Following Blind Leaders

Posted by Larry Miller on March 7, 2009 under How | Be the First to Comment

The initial Paulson/Bernanke/Bush, bailout plan was to get the toxic “assets” off lenders books so they could begin lending again. They came to the conclusion that accounting rules and lack of liquid assets had caused the credit market to “seize up” as they described it… much like your car’s engine would do if deprived of sufficient lubrication. That was the original plan, but it quickly changed to infusing billions of dollars into ailing financial institutions, trusting the management to use it in ways to actually help the economy. We’ve all seen how well that worked.

The accounting rule most reviled by the banks was the “mark to market” rule which required them to carry assets on their books at values they could reasonably expect to sell them for on the open market. That never seemed to be too unreasonable a procedure. That alternative would be keeping values on the books that were greatly inflated beyond any thing they could actually be sold for. For example, why should a five million dollar building be shown on the books for ten million dollars when no one could realistically be expected to buy it at that price? In most other contexts, that would come pretty close to something called fraud. Of course write downs like had a negative impact on the corporate statements. It was, however, a more accurate picture than retaining the higher value and hoping it would, one day, return.

The other rule hurting banks involved reserve requirements for non-performing loans. When a loan, whether a car payment or mortgage is paid on time every one is happy. When the borrower stops paying in timely manner and slips further and further in arrears, the loan is listed as non-performing and the bank needs to keep reserves to cover the situation. This is why lenders will sometimes give substantial discounts to buyers who will take such properties off their books. Considering the costs involved in foreclosures and the release of reserves for other uses, these transactions often turn out to be a win for every one involved. The bank gets a toxic “asset” off the books, the buyer gets a good deal and the borrower is relieved of a debt he can’t pay.

Some are quick to lay this situation completely on the irresponsibility of the home owner, assuming they lied on the application forms and did not pay attention when the adjustment feature of the loan was discussed. There is much truth to this argument, however this does not tell the whole story. Larger economic factors also came into play for many… such as jobs lost to overseas or imported workers or a general downturn in economic activity.

As an example, construction workers were badly hit by this double whammy. First many found formerly high paying jobs going to lower priced workers coming in from our southern border… both legal and illegal. Locally I never could get the local home builders representative to go on record that there were no illegal aliens working on job sites. I was referred to with a variety of terms, few complementary, but never was I given the answer I asked for. The workers plight was then compounded by the drop off in home construction.

Often borrowers would be presented a loan package with low introductory interest rates that came about by Federal Reserve market manipulation with Fannie Mae and Freddie Mac adding encouragement. It was explained to them that loans were easy to get and there was no reason to pay the higher fixed interest rates. Some were even offered rates that resulted in negative amortization – that is, the payments did not even cover the interest being charged and at then end of each of the first several years, they owed more than they did at the beginning. But then who cared, real estate was guaranteed to go up, wasn’t it? They were promised that several years down the road, if they kept up the payments, they could easily refinance to another low rate. The lenders were not lying to them. Under the old rules, this was true. However, as more loans went into default, the accounting rules and federal financial regulations mentioned above began putting lenders into a bind and the rules of the lending game changed.

Even for those who paid on time, refinancing was no longer an option unless they were gold plated and had a stratospheric FICO score. The pendulum had swung back in the direction of sanity, but too far to keep home sales at anywhere near normal levels. Lenders were tasting the bitter fruit of their lending excesses inspired by the low interest, free flowing money supply, government encouragement and intimidation (read regulation meant to open home ownership to people who could not afford it) combined with a bit of their own greed. The whole situation was compounded by the practice of selling off the loans almost before the ink was dry on the closing forms. This appears to be a critical but often missed link in the chain of failure. It meant that for all the hoops the loan underwriters made the borrowers jump through, the lender had no responsibility for collecting the loan… and they really didn’t care. Broker commissions were paid, profits were taken and the risk was passed on to other unsuspecting banks or investors.

So now, by injecting new cash into a banking and economic system, our government is expecting restore the credit market and pump up real estate prices. Let’s think about this a little. In spite of the lessons many of us have learned personally, we are now expected to set the acquired wisdom aside and blindly resume borrowing and spending. Washington is setting the example for us. Ironically, the fact that we have to pay for their example may preclude us from following it ourselves. The fact is that, with the economic downturn, many are in trouble personally precisely because they followed this path to financial disaster. Washington wants the banks to loan out the dollars so we can resume our rush to financial destruction. How kind of them.

As far as real estate prices, many have been saying for years that they are well above any relationship to reality and could not be sustained. Homes got to their astronomical values as a result of the Federal Reserves free flowing money and artificially low interest rates. This made it easier for more and more people to enter the home buying market. Anyone with a rudimentary understanding of economics, which apparently excludes many inside the beltway, can tell you that increased demand without increased supply will drive prices up, up and away. What we are seeing now is a reduction in demand because many cannot get the money to buy a home. What happens next, and again, it only takes an elementary understanding of economics to comprehend, is that prices will come down as more homes are available than are needed to meet the demand.

So our Treasury Secretary and Federal Reserve Chairman, along with a host of congressional types and White House staffers are feverously working to find a way of defying the financial gravity acting on home prices with some sort of scheme to retain the inflated prices in spite of a diminished market. Despite the obvious political implications of facing a public whose home values have dropped in recent years, there is the consideration of retaining bank assets at values that keep shareholders happy and CEOs in their jobs.

It appears that in spite of the deflationary pressures on the housing market, home owners are expected to eat the losses, but for all their involvement in its creation, banks want to limit theirs. Writing down loans to actual values, will, long term, establish an equilibrium that will permit us all to move forward. It is not a good plan, but the President is calling for shared responsibility and sacrifice, maybe it’s the best plan we can come up with. If the banks foreclose, all they will get is the reduced value anyway, and then, only a portion of it. The borrower should not have taken the loan in some cases… but then the banks should not have made the loans in many of those same cases.

It would be best for everyone to get together and work out agreements based on their situations – without government involvement! They helped get us into the mess, it would be foolish of us to expect their wisdom to get us out.

As far as getting back to borrowing and buying, perhaps we should put that on hold for a while. That’s what got us here. We should be thankful it wasn’t worse… then not go out and do it again.

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