Banking is a very complex business, highly regulated, very interconnected – and absolutely vital to the well-being of our nation, and every one of us. So when banking gets in trouble – look out! And much of the commercial banking industry is in trouble these days. So now the finger pointing starts, and the investigations begin (as we see with the Securities & Exchange Commission announcement of open investigations this week).
The dimensions of the problem are becoming more clear. So now we ask: Who is at fault? Who should pay back their bonus (based on sales of exotic new financial instruments that were mortgage-backed)? Who should go to jail? Questions are simple and direct but aahhh, the answers are not that simple or straightforward, as we will see.
Let’s look at commercial banking first. There was a time when most of the banks kept their loans in their portfolios. In the reverse-mirror of bank accounting, an “asset” is a loan out to a borrower. The asset “performs” when the borrower maintains current payments and the loan is not in jeopardy. The “liability” is the opposite of what you and I might think of; the bank owes you the money on deposit in your account, so that is a liability on the books. When we hear that bank “X” has reached $1 billion in assets, a 15 percent gain in one year, that might mean that aggressive lending has put much more money to work (in loans and lines of credit) for the shareholders.
Once upon a time, the bank would take in deposit money and lend it out at a higher rate. Some economists projected the “10-X” rate: One dollar made available to the bank might carry to a trajectory of $10 through many transactions made possible by the availability of that first dollar. The bank would borrow from other banks and from / through federal government entities and raise money in the capital markets…and the “assets” resulting (those performing loans) would stay in the portfolio. A $100,000 mortgage over time could generate up to $300,000 for the bank. Once upon a time the bank really worried about whether you could pay your mortgage back and if you paid your bills on time and if you had a safe / secure job and if you had good credit and what your credit score was and if you were a customer. Enough? Evidently too much – banking been changing dramatically over the past few years.
Most of us remember going into the bank branch and dropping to our knees twice – first to beg for the mortgage and then – when granted – in prayerful thanks for the money. We got a payment book and the checks were written (or direct deposit arranged) with one bank over many years’ time.
Over the past five years the system changed dramatically. The 70-year old “wall” between commercial banks and Wall Street houses (brokerages and investment bankers) came down in 1999 (when our banking system was last “reformed” by Congress). Glass Steagall, the money men argued, was archaic – those bad days of the Great Depression, when so many banks failed, were long gone. (Oh, we hope so!) G-S was an anachronism – especially in the world of global banking.
So US bankers scooped up loan-after-loan and worked with their brethren to move those “assets” out of the portfolio at the bank office and into “Mortgage Backed Securities” (MBS) or “Collateralized Debt Obligations” (CDOs) and other fancy-named financial instruments. As billions flowed out of bank vaults (metaphorically) and into Wall Street houses and thence to institutional investors (such as state pension funds), the bankers began to worry less about risk.
Risk is much different if you are keeping a loan for 30 years and expecting to earn $200,000 and more on your $100,000 loaned out to guys like you and me. Risk is, well, less risky for bankers if the risk is widely shared. So let’s take dozens, hundreds of consumer and commercial mortgages, put them in MBS’s etc. and have our friends on Wall Street peddle them to institutions looking to generate higher returns. After all, the rate-of-return for the pension fund will be higher than anything the US Treasury might pay. And money managers on contract to public employee pension funds (as example) are in a very competitive business – gotta get those better-than-market returns!
And anyway, as requested by the issuers of these exotica, the trusty credit risk rating agencies slapped Triple-A on many of the new instruments – hey, what can go wrong now!
And so the slippery slope begins, all in good faith we might argue. Let’s create new kinds of mortgages – negative amortization and other fancy names – and bring them to eager borrowers. Borrowers win! In too many cases, however, the end result might be predictable: Borrowers not qualified to take on debt or high mortgage payments entered the system. NINA loans were talked of: No Income / No Assets. Banks are there to serve the customers and there plenty of customers. Remember all those home re financed over the past decade to “take the cash out of the house?” As home valuations rose so did “cash out” borrowing.
As the economists are favored to say, “no tree grows to the sky,” and alas, the mortgage merry-go-round had to begin to slow, stall and almost stop. The worse-case situations may be the Adjustable Rate Mortgages (ARMs) that re set at much higher rates. We are told that two to three million of various kinds of mortgages may be / will be in trouble over the coming months.
That also means that 95% of mortgages are performing – good news for bankers, investors, regulators, the rest of us. We tend to overlook good news in a crisis situation.
So – we now work our way backwards to ask “what went wrong, whose fault is it, who can we punish?” That happens after every boom and bust. Hey, we are still arguing about what caused the 1929 stock market crash, and the reasons why we plunged into the Great Depression (1930-131 to 1940) and whose fault it was.
The Congress is now nibbling around the edges of the “mortgage crisis” and trying to decide how to help the situation without “rewarding those who were greedy” etc. The White House says President Bush may or may not sign the legislation if it passes. The leading presidential candidates are carefully offering up solutions. And the SEC, we read today, has opened its investigations. Oh, and two Bear Stearns honchos were arrested on suspicion of fraud.
Criminal fraud convictions require proof of deliberate actions intended to defraud innocent investors (our description here). We think the bar will be quite high for these types of convictions for transactions related to the subprime mortgage crisis.
Many of us were willing participants in the greatest game in town – for a few years – as we turned the built-up equity in our houses into ATMs, or over-speculated in investment properties. (Look at Nevada and Florida – always to be counted on as canaries in the coal mines for over-speculation.) Record bonuses were paid on Wall Street last year – how many of these were based on the newest game in town – subprime lending! Billions’ of dollars flushed into retail markets, for big ticket purchases. All along the chain of transactions from mortgage broker at kitchen table to pension fund portfolio managers snapping up collateralized mortgages from all those thousands of kitchen tables, the players were willing partners.
Should the federal and state regulators have done more to protect borrowers …investors … the economic system of our nation? Yes, of course. Should better risk management systems have been in place? Yes, of course. Should borrowers have known better? Yes, of course. Should mortgage brokers have been more qualified, and should oversight have been in place? Should some borrowers have known better than to take on high-risk loans? Should bankers have stayed the course with loans-in-portfolio approaches (note that a good number of bankers didn’t play the subprime / high risk game)?
The answers are complex and varied. But this much can be safely stated: We had better figure out ways to stabilize the mortgage market, stanch the flow of red ink on bank balance sheets, put better mortgage lending oversight in place (without stifling innovative approaches to banking), keep capital flowing to worthy borrowers, and most important, figure out ways to help borrowers in trouble and who, if they walk away, could plunge entire neighborhoods into despair.
Many of us were involved in some way in the creation of this mortgage credit mess – and most of us now need to be involved in solving the problem. The fraud convictions, if any result, will titillate us on the news reports – love those perp walks — but will solve little if any of the challenges that face us as a People…in the broad scope of things, related to the banking industry mess.
Visit this link for the related article – http://www.accountability-central.com/single-view-default/single-view-lexis-nexis/article/sec-probes-of-sub-prime-crisis-expand-inquiries-target-fraud-market-manipulation-and-breaches-of-d/?tx_ttnews%5BbackPid%5D=1&cHash=2cc93c5ff3