Reforms needed in banking and housing industries

In May 2006, I attended the Federal Reserve of Chicago’s 42nd Annual Conference on Bank Structure Competition/Innovation in Real Estate Markets. My purpose was to see recently appointed Fed Chair Ben Bernanke in action, but I was also interested in what economists and industry leaders would say on housing and mortgage finance.

In this, my interest was selfish, as I had predicted major stresses for these areas over the next three years.

Frankly there was less to Mr. Bernanke than met the eye. His concerns were academically fixated on bank consolidation and the health of the banking industry, rather than the economy. I observed that five to six banks controlled over 50 percent of U.S. banking assets, so that Mr. Bernanke had become the dog that the tail wagged.

Our luncheon speaker was Ken Thompson who was introduced as the president, CEO and chair of Wachovia. Mr. Thompson started off his talk by declaring that he knew little about mortgage banking so that he would talk about his bank, which he proceeded to do.

There was time for questions and several innocuous ones were asked. I then asked Mr. Thompson if he thought it was ethical for banks like his to buy predatory loans on the secondary market. He replied that he did not think it was ethical and that he would check to see if they had such loans the next morning when he returned to his office.

Evidently, he did not, given the write-offs that ensued.

A follow up letter to Mr. Thompson was not answered. A letter to Mr. Bernanke, which warned of the coming crisis and made several positive suggestions, was screened and answered by a PR flack, who I called to ask if Mr. Bernanke would get my letter. My guess is that he did not.

I mean no disrespect to Mr. Thompson, who was ousted recently from Wachovia. My point is that both he and most of the leaders of most big banks are so distant from the way their firms make money that problems like those we are experiencing are inevitable. In short, these leaders are out of contact and have lost control over their corporations. They no longer “walk the factory floor.”

After 9/11, banks needed a way to generate revenue. The Fed lowered interest rates. Corporations needed to borrow less. The banks turned to funding predatory loans and innovative mortgages, such as interest only and teaser variable rate mortgages.

The other guilty party was the Federal Reserve. Banks need to be examined, and the red flags that were raised and known were not addressed. I refer such practices as appraisals “made as instructed” home equity loans used for down payments, daisy chain traded mortgages, etc. It is not as if these types of problems had not occurred in the past. When the S&L and Mutual Savings and Loan industries were deregulated by the Hunt Commission, they were left with no new regulations and a major crisis arose. (I predicted those problems in several speeches and articles.)

I do not want to state the obvious, but inflated housing prices were fueled by cheap money, lax regulation and speculation.

Well, what can we do to extract ourselves from this crisis? What do we need to do to prevent such events from happening again?

Uniform regulations

First, we must be proactive, not reactive, in regulating the banking, insurance and securities businesses. The history of American regulation is to address problems after a crisis. That is how the SEC was created and how Glass-Segal came into existence.

In part, we need to recognize that some leaders in business are greedy, unethical and short-sighted. They will do whatever they can to accomplish short-term goals. These few ruin it for the majority through loss of confidence by the public.

Now, I am not so innocent to believe that good always overcomes evil, or that we can trust in the good will of these few to do the “right thing.” They won’t, either because of greed or stupidity. Indeed, this is why we need regulation and why regulations need to be enforced.

But regulation ought not to be unified or centralized. You need only to point to recent scandals. Did the SEC, NYSE, or NASDAQ investigate wrongdoers on Wall Street? No, it was Eliot Spitzer, as attorney general of New York State, who did. Did the Federal Reserve’s bank auditors try to enforce bank regulations to prevent the crisis we are in? No, again.

Thus, I am in favor of competing regulatory systems that do not duplicate regulation, and enforcement that is independently funded and operated by civil servants. My emphasis here is on independence – for funding and management.

Some things should be streamlined. For instance, it is a good idea to have continuing education, but this should be done on a national basis, as should  licensing. However, banking, securities brokerage and insurance need to be watched over independently, in part because these businesses differ greatly from each other. States like New York, California and Wisconsin should retain the ability to sue on behalf of their citizens.

Banks need to be restricted on the risks they are permitted to take, and there needs to be a wall between banks and other businesses they own.

Large groups that influence our economy, such as hedge funds, need to be transparent and they should be regulated. The failure of several of these firms was caused by the heavy use of leverage. Several years ago, one of these firms, Long Term Capital, run by two Noble Prize winners, almost collapsed our financial system. As Bill Donaldson, former SEC Chair, said, hedge funds have been central figures in a variety of market trading abuses and that registration is a modest and essential way for regulators to begin to understand them.

