How Reform Can Break Bank’s Stranglehold On The Economy

Large banks are pushing the federal government to create more government sponsored entities that can assist them in lowering the cost of capital. Meanwhile, institutional investors are urging …

Large banks are pushing the federal government to create more government sponsored entities that can assist them in lowering the cost of capital. Meanwhile, institutional investors are urging the US government to take steps to reform the asset-backed securities market to break the stranglehold that “too large to fail” banks have on the economy. See the following article from Money Morning for more on this.

A white paper on bank reform delivered to Congress and regulators last week by the Association of Mortgage Investors – the powerful lobbying group that represents huge institutional investors – warns that if the securitization market isn’t radically reformed “it will be difficult if not impossible for capital market investors to return to funding economic activity.”

What the report doesn’t say is that banks – standing in the way of bank reform – don’t want a simplified, standardized, and transparent securitization market, because that would revitalize free-market disciplines and undermine the control they exercise over the credit markets.

Right now, the stock market is discounting news about tight credit conditions. But analysts worry about an increasing disconnect between rallying stock prices and the hoped-for rebounds in consumer-driven growth and the U.S. housing market – both of which are struggling with a lack of access to credit. This disconnect is fostering fears of a stock-market correction.

Investors need to understand exactly what’s at stake here. And they need to know how to protect themselves and – even more important – how to profit from the volatile-but-powerful capital waves that will result from this fundamental battle over our future.

Taking No Prisoners

What the big banks want is the socialization of their risk exposure and the privatization of their unbridled profitability.

And they are willing to hold the economy hostage to get it.

To achieve that goal, banks are concentrating their too-big-to-fail power so that the federal government has no choice but to backstop them – permanently lowering the cost of capital for these large lenders. And that’s not all. To counteract the credit squeeze the concentration of lending power in too few banks fosters, the federal government will be forced to once-again back loan-level guarantees from privately owned, government-chartered guarantors – in other words, more government-sponsored entities (GSEs) such as Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

On March 23 – during a House Financial Services Committee hearing labeled as “Housing Finance: What Should the New System Be Able to Do?” – U.S. Treasury Secretary Timothy F. Geithner was questioned about the future of the biggest insolvent GSEs, Fannie and Freddie. Those two – explicitly bestowed with unlimited backing by former Treasury Secretary Henry M. “Hank” Hank Paulson Jr., have by themselves so far siphoned $165 billion from taxpayers’ pockets.

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Geithner told a flabbergasted panel that there were no immediate plans to unwind the entities, stating that “realistically [speaking], it’s going to take several months to do a careful exploration of the problems, solutions, alternative models, and to try to shape legislation that could command consensus.”

Several House members were even more disturbed when Geithner told them that “my own view is there’s probably going to be a good economic case [and a] good public-policy case … for some continued provision of a carefully designed guarantee by the public sector going forward.”

In short, not only are Fannie and Freddie destined to stay with us, their gross failures have elicited a very-banker-friendly fix to their troubled existence – create more of them.

Repeating Earlier Mistakes?

At the same hearing, Mortgage Bankers Association Chairman-elect Michael D. Berman proposed that a new breed of mortgage-backed securities should be structured with a federally guaranteed wrap. The association wants the government to provide an explicit credit guarantee financed by risk-based fees paid into a federal insurance fund.

The hybrid proposal – a cross between the existing government guarantee that already backs Ginnie Mae securities and the Federal Deposit Insurance Corp. (FDIC) insurance fund that covers bank deposits – came with a fresh recommendation “that regulators charter enough entities to establish a truly competitive secondary market and to overcome issues associated with too-big-to-fail.”

It doesn’t matter to the Mortgage Bankers Association that the Federal Housing Administration (FHA), which backs its loan-level mortgages with a government guarantee and then collects and packages those mortgages into the Ginnie Mae securities, is itself insolvent. It also doesn’t matter that Ginnie Mae securities are the only mortgage-backed securities whose principal-and-interest payments to investors are 100% government-guaranteed. Nor does it matter that Ginnie Mae is stumbling down the same blind path as Fannie and Freddie.

What matters to the bankers is that they don’t have to assume any risk on the mortgages they originate as long as the government guarantees them. As long as bankers can generate fees from originating loans – and then offload those loans to investors as “guaranteed” – these institutions can go back and borrow additional cheap money from the U.S. Federal Reserve and leverage their balance sheets with the very same risk-free securities. Once that’s done, the banks are positioned to reap gigantic profits, pay their top executives huge bonuses – and have plenty left over to spread across Washington in order to institutionalize their latest scheme.

Outraged critics contend that regardless of whether institutions are too big to fail, or that if enough smaller institutions are afforded the same socialized model, eventual contagion resulting from systemic risk concentration and integration will kill democratic capitalism. The point is that the market is no longer allocating capital, the government is.

A Real Blueprint For Change

There is a way to break the stranglehold banks have on the economy, and at the same time arrest moral hazard and unshackle free markets.

It’s simple. Congress needs to immediately enact all 10 of the recommendations called for in the Association of Mortgage Investors white paper: “Reforming the Asset-Backed Securities Market.” Those 10 recommendations are:

  1. Provide loan-level information that investors, ratings agencies and regulators can use to evaluate collateral and its expected economic performance over the life of the securitization.
  2.  Require a “cooling-off” period when securities are offered so that investors have time to analyze them before making investment decisions.
  3. Make deal documents for all asset-backed and structured securities publicly available to market participants and regulators.
  4. Develop standard-pooling and servicing agreements with model representations and warranties as a non-waivable industry-minimum legal standard.
  5. Develop clear standard definitions for securitization markets.
  6. Directly address conflicts of interest of servicers that have economic interests averse to those of investors.
  7. Require the appointment of a suitably independent and qualified trustee to act for the benefit of holders of the securities.
  8. Make asset-backed securities subject to private right-of-action provisions of anti-fraud statutes in securities law.
  9. Encourage secondary trading on venues such as exchanges where trading prices are visible to investors and regulators.
  10. Make ratings agencies use loan-level data in their initial ratings and to update ratings as market conditions evolve and collateral performance is reported.

Of course, banks will oppose all these recommendations for various reasons, but mostly under the guise that they are too onerous and expensive to implement and would raise the cost of capital and impede market functionality.

Self-Protection Strategies

The truth, of course, is that every one of the recommendations cuts through the opaqueness, issuer protections and marked-up fees that banks enjoy when pooling, issuing and trading their purposely complex and asymmetrically divined instruments.

We are at a critical crossroads in the evolution of capitalism. We have manufactured enough rope to hang ourselves on the gallows of socialism. With the partisan and bitter battle over healthcare momentarily behind us, and after admitting that regulatory reform should have been U.S. President Barack Obama’s No. 1 agenda item when he first took office, now is the time to act decisively.

The arguments against the protective and prudent regulations that safeguard investors and the economy are always made by those with a stake in circumventing those protections for personal gain. America has an unparalleled history of creating wealth, while adapting to unforeseen and unintended consequences of both good and bad legislation, as well as the unmitigated greed of usurpers and shysters. For the sake of the republic, democratic capitalism and our economic future, it is time to empower Americans to return the country to the top of the economic world order.

Investors can help themselves on an individual level. First and foremost, I recommend you follow and actively participate in the looming regulatory battles. Write to your elected representatives, letting them know where you stand. Place stop-loss orders on all your investments: If the bankers win the regulatory-reform battle, you will get “stopped out” when the market eventually crashes. At that point, take all your capital to China, because at least there they are honest about their government-directed, socialist-economic model.

This article has been republished from Money Morning. You can also view this article at Money Morning, an investment news and analysis site.

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