[Swiftwater Gazette] Banking - More Stupid Ideas

[Brad Haslett]

Here's a couple of interesting articles, the first from the WSJ and
the second from the New York Times. So let me get this straight, we
had too much money chasing unqualified borrowers, and now the Treasury
is "floating" ideas as trial balloons to get lenders to loan more
money to unqualified borrowers?  Trust me, if you have good credit you
can borrow all the money you can responsibly use right now. So now
we're in search of new methods to do the same things that got us in
trouble in the first place?  Sounds to me like we need fewer of "the
best and the brightest" and more common sense.

Brad

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    * FEBRUARY 20, 2009

Deregulation and the Financial Panic
Loose money and politicized mortgages are the real villains.



By PHIL GRAMM

The debate about the cause of the current crisis in our financial
markets is important because the reforms implemented by Congress will
be profoundly affected by what people believe caused the crisis.
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President Bill Clinton signs the Financial Services Modernization Act of 1999.

If the cause was an unsustainable boom in house prices and
irresponsible mortgage lending that corrupted the balance sheets of
the world's financial institutions, reforming the housing credit
system and correcting attendant problems in the financial system are
called for. But if the fundamental structure of the financial system
is flawed, a more profound restructuring is required.

I believe that a strong case can be made that the financial crisis
stemmed from a confluence of two factors. The first was the unintended
consequences of a monetary policy, developed to combat inventory cycle
recessions in the last half of the 20th century, that was not well
suited to the speculative bubble recession of 2001. The second was the
politicization of mortgage lending.

The 2001 recession was brought on when a speculative bubble in the
equity market burst, causing investment to collapse. But unlike
previous postwar recessions, consumption and the housing industry
remained strong at the trough of the recession. Critics of Federal
Reserve Chairman Alan Greenspan say he held interest rates too low for
too long, and in the process overstimulated the economy. That
criticism does not capture what went wrong, however. The consequences
of the Fed's monetary policy lay elsewhere.
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In the inventory-cycle recessions experienced in the last half of the
20th century, involuntary build up of inventories produced
retrenchment in the production chain. Workers were laid off and
investment and consumption, including the housing sector, slumped.

In the 2001 recession, however, consumption and home building remained
strong as investment collapsed. The Fed's sharp, prolonged reduction
in interest rates stimulated a housing market that was already booming
-- triggering six years of double-digit increases in housing prices
during a period when the general inflation rate was low.

Buyers bought houses they couldn't afford, believing they could
refinance in the future and benefit from the ongoing appreciation.
Lenders assumed that even if everything else went wrong, properties
could still be sold for more than they cost and the loan could be
repaid. This mentality permeated the market from the originator to the
holder of securitized mortgages, from the rating agency to the
financial regulator.

Meanwhile, mortgage lending was becoming increasingly politicized.
Community Reinvestment Act (CRA) requirements led regulators to foster
looser underwriting and encouraged the making of more and more
marginal loans. Looser underwriting standards spread beyond subprime
to the whole housing market.

As Mr. Greenspan testified last October at a hearing of the House
Committee on Oversight and Government Reform, "It's instructive to go
back to the early stages of the subprime market, which has essentially
emerged out of CRA." It was not just that CRA and federal housing
policy pressured lenders to make risky loans -- but that they gave
lenders the excuse and the regulatory cover.

Countrywide Financial Corp. cloaked itself in righteousness and
silenced any troubled regulator by being the first mortgage lender to
sign a HUD "Declaration of Fair Lending Principles and Practices."
Given privileged status by Fannie Mae as a reward for "the most
flexible underwriting criteria," it became the world's largest
mortgage lender -- until it became the first major casualty of the
financial crisis.

The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie
were to achieve in meeting the housing needs of low- and
moderate-income Americans. In 1995 HUD raised the primary quota for
low- and moderate-income housing loans from the 30% set by Congress in
1992 to 40% in 1996 and to 42% in 1997.

By the time the housing market collapsed, Fannie and Freddie faced
three quotas. The first was for mortgages to individuals with
below-average income, set at 56% of their overall mortgage holdings.
The second targeted families with incomes at or below 60% of area
median income, set at 27% of their holdings. The third targeted
geographic areas deemed to be underserved, set at 35%.

