We the Cared For

Bad Bank – Bad Consumer – Bad Stimulus – Bad Economy

Our country, our citizens and our policy makers need to begin to face reality. Nothing they have done and nothing they are preparing to do, will fix the fundamental problems plaguing our economy. For the sake of political expediency, policy makers are addressing the very real fear and panic of the people by applying chiropractic manipulations to shrink a cancerous tumor. It hasn’t worked to this point, and it’s not going to work in the future and here’s why…

Our economy faces three primary issues:

1. Getting credit flowing to businesses and consumers
2. Creating jobs to stimulate the economy
3. Stabilizing the housing market

Credit

The only way to get credit flowing to the levels policy makers and the public think we need, is to guarantee the banks against losses on new lending moving forward.

Banks will not increase credit availability regardless of how many trillions are pumped into the system, because it would be fiscally irresponsible to do so. They will make loans to businesses and consumers when they think they will be paid back.

How do they know who will pay them back, when unemployment is reaching record levels and over 466,000 new lay-offs were announced from October 2008 through the month of January 2009?

The amount of lending will not change by giving the bank’s more capital or buying bad assets from them. No matter how much capital banks have or are given, they will hoard the funds until the future looks more promising.

Stabilizing the Housing Market

Unless there is a different response, credit will continue to be restrictive, jobs will continue to be lost and housing prices will continue their decline.

A significant portion of previously qualified home buyers can’t obtain a mortgage because far fewer people now qualify with the revised guidelines and limited products available. Home values have declined so far and fast, that existing mortgages exceed the value of the property and can’t be refinanced. Banks own more and more of the homes through record foreclosures and need to liquidate these properties at severely reduced prices. Unfortunately, this will continue for the foreseeable future.

Continuing job losses means even fewer qualified borrowers with access to credit which translates to reduced home sales and a continuing decline in home values.

Creating Jobs

The government can’t create sustainable jobs. The only way to create sustainable job growth, when sales and profits are down, is to give companies more capital to work with. This should be done by letting them keep more of the money they already earn. This should not be pursued through any government loan or equity ownership; it should be stimulated through tax policy. If these bail-out and stimulus dollars are to be spent, it should be spent on creating jobs in the private markets.

We need to cut personal and corporate taxes immediately. This will leave more capital with the people who earned it and lead to sustainable job creation.

The “Bad Bank” and the New “Stimulus” Plan

As I’ve already established, relieving banks of their bad assets will not increase credit availability. It will concentrate the bad assets and provide some operating relief to the banking system, while loading it elsewhere. All of these actions resolve nothing in addressing the real problems. Leaving these assets on bank balance sheets and allowing the write-up of the values and/or reducing the capital requirements, and/or providing a federal guarantee accomplishes the same thing.

The “Bad Bank” is a Bad Idea and will solve none of the 3 top issues facing the economy.

It seems apparent to the people serious about actually stimulating the economy, that the stimulus package, as approved in the house, is quite disassociated from actual stimulus. Infrastructure spending seems to make everyone feel good, but it will take too long to ramp up. And in the end, what sustainable job growth will result when the government is out of money and/or the bridge is built and we have to put the shovels down?

If we are going to address these issues and we are going to do it with taxpayer dollars, we need to get directly to the tumor. How many of you have spent and borrowed your way into prosperity in your personal lives?

Here is a suggestion for how to do it...

1. Banks should be allowed to write up the value of their assets and/or reduce their capital requirements.
2. This one I find the most painful, since I believe the companies should be allowed to fail and these bailouts have no place in free market capitalism. However, we’re well past that point, so if we actually want to have an impact, the government should temporarily step-in and guarantee losses on new credit advances and on mortgages in particular. This would include extending credit to borrowers who are not qualified for a loan today because of their job and/or credit record, and don’t meet the more restrictive hurdles created by market conditions with high loan-to-value ratios and high debt-to-income ratios.
3. This is where something akin to the covered bond structure would come into play using the government; take the $1-$2 trillion we are getting ready to commit for nothing, and use it as the insurance wrap on a covered bond pass-through structure. This scheme sells the bonds collateralized by the loan (i.e., mortgages) to private investors bringing private capital back into the banking system. Normalized losses would be allocated to the bank and to investors; excess losses would be covered by the government. You can find extensive coverage on covered bonds at the "Covered Bond Investor".

This outright government guarantee is the only way credit will get flowing to a more un-rational level again. The structure can be debated, but excess losses will have to be picked up by the tax-payer if we want to get things moving.

The bottom line is that it doesn’t take this complex patchwork of ineffective policies that just flush trillions in tax money down the drain. A government guarantee of losses to the banks will stimulate lending, significant reductions in corporate and personal taxes in combination with credit access will stimulate jobs and housing can be stabilized... eventually.

Back to the Future: Banking and the Nations Housing Policy

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.

Too Big to Fail - The Fourth Branch of Government

There is, and should be, a significant amount of consternation over the size, speed and impact (or lack thereof) of the actions taken by the Federal Reserve, the Treasury and Congress to address the credit crisis, now sans economic crisis. The significance of the unintended consequences of these actions should not be underestimated.

I will only be addressing the immediately obvious consequences to the banking system however the reader may translate these same issues to the other industries participating in the governments’ largesse.

The first of these unintended consequences is the lack of impact that pumping almost $3 trillion dollars into the banking system has had on making credit more available. The second is what we have created by saving all of the institutions under the banner of “Too Big to Fail”. Policy makers have rushed to the public trough to address the “Too Big to Fail” companies and in typical governmental fashion have created ever larger institutions that we may now consider the “Fourth Branch”.

This Fourth Branch consists of now massive financial institutions that are completely privately held, yet fully backed by the U.S. taxpayer. If you thought the “Quasi Governmental” agency models of Fannie Mae and Freddie Mac were a problem, you ain’t seen nothing yet. That tragic policy has been leapfrogged by the Fourth Branch.

The omnipresent example is the banking system. I have taken two points of observation from the FDIC Statistics on Depository Institutions. The first is 12/31/2006, which is a date prior to the recognition of the credit crisis, and 9/30/2008 the last quarter the bank data is available within the eye of the storm. Consider the following:

• There are 255 fewer commercial banks
  In the Banks with Assets Greater than $1 billion category:
  • There are 509 in 2008 vs. 494 2006
  • Assets have increased by $1.9 trillion in the period
  • The total number of employees has increased 28,425
  • Total deposits have increased $1.7 trillion
  • Total unused commitments have increased $1.2 trillion