I heard on the radio this morning that the Treasurey Department is thinking of adopting the British rescue plan of recapitalizing banks by purchasing a majority of the shares in banks that opt into the rescue plan. Now keep in mind this is completely unconfirmed because at this point I can’t find any articles anywhere that back this story up. However, such a move is probably a really, really bad idea.
Part of the problem with the financial industry over that last 30 years or so has been the politicization of home loans. Getting people who don’t have the 20% down payment for a home loan into homes with less than the 20%, no down payment at all, and even people who have no credit and even bad credit. The last one in particular is extremely foolish. These are people with a proven track record on not being reliable in paying bills and you are going to give them a loan that could be for several hundred thousand dollars and think that the risk is going to disappear simply because the way multiple mortgages are bundled together?
Now some will say that sub-prime loans under things like the CRA were really not the root cause of the problem. I don’t think there was a simple single cause, and I think defenders of the CRA are a bit disingenuous when they make arguments defending the CRA. For example defenders will argue that CRA was enacted in 1977 with little or no problems for the next 20 years. True enough, but CRA now is not the same as CRA in 1977, just as Medicare now is not the same as Medicare in the 1960s. To pretend otherwise is intellectually dishonest. According to Wikipedia the CRA was changed in 1989, 1992, 1994, 1995, 1999 and 2005. So when people like Ellen Seidman tells us “the timing is all wrong since CRA was first passed in 1977,” she is being deceptive at the very least. For example, under the CRA entry at Wikipedia we have this,
In October 1997, First Union Capital Markets and Bear, Stearns & Co launched the first publicly available securitization of Community Reinvestment Act loans, issuing $384.6 million of such securities. The securities were guaranteed by Freddie Mac and had an implied “AAA” rating.[18][19] The public offering was several times oversubscribed, predominantly by money managers and insurance companies who were not buying them for CRA credit.
In October 2000, in order to expand the secondary market for affordable community-based mortgages and to increase liquidity for CRA-eligible loans, Fannie Mae committed to purchase and securitize $2 billion of “MyCommunityMortgage” loans.[21][22] In November 2000 Fannie Mae announced that the Department of Housing and Urban Development (“HUD”) would soon require it to dedicate 50% of its business to low- and moderate-income families.” It stated that since 1997 Fannie Mae had done nearly $7 billion in CRA business with depository institutions, but its goal was $20 billion.[19] In 2001 Fannie Mae announced that it had acquired $10 billion in specially-targeted Community Reinvestment Act (CRA) loans more than one and a half years ahead of schedule, and announced its goal to finance over $500 billion in CRA business by 2010, about one third of loans anticipated to be financed by Fannie Mae during that period.[23]
Under the 1995 change to the legislation we get this,
According to a 2000 United States Department of the Treasury study of lending trends in 305 U.S. cities between 1993 and 1998, $467 billion in mortgage credit flowed from CRA-covered lenders to low- and medium-income borrowers and areas. In that period, the total number of loans to poorer Americans by CRA-eligible institutions rose by 39% while loans to wealthier individuals by CRA-covered institutions rose by 17%. The share of total US lending to low and meduim income borrowers rose from 25% in 1993 to 28% in 1998 as a consequence.
In short, over the years there was a concentrated push to expand the number of low income/riskier types of borrowers who were covered under CRA. To claim that the timing is all wrong is just not true. CRA was the umbrella under which all of these changes took place.
Now, the problem here is that government has gotten involved in the home loan market with an eye towards subsidizing home ownership for those who are low income and/or higher risk. And instead of doing it in a straight forward manner–i.e. giving such borrowers the 20% needed for the down payment they forced banks to make loans that they otherwise would not have made. Banks and Wall Street firms tried to mitigate the risks with MSBs but in reality it hid the risks (and Fannie Mae and Freddie Mac were very much involved with this too), and with housing prices rising many people saw it as an opportunity to get rich.
Some might wonder, but it was just a house of cards how could people fall for it. The same way they fall for pyramid schemes, 419 scams and so forth. They are greedy and either figure they can get out before the bubble bursts or that they are special and wont get scammed. The problem is that in this case it was a huge house of cards and so much of the rest of the economy stands to be adversely impacted by the mess.
But the bottom line is that politicians have different objectives than bankers. Politicians crave power that their elected office conveys on them. Bankers on the other hand are concerned about profits, the soundness of the bank, share holder value and his own paycheck. The politician realizes that he can secure his hold on power by tossing pork and other goodies to his constituents. The banker realizes that one way to improve profits, soundness of the bank, shareholder value and his own paycheck is to not lend to borrowers who are too risky. And this is where we have a potential problem. If the politician decides to try and toss some home loan pork to his constituents then you could have a bank that is lending to riskier borrowers and you risk the health of the bank. Do that enough and soon you could have problem in the entire banking industry.
This shouldn’t be shocking nor should it be controversial. We’ve seen what happens when politicians/government takes control of allocating resources. Was the Soviet Union a great place to live where they couldn’t even produce enough toilet paper? In the first half of this century millions starved due to crappy central planning. Look at North Korea, China, and Cuba. Not exactly countries noted for their high standards of living. And in the case of China one reason why they’ve had some measure of economic success is because they’ve gone in the opposite direction–i.e. more market oriented reforms.
Having the government take a majority ownership stake in U.S. banks would be a bad idea. It would not address the problem that led to this crisis: government involvement in the home loan industry.