The results? In 1994, 4.5% of the mortgage market was subprime and 31%
of those subprime loans were securitized. By 2006, 20.1% of the entire
mortgage market was subprime and 81% of those loans were securitized.
The Congressional Budget Office now estimates that GSE losses will
cost $240 billion in fiscal year 2009. If this crisis proves nothing
else, it proves you cannot help people by lending them more money than
they can pay back.

Blinded by the experience of the postwar period, where aggregate
housing prices had never declined on an annual basis, and using the
last 20 years as a measure of the norm, rating agencies and regulators
viewed securitized mortgages, even subprime and undocumented Alt-A
mortgages, as embodying little risk. It was not that regulators were
not empowered; it was that they were not alarmed.

With near universal approval of regulators world-wide, these
securities were injected into the arteries of the world's financial
system. When the bubble burst, the financial system lost the
indispensable ingredients of confidence and trust. We all know the
rest of the story.

The principal alternative to the politicization of mortgage lending
and bad monetary policy as causes of the financial crisis is
deregulation. How deregulation caused the crisis has never been
specifically explained. Nevertheless, two laws are most often blamed:
the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures
Modernization Act of 2000.

GLB repealed part of the Great Depression era Glass-Steagall Act, and
allowed banks, securities companies and insurance companies to
affiliate under a Financial Services Holding Company. It seems clear
that if GLB was the problem, the crisis would have been expected to
have originated in Europe where they never had Glass-Steagall
requirements to begin with. Also, the financial firms that failed in
this crisis, like Lehman, were the least diversified and the ones that
survived, like J.P. Morgan, were the most diversified.

Moreover, GLB didn't deregulate anything. It established the Federal
Reserve as a superregulator, overseeing all Financial Services Holding
Companies. All activities of financial institutions continued to be
regulated on a functional basis by the regulators that had regulated
those activities prior to GLB.

When no evidence was ever presented to link GLB to the financial
crisis -- and when former President Bill Clinton gave a spirited
defense of this law, which he signed -- proponents of the deregulation
thesis turned to the Commodity Futures Modernization Act (CFMA), and
specifically to credit default swaps.

Yet it is amazing how well the market for credit default swaps has
functioned during the financial crisis. That market has never lost
liquidity and the default rate has been low, given the general state
of the underlying assets. In any case, the CFMA did not deregulate
credit default swaps. All swaps were given legal certainty by
clarifying that swaps were not futures, but remained subject to
regulation just as before based on who issued the swap and the nature
of the underlying contracts.

In reality the financial "deregulation" of the last two decades has
been greatly exaggerated. As the housing crisis mounted, financial
regulators had more power, larger budgets and more personnel than
ever. And yet, with the notable exception of Mr. Greenspan's warning
about the risk posed by the massive mortgage holdings of Fannie and
Freddie, regulators seemed unalarmed as the crisis grew. There is
absolutely no evidence that if financial regulators had had more
resources or more authority that anything would have been different.

Since politicization of the mortgage market was a primary cause of
this crisis, we should be especially careful to prevent the
politicization of the banks that have been given taxpayer assistance.
Did Citi really change its view on mortgage cram-downs or was it
pressured? How much pressure was really applied to force Bank of
America to go through with the Merrill acquisition?

Restrictions on executive compensation are good fun for politicians,
but they are just one step removed from politicians telling banks who
to lend to and for what. We have been down that road before, and we
know where it leads.

Finally, it should give us pause in responding to the financial crisis
of today to realize that this crisis itself was in part an unintended
consequence of the monetary policy we employed to deal with the
previous recession. Surely, unintended consequences are a real danger
when the monetary base has been bloated by a doubling of the Federal
Reserve's balance sheet, and the federal deficit seems destined to
exceed $1.7 trillion.

Mr. Gramm, a former U.S. Senator from Texas, is vice chairman of UBS
Investment Bank. UBS. This op-ed is adapted from a recent paper he
delivered at the American Enterprise Institute.

 -------

February 20, 2009
U.S. Tries a Trillion-Dollar Key for Locked Lending
By VIKAS BAJAJ

Credit cards, home equity lines, student loans, car financing: none
come cheaply or easily in these credit-tight times. The banks, the
refrain goes, just will not lend money.

But it is not simply the banks that are the problem. It is also what
lies behind them.

Largely hidden from view is a vast financial system that serves as the
banker to the banks. And, like many lenders, this system is in deep
trouble. The question is how to fix it.

Most banks no longer hold the loans they make, content to collect
interest until the debt comes due. Instead, the loans are bundled into
securities that are sold to investors, a process known as
securitization.

