Deep Freeze?

My last blog recommended a consolidated approach to financial regulation to oversee the strategic objectives and decisions of financial services organizations, rather than the specific product lines and operations considered in our current ineffectual regulatory approach. Beyond that change, there are several other issues to consider. Should we put a halt to the real estate lending practices of the banks? This involves making loans, the earning of origination fees, the sale of the loans, and then making new loans with the freed capital. 

 

There is nothing inherently wrong with this process so long as borrowers have adequate income and the collateral (the house or other real estate) is properly appraised at an amount reasonably close to the market value. However, real estate has been inadequately examined, borrowers were  not been adequately vetted as to income and other debt obligations, real estate became overpriced and overbuilt, borrowers stopped making payments, and financial institutions found themselves with properties that could not be sold.

 

The problem was exacerbated by the securitization of loan packages, pieces of which were wrapped into securities and then sold and re-sold. (“Securitization” involves bundling a pool of loans into debt securities with various maturities and credit ratings that could be sold to investors.) This process is so complex that it is impossible to know the worth of these securities, and so, in the current atmosphere of ultraconservative short-term trading, there is no market for them.

 

The current financial crisis has shocked all of the parties who normally are quite willing to be counterparties (buyers or sellers), and fear has put a hold on what previously were commonplace transactions. Normal business and consumer lending cannot resume until the government intervenes to clear the market through bankruptcies (e.g., Lehman), liquidity guarantees (e.g., AIG), forced mergers (e.g., Merrill Lynch with Bank of America), and government purchases of troubled investments (e.g., the $700 billion package that was requested by Secretary Paulson to buy troubled bank loans).

The freezing up of the financial system occurred because counterparties could no longer trust in the value of the assets being offered for purchase and sale. One of the problems is the concept of getting to a market price that will clear the market. In the next blog I will talk about valuation and the failed concept of marketed-to-market accounting.

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