Banking on Big Changes

Will the next president will use the U.S. Treasury to refloat lending? Signs point to yes.


Democrats in Denver are droning on about the harm done to the middle class by the current financial system pullback. The Federal Deposit Insurance Corporation (FDIC) is adding banks to its "watch list"—now at 117—and warning that it may not have enough money to insure all depositors. The FDIC seized another bank last week, the ninth such action this year.

Given all this attention, not to mention hourly stock market gyrations based on home sale and price data, you might think the American banking system must be fairly well understood, especially what brought us to the present meltdown. But this doesn't seem to be the case.

The present situation is portrayed overwhelmingly as an economic story when, in fact, it is primarily about regulation and public policy—the past 30 years of bipartisan, nearly universally-praised policy to be specific. And it is probably that universality of opinion that keeps misconstruing what is really happening.

The history of the FDIC illustrates what has transpired. Born out of Great Depression economic turmoil, the FDIC was created to ensure the safety and soundness of bank deposits, hence the deposit insurance bit. In the face of bank runs, the feds stepped in to say, "Not to fear, your money is not going anywhere. Uncle Sam has you covered."

Yet that is not what the FDIC is now doing. Its mission has changed. As it tries to clean up California's Indy Mac Bank, for example, its first order of business is avoiding foreclosure on bad loans the bank made to homeowners. An analyst with Barclays Capital called this approach "dangerous" because it gives investors in mortgage-backed securities a reason to run for the exits if the FDIC does not care about recovering their money. In effect, the policy shorthand has changed to read, "Not to fear, you are not going anywhere. Uncle Sam will pay your mortgage." This is very different from its original mission but perfectly consistent with the public policy trend which began in the 1970s and accelerated with the Community Reinvestment Act (CRA). The goal was to make banks agents of social change.

The federal government, Democratic and Republican, wanted trillions of dollars of credit extended to private borrowers. This was primarily done via the active secondary mortgage market participation of government-backed Fannie Mae and Freddie Mac, but also through leverage the CRA provided by requiring expanding banks to explicitly promise to lend money to higher risk borrowers. And incidentally, the overwhelming beneficiaries of that flow of credit was America's supposedly beatdown middle class, which took the money and ran to buy not just homes, but cars, boats, college educations, diamonds, furs, boobs, computers, widescreens, flatscreens, and then second homes.

So then, the policy worked? Yep, private investors created ever more complex ways of leveraging capital into ever more lendable money. They took the federal directive to spread the wealth around (quite literally) to the point where risk was no longer a negative aspect of the credit calculus. In fact, by the dawn of the 21st century, risk was courted by banks because it was more profitable in the short-term. Federal regulators, who in decades before might have been aghast at such practices, applauded because the larger goal of extending credit to every corner of the American landscape was advanced.

But with risk out of the picture it was only a matter of time before the entire enterprise became over-extended. The oil shock of $4 gas, Fed missteps, wild speculation in condo markets, or maybe the moon cycle provided nudges over the past few quarters. No matter the short-term cause, the foundation was rotten and a great de-leveraging is underway. Capital is scarce and lending nonexistent in some sectors. Now what?

How about a little honesty? Fannie and Freddie are in the process of being de facto nationalized by the Treasury. The implicit federal guarantee of their solvency is being made explicit and may hit $50 billion over time. But this may be just the start.

In a memo to clients and the president-elect, Chris Whalen of Institutional Risk Analytics suggested that the bailout of the government-sponsored enterprises (GSEs) Fannie and Freddie is part of a larger picture. Whalen explains:

Since last summer, the various parts of the securitization market have been slowly imploding, right on up the food chain from subprime [collateralized debt obligations] to the AAA-rated GSEs. The only way to staunch the bleeding and begin the process of restoring confidence in all manner of securitizations is to take the GSEs off the table as a concern for investors. When and only when the GSEs are affirmed as affiliates of the U.S. Treasury will yield spreads on GSE debt start to fall, ending the immediate crisis.

Once the GSEs are safely under a conservatorship, with a program in place to slowly run-off the retained portfolios as the debt supporting them matures, then we can start focusing on the next task, namely fixing the securitization markets and recapitalizing the commercial banks.

Whalen also adds the important insight that banks are government-sponsored enterprises too, just more competitive and charged with providing capital to the private economy in ways federal regulators and politicians desire. If that is the case, and the past 30 years certainly suggests it is, then recapitalizing the banks is going to take money from the Treasury. Lots of it.

The alternative is to permit market forces to allocate capital from private sources without direction from officials Washington or New York. Not very likely, especially in an election year.

Jeff Taylor writes from North Carolina.

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  1. I wish Jeff would write more stuff for Reason.

  2. You’ve got it all wrong. The government stepped in to correct a market failure. We just need to do a little fine tuning, and then everyone will have a home of his or her own, with a chicken in the pot, and a flying car in the garage.

    And a, you know, pony out back.

  3. Don’t worry. The government will get it right this time. A few more regulations, a few more directives, many more taxpayer billions and then everybody gets a home loan that they won’t default on.

    And a pony.

  4. Well written and logical, always love an article from Jeff Taylor. I second TWC that he should do more articles for reason.

  5. The alternative is to permit market forces to allocate capital from private sources without direction from officials Washington or New York.

    “Market forces” don’t allocate anything, people do. And the people with the money aren’t allocating it, probably because they don’t want to lose it.

    The alternative to government action is Hooveresque stagnation. I don’t know anybody other than Amity Schlaes that really wants to “purge the rottenness from the system” for the next 5 years. Even Jeff Taylor didn’t take the pledge, at least in this article.

  6. I 99.9% agree with Jeff, but the FDIC was overwhelemed by the sheer number of bad mortgages at IndyMac.

    The FDIC is supposed to be preparing IndyMac assets for sale. Foreclosure is a drawn-out process and requires lawyers – the FDIC would deplete its funds just on legal fees going through the forecolusre process. Then selling the REO parcels would either require time-consuming piecemeal sales or selling in bulk below market value.

    If this were a few hundred bad mortgages, the FDIC would just foreclose and get it over with. But we’re talking thousands of bad mortgages – the FDIC would be foreclosing for years or would burn through 10 million in legal fees to get it done faster. Seems like the FDIC is just doing the math and figuring the better value for the FDIC is to fix up as many mortgages as they can and will be able to sell the loans at a higher return than foreclosing-and-selling-REO would return.

    Personally, I think the FDIC is in for a shock when they see how few borrowers are going to accept or qualify for the FDIC’s workout terms. Then the FDIC will have little choice but to foreclose. And another issue is how much volume the state courts can handle at a time. The foreclosure line might be over a year long now. (Welcome to Sapce Mountain!) If they’re trying to sell assets as qucikly as possible, loan workouts might be the only choice.

    Yeah the FDIC talks about “keeping people in their homes” but bureaucracies always put a bullshit face on their real intentions. And yeah it sucks, but they might have to write down a loan from $700,000 to $450,000. Then again, the house was really only worth $450,000 anyway except for some insane blip. I don’t think anyone is going to come away with buying a house properly valued at $450,000 for $350,000.

  7. …”Then the FDIC will have little choice but to foreclose. And another issue is how much volume the state courts can handle at a time.”

    There would be plenty of court capacity if cannabis was re-legalized and the war on some drugs was ended.

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