But the securitization markets broke down last summer after investors
suffered steep losses on these investments. So banks and other finance
companies can no longer shift loans off their books easily, throttling
their ability to lend.

The result has been a drastic contraction of the amount of credit
available throughout the economy. By one estimate, as much as $1.9
trillion of lending capacity — the rough equivalent of half of all the
money borrowed by businesses and consumers in 2007, before the
recession struck — has been sucked out of the system.

Banking chiefs, who have come under sharp criticism for not making
more loans even as they have accepted billions of taxpayer dollars to
prop themselves up, say it is the markets, not the banks, that are
squeezing American borrowers.

The Obama administration hopes to jump-start this crucial machinery by
effectively subsidizing the profits of big private investment firms in
the bond markets. The Treasury Department and the Federal Reserve plan
to spend as much as $1 trillion to provide low-cost loans and
guarantees to hedge funds and private equity firms that buy securities
backed by consumer and business loans.

The Fed is expected to start the first phase of the program, which
will provide $200 billion in loans to investors, in early March.

But analysts question whether this approach will be enough to unlock
the credit that the economy needs to pull out of a deepening
recession. Some worry it may benefit only select investors at taxpayer
expense.

The program also does not try to change securitization practices that,
many investors say, spread risks throughout the world and destroyed
financial institutions. Policy makers acknowledge that for now, fixing
credit ratings, reducing conflicts of interest and improving
disclosure can wait.

Under the program, the Fed will lend to investors who acquire new
securities backed by auto loans, credit card balances, student loans
and small-business loans at rates ranging from roughly 1.5 percent to
3 percent.

Depending on the type of security they are borrowing against,
investors will be able to borrow 84 percent to 95 percent of the face
value of the bonds. Investors would not be liable for any losses
beyond the 5 percent to 16 percent equity that they retain in the
investment.

In the initial phase, the Treasury will provide $20 billion and the
Fed will provide $180 billion. Treasury Secretary Timothy F. Geithner
said last week that the Treasury could increase its commitment to $100
billion to allow the Fed to lend up to $1 trillion.

Investors and economists said that the effort could help restore some
lending, but added that it might not be big enough to fully replace
all or most of what has been lost, especially if the nation's biggest
banks are not restored to health.

"The gap to be made up is huge," said Hyun Song Shin, an economist at
Princeton who has written extensively about the shadow banking system.
"Ideally, you would like the commercial banking sector to step up and
take charge of the train but they are in no position to do that
because they are undercapitalized."

The market for new securities backed by mortgages and other types of
loans has collapsed. Last year, investors bought $313.9 billion of
these securities, down from $1.6 trillion in 2007 and $2.1 trillion in
2006, according to Dealogic.

Last month, banks issued just $1.6 billion worth of such deals.

Banks and finance companies are holding more loans on their books, but
their ability to do so has been eroding as losses rise on their
existing assets. Since October, banks' holdings of loans and leases
have shrunk by 2 percent, to $7.1 trillion.

In the mortgage market, banks own just one-third of all loans, down
from half as recently as 1990.

Investors and bankers say the Treasury program, called the Term
Asset-Backed Securities Loan Facility, or TALF, could help unclog
vital channels of capital, but they add that it is hard to know how
big an impact it will have.

For one thing, the Fed will make loans against only triple-A rated
securities, not lower-rated bonds, which are first to suffer losses
when borrowers default on loans. That will not help banks sell junior
bonds, which many investors have shunned because of fears that losses
would rise as the economy worsened, said Thomas H. Atteberry, a
partner at First Pacific Advisors, an investment firm based in Los
Angeles.

"It's probably a step forward but it may only be a baby step forward,"
said Mr. Atteberry, who does not plan to use the TALF.

Jerry Marlatt, a partner at the law firm of Clifford Chance who
specializes in securitization, said that lenders using the TALF would
be willing to retain more of the risk associated with loans on their
own books to get deals done. That should help ensure that lenders make
better-quality loans in the future, because they will be liable for
most of the losses.

Simon Johnson, an economics professor at the Massachusetts Institute
of Technology and a former chief economist at the International
Monetary Fund, said many people might take a dim view of the TALF
program because it provided government subsidies to investors like
hedge funds. Investors who borrow from the Fed could enjoy annual
returns of 20 percent or more.

"The TALF," he said, "raises a lot of questions."