Friday, November 16, 2007

The Mortgage Crisis at the Intersection of Main and Wall

On Thursday, November 15, 2007, the House passed a bill that would provide for licensing of mortgage brokers, require that mortgage loans be within the capability of borrowers to repay, and place liability for loan violations on banks that package mortgages into mortgage-backed securities. Bankers were quick to complain, and are reportedly seeking aid and comfort in the Senate. They may get a friendlier reception there, but the outcome remains unclear.

This legislation was predictable. The history of government regulation in America follows a well-established pattern. An industry grows and becomes economically powerful. It overreaches. A lot of people are injured. Public outcries for government action lead to regulatory initiatives. Thus it was for the railroads, whose monopolistic pricing led to the creation of the Interstate Commerce Commission. Thus it was for insurance companies, whose legendary use of impenetrable legalistically worded exceptions, exclusions and limitations gave the term "fine print" its popular meaning. Their reward was regulation by every state of the Union. And, so, too, for the banks, whose inability in the late 1800s and early 1900s to deal with a series of credit crunches left numerous depositors ruined, not through any fault of their own but because of faulty lending by the banks. The result was the creation of the Federal Reserve System.

In the manner of greased pigs at the county fair, businesses try to slip out of the grasp of regulators. For the financial services industry, the tactic was to convince the government not to regulate derivatives. And for the better part of the last 30 years, as derivatives were developed, the government largely refrained from regulating them. Realizing that they had the government where they wanted it, the financial services industry then slipped the business of banking into the unregulated derivatives market. Loans, the traditional province of banking, were packaged into asset-backed securities and sold to investors. The vehicles that connected investors to loans became, functionally speaking, the real banks. These vehicles, like Detroit's products, came in various shapes, sizes, models and colors. They have names like ABS, MBS, CDO, CLO, CMO, CBO, SIV, SPE, and so on and so forth. They were the actual source of funding for loans, using money from investors who effectively were depositors.

Given the absence of regulation in the derivatives sector of the banking industry, it's not surprising that this sector grew phenomenally. Without the limitations imposed by regulation (such as fair treatment of customers or adequate capitalization) and the costs of complying with regulation, revenues could flow faster toward the bottom line and gratifyingly large bonuses. Thus, bankers had every incentive to slip quietly out of the purview of the regulators.

Unfortunately, a lot of mortgage borrowers were trampled on the bankers' way to the Bentley dealer. Granted, many of those borrowers are in places like Cleveland and Detroit, cities that Wall Streeters might hardly deign to fly over. To a Leona Helmsley, these borrowers might have been little people. But in a democracy, they're the people, and they have votes.

Markets and market-based economies are harsh. They make some people winners, and some people losers. They have no code of chivalry. All too often, a small number of people become extremely wealthy by exploiting and victimizing many other people. This creates enormous imbalances of power and wealth that foster envy and social instability.

Government regulation enacted through democratic processes is how society regains its balance. Americans believe in the free enterprise system, and have no problems with a person accumulating dollars honestly earned, even a lot of dollars. But our economy is national and even international in scale. Only governments and their regulatory power can restrain the worst excesses of unregulated businesses. And we have certainly seen excesses in the subprime mortgage mess.

The legislation that passed the House will begin the process of bringing the unregulated portion of the banking industry under government oversight. It may not get through the Senate. And if it does, it will probably get a really big frown at the White House. (The big guy at 1600 PA Ave will probably forget that it was FDR, not Herbert Hoover, who was mourned by thousands of weeping people lining the streets of Washington when his horse-drawn caisson passed by; but W seems to have a problem with the vision thing.)

This is a win, win situation for the Democrats. If legislation is adopted, they can claim credit. If the Republicans block it in the Senate or the White House, the Democrats gain ammunition for the 2008 elections. All indications are that mortgage defaults for 2008 will be worse than they've been for 2007. More pain will be inflicted on Main Street, and the people will respond through the political process.

Could the bankers have avoided this outcome? Yes, if they had refrained from excess. But that would have required long term thinking and strategic planning. With the year-end bonus beckoning, why think about some schlemiel in a rundown Midwestern city who has a mortgage reset in a couple of years?

A few banking executives will perhaps realize that there may be other areas of banking with the potential for blowups like this. After all, mortgages aren't the only thing you can ease off the balance sheet through structured finance legerdemain. Perhaps they will quietly consult with their Audit Committees, auditors and attorneys about whether or not prudence might be the better part of valor. And perhaps this time, they will act before the government does.

Food News: world's record for downing hot sauce. What follows? The world's record for downing antacids?

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