there.
The bottom line to all of this is that the standard of living and the steady increases in the standards of living are on a permanent slide back to the equilibrium of rational credit availability within the system.
Solutions
These solutions recognize the fact that we have already socialized the banking system; however, we need to find our way back. This restructuring has, and will require public investment with the goal of moving us back to accountability in the credit markets and banking as quickly as possible.
Public Finance Agency
The first solution I would propose is to recognize the reality that we can’t seem to extract government from housing policy. To that end, I would propose breaking the system into two parts. The first would be to create a single Public Finance Agency entity that would be owned by the government and lend or provide guarantees to borrowers who would not qualify for mortgages from the private system (more on that later). Unlike Fannie, Freddie and Ginnie (FHA), this entity would originate, own and guarantee these mortgages. Fannie, Freddie and Ginnie assets would be transferred here and those entities effectively cease operations. This will segregate and make completely transparent the public cost of our nations housing policy.
The Private Banking System
My second proposal pertains to the private banking system, it requires a number of changes. The first of which is to establish an asset size limitation to mitigate risk concentration and the “Too-Big-To-Fail” problem we have just doubled down on. We need smaller banks that are more manageable. You will trip over the examples of the risks associated with expansive management and risk controls in our global information age economy. One rogue or misguided trader has put many a firm out of business, let alone the capital that has been squandered by just plain poor management. Poor management will always exist but I think the reader will agree that managing the expanse of a $1 trillion bank enterprise is far more difficult than a $10 billion dollar bank. This addresses the risk and control issue, as well as the massive concentration risk we have created today. Large loans needed in the market would be syndicated.
Second, and this is painful because it recognizes the “fundamental problem”, but it is reality… we need to bring back the ownership of risk and loss to the lender making the loan. This means shelving the asset securitization in its current form. When the bank books the loan, it should own the loan. These loans represent collateral that the bank may borrow against in the form of bonds (this is the basics of the covered bond structure). Additionally, banks may be allowed to sell whole loans or pools to other banks regulated within the banking system. This means other lenders, who would have to reserve for the loss on their balance sheets, would require a high degree of due diligence from what are hopefully trained underwriters rather the rating agency structure we now have. The bonds would have to be rated by a rating system and I’ll cover that further along.
Third, all third party originations would require 100% underwriting by the lending institution staff whether the loans are bought on a flow (one by each) basis or in pools.
Fourth, one rating agency would be responsible for rating the company only. A second entity would bear the responsibility for rating the underlying collateral (mortgages) only. Neither rating entity would be allowed to have any other relationship with the banks. The collateral rating entity would be paid fairly up front and then receive stepped payments over time based upon the performance of the collateral. Obviously, provision will have to be made for the quality of the servicing, but that is certainly manageable.
Fifth, the loans made by the private banking system would only be allowed using criteria that exceeded that used by the Public Finance Agency. This should keep a counterbalance in place in the form of constructive tension as these criteria are regulated by a body consisting of representatives from both sides of the equation.
Sixth, as the holder of billions in toxic assets now, and at the conclusion of this restructuring, the Federal Reserve would go back to its normal operations and charter restrictions pre-crisis. Hopefully, they will to do less meddling than they did previously.
This hardly covers it all and the devil is always in the details; however, rather than just point out the problems I thought I would offer a few solutions from my experience and without a constituent interest.
I would greatly appreciate any and all ideas readers may wish to share theirs.
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