When the gears of a machine are out of alignment, mechanics adjust the gears and lubricate them, allowing the gears to flow more freely. So too, the gears of our economy need a mechanical adjustment.
When government buys or backstops toxic assets as a cure, we may expect results in the positive, but in the long term, the Institute believes market forces will view that as merely an adjustment of the gears, without the lubricant and those gears will grind slowly.
The American economy is such that bank deposits do not meet the lending requirements of our society. We are a consumer-based economy in which the participants, be they individuals or businesses, are encouraged daily to spend. When the public and business fail to do that, and save or hoard cash, commerce slows considerably. Business depends on the heavy, indeed excessive, spending habits of the public. Our trade policies are driven by that spending; as well as foreign relations.
To compensate for the shortfall in bank cash to make the loans needed to keep this economy flowing, the banks offered securities backed by the revenues of the loans they originate. These securities, called MBS (Mortgage Backed Securities) and CMBS (Commercial MBS), provide the banking industry with a flow of capital to allow them to make more loans.
Several factors hit the MBS and CMBS markets in the past two years. First, the sub-prime bubble put too many bad loans into the portfolio and the default rate of the loans impacted the value of those securities. Many investors lost their money as a result of a high default rate. Those defaults stemmed from bad lending practices, not only in residential, but commercial mortgages and other lending.
To lubricate the grinding wheels of bank capital, it is necessary to look at how the wheels grind… or how the process is executed and to fix the process at its core. Without doing that, any application of gear changes or adjustments to the gears will continue to grind poorly and may eventually lead to a complete jam.
The Institute did exactly that, starting in 2006, reviewing the business lending process, and later the residential mortgage process. We’ve interviewed hundreds of bankers, investors, chief executives, financial analysts and government leaders to determine exactly how the process works and how it may be fixed. We’ve consulted economists within the Institute, and in the world of business and academia, and pulled together programs that would fix the bank crisis at its core.
Essentially, we believe that to resolve the present bank crisis, it is necessary to make some minor modifications:
- Loans should be validated independently, without reliance upon the banks to police themselves.
- Business loans must be analyzed by individuals, not data-modeling alone, with review of submitted business plans for any business lending over $25,000.
- Mortgages must be in compliance with regulations or halted until in compliance with regulatory oversight in real-time.
- Investors in MBS and CMBS should be able to verify that the loans in the portfolio they’re looking at have been validated independently.
Taking these steps, as specified in greater detail in previous articles in this site, would create transparency, minimize the impact of what will undoubtedly be excessive regulation, and control the cost of regulatory controls while producing the desired effect of making it safe for investors to return to the MBS and CMBS markets.
To grease the wheels of lending, one need only apply a process of validation and transparency. If investors know that someone outside the influence of the banks has reviewed the lending process or the ability of the borrower (businesses) to repay the debt, they will feel much more comfortable with investments in the bank products.
Once investors are putting capital back into the system, the wheels of lending will turn smoothly, with the added benefits of better oversight and vastly improved lending. Let’s remember that by putting a real-time verification process in place, banks will be compelled to work towards much better lending decisions to begin with, as opposed to the present and past model of poor lending.
Investors know that if the systemic issues are not resolved at the core, the bad lending will continue. This is evidenced with the high re-default rate among those who refinanced after the July 2008 Housing Reform Bill went into effect in October.
We continue to urge the passage of these fundamental reforms keeping in mind that the squeeky wheel gets the most grease.