Yet earlier this year, the Bush administration said that there was no need for greater government oversight in the hedge fund industry. Instead, the administration, in an agreement it reached with independent regulatory agencies, announced that investors, hedge fund companies and their lenders could adequately take care of themselves by adhering to a set of non-binding principles. Foxes guarding chickens might lead to better results!

I agree with Treasury Secretary Henry Paulson that, “Government has a responsibility to make sure our financial system is regulated effectively.” But his plan would have the Federal Reserve oversee a master plan of regulation. This is a very bad idea. As was pointed out above, a handful of banks control our banking system, and, alas, now control the Federal Reserve. While we might be lucky to get an independent Federal Reserve Chair, we would much more likely get a myopic leader who would be co-opted by the banks.

Home, sweet home

One question that many have asked is, “When will the housing market stabilize?”

Bearing in mind that all housing is local, my guess is that another year or so might be needed before buyers and sellers become more realistic as to what home values are. Prices went up in some areas by 90 percent in the first six years of this decade. In these and other markets, investors made up one third of the market. When existing home sales peaked mid-year in 2005, homeownership was 69 percent, a record, and renting was down.

Let us look at several “truths” about the housing market.

• Many homes have been taken off the market. Most people need to sell their homes before they can upgrade.

• When a neighborhood has too many homes that are for sale because of foreclosures, the area can turn bad. In part this is because many of these homes are bought and rented; or homes lay empty. The bad brings down the good.

• Our aging demographics will aid purchases in retirement communities and in cities, where many are retiring.

• Homeownership is good for our communities. Such local organizations as ACORN work with people with modest means to create budgets, inspect homes, get financing at reasonable rates, and insure that the homes have a value approximating the purchase price. Compare their successes with predatory lenders.

• Homeownership requires the buyer, an insurer (private or government) and/or bank have some skin in the game. This is basic to mortgage lending. It is the key to the success of the private mortgage insurance industry, whose past and current problems stem from very stupid managerial decisions and investments.

• There is a crisis in mortgage-backed bonds where liquidity has disappeared.

So what should be done?

1. Continue the Federal Reserve’s policy of stopping runs on banks and bank-like institutions, like Countrywide and Bear Stearns. The Fed gets kudos for their actions.

2. Consider federal credit guarantees on new mortgages so these securities can be sold. The emphasis here is on “new” mortgages. 

3. Be patient. Recognize that time is needed to come to a balance between buyers and sellers of property. Financing is only part of the problem. The negative tone of the economy has combined with tighter money. Many home properties are still overvalued because speculators have left. However, the demographics of our retiring baby boomers, combined with a massive transfer of wealth, will stimulate housing. It will take one to one and a half years in many markets for this to take place.

4. Enlist organizations like ACORN to work with homeowners who face default, especially those who took predatory loans (where loans might have been made illegally). Work with neighbors where there are many defaults to “keep up the neighborhood” as a way of maintaining values.

5. Coordinate services to help keep neighborhoods healthy. Some communities, such as Milwaukee, are coordinating the efforts of government, lenders and organizations like ACORN to reduce foreclosures and develop work-outs.

6. Encourage efforts such as the Hope Now Alliance to protect neighborhoods by preventing foreclosures. Hope Now is made up of lenders and mortgage service companies and has the purpose of working with borrowers to keep their homes by guiding borrowers through the maze of mortgage owners.

7.    In regards to predatory loans, allow borrowers to refinance without having to pay one to two years of prepayment interest.

8.    Require all home loans that can be sold on the secondary market to conform to specific standards, such as those used by Fannie Mae. Underwriting should be standard. Prepayment penalties should be eliminated after one year and charges for getting a loan should be regulated.

9. Create a central location to answer complaints and help homeowners.

10. Maintain Fannie Mae guarantee for $750,000 mortgages so that these loans can be sold on the secondary market.

11.  Allow banks to carry some non-performing loans on their books if they are in a workout.

12. Help certain neighborhoods in order to insure that they do not decline, and with this decline, ruin all values. In this respect, Congressman Rangel’s suggestion for refinancing at lower values might make sense, but his idea should be used sparingly.

We need to understand that the housing problem is local, that it involves a wide spectrum of home prices and that it will take time to unravel. The important point is that we need to ensure that regulation is standard and fair and that it is enforced so that liquidity can come back.

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