The Fed’s last arrow

The Federal Reserve has one last good arrow in its quiver.

It costs nothing. It involves little risk. It will jumpstart the economy.

The Federal Reserve can enact reasonable underwriting standards for its banks. It can also encourage reasonable underwriting standards from Fannie Mae/Freddie Mac and restart the secondary market in residential mortgages.

While the Fed has reduced interest rate dramatically with an eye to make credit available, it has directly and indirectly restricted credit to small and mid-sized business. And it has given great incentives for banks not to lend.  At the same time, Fannie Mae/Freddie Mac have made the issuing of mortgages difficult through restrictive lending standards.

To make myself clear on this issue, I am not for non-regulated, free markets. In 2005 and 2006 I warned our elected government officials in Washington and Wisconsin about the non-enforcement of regulations already on the books. These were common sense regulations that balanced risk with good underwriting standards.

I also pointed out that our history is that we move from one extreme to the other. First we go from not enforcing our own rules and regulations to going overboard with enforcement. This is what we are doing now.

This is our pattern. We close the barn door after the horses get out. This is human nature, of course. But this practice generates unintended consequences, such as the current restriction of credit.

Here are a few current examples:

  • A Mequon, Wisconsin manufacturer needs to borrow $30,000 short-term to purchase raw materials for a $100,000 government contract. The company needs to pay for the materials in advance, but cannot wait the month or longer it will take to get it from a bank. In fact, he does not know if he can get credit. Instead, the owner is forced to dip into his retirement plan to borrow the money.
  • A South Carolina business executive buys a home in foreclosure. He and his wife have liquid assets of more than $5 million. The house is on the market for $1.7 million, but appraised by the bank at $1.3. The executive buys the home for $1.2 million and wants (for tax reasons) a $300,000 loan. The bank refuses him. They won’t include a business he bought that cash flows $200,000 a year because he hasn’t owned it for three years nor his personal account which they say he could move or the income from several boards he sits on. They will count his IRA if he annuitizes it (he is not 59½ yet). He finally goes to a mortgage banker who makes the loan and then sells the loan to the original bank that refused him!
  • NPR reported that American Natural Foods of Kyle, S.D., couldn’t get loans for its expanding business after visiting 11 South Dakota banks. The banks wouldn’t even take an application! This company makes energy bars, organic buffalo jerky and buffalo hot dogs. They have annual sales of $1.5 million and distribute to 4,500 stores. They needed to borrow $80,000 to buy meat for their hot dog line that is expanding 12 times faster than expected. Their 6,000-square-foot headquarters cannot be used for collateral since it sits on an Indian reservation. At last, they obtained financing from a wealthy Minnesota tribe and a community development fund.
  • A Michigan man refinances his home. His mother has just died, and a trust that had been set up by his father dissolved. The bank’s underwriters required details on the transfer. After stalling the man for five months, they required a copy of his late mother’s will. They are not convinced that her will has nothing to do with the funds he has received.


In none of these examples was the lender at risk.

Banks have a Tier 1 capital requirement, which as been raised for banks. For most banks, this means that they cannot hold the mortgages they make but must sell their loans to Fannie Mae/Freddie Mac, who now have unrealistic and unneeded requirements. Underwriters are scared to death to make a mistake. This has led to caution in the extreme.

Fannie Mae & Freddie Mac were created to make a secondary market in mortgages. This market has lost its prominence because mortgage-backed bond and pass-thru paper have been tainted by complicated manipulations that far exceeded what they were designed for. This market needs to be revamped so that it is again liquid.

The Federal Reserve has a new program called Operation Twist. Here, they are buying longer termed bonds in hope of giving banks more liquidity. But that is all this is – a hope. What many banks are doing is to borrow from the Fed window at 0 to .25 percent and then leveraging 10- to-1 (and higher?) to buy three-year paper. Leverage is up 14 percent this year. It is a “riskless” way to make money, but it is not pushing out loans to those who need it to move the economy. This is another of the unexpected consequences of Fed policy. Low interest rates encourage arbitrage, not lending.

Much of this problem stems from the leadership of the Federal Reserve, which is led by very intelligent men who are far removed from the actually economy of small businesses. They may sympathize with these groups, but frankly they socialize with the wealthy and the well-educated, and have forgotten the lesson that J P Morgan taught us – that character above all else is the key to successful lending.

So what steps should the Federal Reserve and the government take to expand lending?

  • First, the Federal Reserve should encourage its member banks to use common sense underwriting and not underwriting designed to cover the backs of the banks. This same approach should permeate Fannie Mae/Freddie Mac. Does anyone think that a $1.2 million home with only a $300,000 mortgage presents a risk to the lender? This loan has a $900,000 cushion! Look at risk. Confirm what information has been given. Check character.
  • Second, discourage member banks from borrowing from the Federal Reserve by using leverage to make a profit. Require these banks to make a specific number of loans before they can use leverage. United States policy under both Bush and Obama was designed to buy time for surviving banks and such businesses as General Motors and AIG. The purpose was to generate liquidity and to allow the unbundling of assets in an orderly manner. In this respect, both U.S. government policy and Federal Reserve actions were successful.

Now it is time to get back to normal business.

Bob Chernow is a Milwaukee business and futurist who identified both the S&L crisis and the sub-prime crisis. He was recently elected to the Board of the World Future Society.

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