Thursday, October 3, 2013

Discourse on the Great Recession – BANKING & REAL ESTATE LENDING

Credit has always presented a challenge to managing a financial system, hence the name “usury”; or perhaps look at a religion that evolved at a time of the earliest advanced banking system – Sharia and the resulting laws banning lending as a practice. Lending, coupled with fiat currency, poses a challenge to manage for modern governments as well, governments role, save in a small number of cases, is to contain over exuberance as opposed to heightening it, as it did in the years leading up to the great recession. In tandem with government policy came the advancement of “financial sciences” and the development of derivative products to allay risk to lenders.


It is a laudable goal of the United States Government to give every citizen an opportunity to have a home. Laudable because, ownership provisions stronger ties to society at larger than the absence of ownership. Laudable because, in provisioning the opportunity for people of limited means to build capital in an appreciating asset it gives them opportunity in general. Laudable because, people of limited  means with a little help can escape the rental trap. Laudable because, elderly people can live more easily when they are absent a rent payment. Laudable because, in broadening home ownership the government broadens all the supporting markets. The commentary post the crash in the housing market coming from talking heads was deplorable – they seemed to indicate that generalized participation in capitalism was impractical, that a goal of generalized home ownership was impractical because some were unable to manage it. You can rest assured that the people trying to claw their way to prosperity via home ownership, where in no way to blame for the real estate crash, government and industry were the culprits.  


The US government brought Freddy Mac and Fanny May into being to create a circumstance that would support the banks in lending for housing to a broader segment of the population. These entities were government initiated corporations charged with lending via banks to support a policy to generalized housing ownership in the US. While it was never the intention for the government to underwrite these organization’s lending, when things got bad, the government did, as Wall Street suspected they would. The tacit understanding by industry that government would intervene was one leg in support of aggressive lending.


The Asset Back Securities (ABS) related to mortgages grew. The underlying rationale for  ABSs was to reduce risk, by pooling mortgages, and in issuing bonds in accord with risk strata the banks could attract capital to the market – no single individual or institution was exposed to the full risk of any given mortgage. It was the separation of lender and borrower that contributed to “irresponsible” lending; prior to these broad based risk mitigation tactics the bank would lend to an individual and the bank would hold that mortgage on its books. The incentive for a bank to screen borrowers, assess the lending environment and follow through on the collection of a mortgage, that is in the sole possession of a that bank, is far greater when mortgage losses falls to said bank.  


Banks have a tier one capital requirement (more or less balance sheet equity), recently elevated in the aftermath of the financial crisis. Banks need to leaver relatively small profits over large volumes of funds, so they require a method to circumvent the tier one requirements. This was achieved in some cases by a Special Investment Vehicle (SIV). A SIV is an arm’s length company that takes ownership of mortgages and often packages said mortgages in ABS. Once the mortgage is held in a SIV the bank has no exposure to that mortgage. You can see here how, the lender and/or the ABS holder, are now three or four tiers away from the borrower - worse, in many cases no one knows who the lenders are.


In the environment generated by these realities and a rapidly valuing real estate markets, “freelance” lenders were issuing mortgages that they would never have to answer for, so they adopted very aggressive tactics with complete disregard for a correction in the market or the prospect of an interest rate increase and under the premise that housing prices would always go up. When the market did correct thousands of people found themselves “up side down”, they owed more than the value of the asset the lone was issued against – they walked away in droves – unsold inventory grew, prices dropped – in some markets no floor was found – acres of homes have been bulldozed. The human toll was massive, the institutions that precipitated the event have enjoyed more benefit than harm and the tax payers are paying and paying some more. So our system is less than perfect to be sure, but to paraphrase Winston Churchill, “it is awful but better than all the other options”.   

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