Friday, October 03, 2008

There are TWO ways the U.S. government has destroyed the financial system

The email below from someone in the system (Steve Goodman of Voorhees, NJ) explains all. Not only did the government cause the problem with its insistence on lending money to anybody capable of staggering into a bank but it is now preventing any recovery of the system with its "mark to market" regulation. The essential point is that most sub-prime borrowers are in fact making their payments but the regulations not only ignore that but force the financial system to treat the mortgages concerned as worthless

I am an attorney and have spent most of my career advising banks and other lenders on compliance with the many laws and regulations that govern loans to consumers and businesses.

I think that the culprit behind this mess is fast coming to light. It is our government. In part the crisis is a runaway subprime loan giveaway foisted on regulated lenders by the government. Banks and other mortgage lenders were required by federal law to make and invest in mortgages made to persons who could not afford to borrow, or they would be in violation of the federal 1977 Community Reinvestment Act (CRA). Over the years, consumer activist groups, such as ACORN (but there are others), used the CRA to interject themselves in the regulatory process regarding requests by banks to open new branches or to merge with other institutions. Initially, the Federal Reserve Board gave little weight to these activist claims but, as the Congress criticized the Fed to enforce the CRA (and thereby to STOP discrimination in home lending, of which there was little or no evidence), banks were forced to enter into contracts with ACORN and other activist groups under which they committed to make billions of dollars of subprime loans.

The CRA was used more recently as a cudgel to force banks to make loans the banks would not make on their own. How could a bank refuse to make a loan if it would be approved by applying the very low approval standards adopted by the gse's (Fannie and Freddie)? And, under Andrew Cuomo, the Chairman of HUD in the 90's, the then "normal" rules for rejecting loans were replaced by very lax standards intended to rapidly increase home ownership by those persons who could not afford to buy homes under the old rules. HUD permitted the charging of broker's fees, ALT-A loans, interest only, and whatever the market would bear. It created the subprime market we know today and induced lenders to participate. States and localities are adopting laws and ordnances to regulate the practices of mortgage lenders and brokers, with no real understanding of how the market got to this point.

The majority of CRA (subprime) loans are now performing. But, that fact seems to have no impact on their "market" value, at least to regulators, auditors and accountants. The market for subprime loans has quickly dried up because the "mark to market" rule adopted by the Financial Accounting Standards Board requires that all assets be valued and revalued based on their current market worth. If the secondary market for any financial product (such as a loan) tends to dry up, the mark to market rule comes into play to further devalue those products traded in that market. Thus, fairly quickly, an otherwise performing subprime loan secured by residential real estate collateral has a near zero market value. Even if a buyer wanted to purchase the subprime mortgage for what the buyer deemed its worth based on the performing stream of payments. interest rate, and the like, the buyer would be required to immediately mark the asset value down on its books and undermine its own stock market value.

So, if a buyer purchased a mortgage that, based on the likelihood of payment, remaining payments, interest rate, and credit worthiness of the borrower it valued at $100,000, it would then have to apply the mark to market rule to value the loan at near zero on its books. No publicly traded or regulated company or bank can do that. Moreover, in my experience, the bank regulators will soon demand that other loans, such as prime mortgage loans, car loans, installment loans, and the like, be written down as their marketability will come into question. The regulators can themselves bring a loan market to a standstill. They did it before and will do it again.

Thus, the net effect of the mark to market accounting rule is to create a downward spiral in valuation of all loans, without regard to their true worth. And, while the mark to market rule was supposed to create a better understanding of a company's (or bank's) value, which the cost basis somehow did not do (although it worked for a long, long time and there was no perceived need to change it), it has quickly been found to artificially undermine that net worth.

So, instead of throwing $700 Billion into a black hole, to be doled out at the discretion of some bureaucrat who will have no idea what he or she is doing, and thereby prolonging instability in the market and inviting a depression, we should simply rescind the mark to market rule and let buyers and sellers reach the price for loans that would allow them to value loans in the real world and use that cost or historical value for bookkeeping purposes. To do so will keep bank regulators, accountants and auditors at bay and open the market to market trading.

(It would be a positive on public confidence in the banking system to raise the cap on deposit insurance, too but, in my opinion, that is not as essential as rescinding the mark to market rule.)

Note that by requiring the use of the mark to market rule, the government that required that subprime loans be made, is now requiring that they be written down to near zero values that Secretary is advising the Congress are much less than their real worth. After all, his argument in selling his plan to the Congress is that the government can hold the loans for a short while and then sell them into the market for large profits. But, unless and until the mark to market rule is rescinded, The government will be able to sell subprime loans only to nonpublicly traded companies. So, to unload these loans for the promised profits, the mark to market rule will rescinded when it is in the interests of our government to do so.

In essence, the U. S. Government has required banks and other mortgage lenders to make imprudent subprime loans and, under Paulson's plan, gets to steal them and later sell them for a profit. This is not a bailout. It is highway robbery. And, we are now getting to see the Paulson plan for what it is. This is a very incompetent man who rose far above his capabilities.

1 comment:

Kevin Stroup said...

Exactly. Why else is the government in such a big hurry to bury this story? Because the longer this story goes on the more it will become apparent that the government is a major cause of this fiasco, and negligent conduct must be covered up. Rotten bastards all.