Wednesday, October 1, 2008

No Confidence in the System? Let's Create a "Run on the Bank"


(NOTE: A few definitions are necessary and should have been set out in the first posting:

1. There are no subprime loans. There are subprime borrowers -this is governed solely by the FICO credit score. Under 680 and you are subprime. Do you pay your bills on time, have a good and steady job, have equity in your home, have a promotion coming up along with a raise? IT DOESN'T MATTER; if your score is low - you are subprime. Maybe you have too much credit, or not enough, or have closed a number of credit card accounts - all of these things affect the score.

2. There are no predatory loans. The are loans that are used by not-so-nice originators who prey on borowers. Therefore, no predatory loans but Predatory Lending and Lenders)

In the last post, I postulated that only 4% of the value of all of the loans, now part of huge securitizations, called mortgage-backed securities, will be lost. Is a 4% loss a crisis? Are all of the loans made to subprime borrowers going to be worth $0.00? The answer is NO to both questions. If that is the case, then what is the problem? How much is an acceptable loss?

Imagine a small to medium sized "local" bank. Imagine every depositor showing up at all of the bank's offices on the same day demanding their money, in cash. Can the bank pay everyone? NO! The deposits have been invested in all kinds of normal loans and other earning assets, like overnight loans to other banks. What happens to the bank when all of its depositors demand immediate cash? THE BANK FAILS, and FDIC steps in to pay depositors what was in their accounts. That is essentially the Indy-Mac Bank scenario. There, FDIC rather than closing the bank figured it would just take over, everything, and fix the reason for the "RUN ON THE BANK". That is the term to describe what depositors did.

Due to the failures and the uncertainty surrounding the subprime loans/predatory lending, banks do not know how to value assets that they hold. Further, if no one can determine the value of a mortgage-backed security ("MBS"), then the investors do not have anything that can be sold. Banks that are holding MBSs are stuck. The pools are static. Banks wii not trust each other because no one knows which bank will fall next!

This lack of confidence, created somewhat artificially by hype about subprime loans etc, has left depositors shaking, not knowing what is safe, banks not lending to other banks which stops everything because there is no liquidity, and the stock and bond markets, here and abroad, extremely violatile because everyone is looking for CONFIDENCE that everything is not worth nothing. Again, I will state over and over that even if the misnamed subprime loans are defaulting at a higher than average rate, higher than that which would be seen in a "normal" loan portfolio in "normal" times, these loans do not make up the entire world of mortgages.

Step back for a moment (watch your step though) a think about billions and billions of dollars of residential mortgage loans where some, not all, and mainly originated since 2004, will have a higher loss ratio than should be expected. The MBSs are not comprised of only these "toxic" loans (I suppose swallowing enough inky paper would be toxic, but otherwise the term is just more inflammation). They are a subset of all of the loans put on the books during the same period. The MBSs are made up of all types of loans - most are a more or less random assortment.


The problem is the MBS structures. As dealt with earlier, the Pooling and Servicing agreements that bind these MBS packages and get SEC approval, restrict the ability to modify individual loans owned by the pool. There are legal issues involved in disturbing the pool beyond a certain point, and tax issues for the investors, servicer, and the MBS itself.

One possible solution is for Congress to pass legislation that mandates the MBSs be opened and the indiviual assets managed. IRS could deal with the tax issues later. Getting the ability to really determine the value of the particular security would restore confidence to the markets. It would also permit a so-called "mark to market" - valuation of the portfolio based on the real up-to-date figures and loan histories. THE TASK WOULD BE ENORMOUS, but so is dealing with the lingering loss of confidence, bank failures, tightening of credit due to liquidity problems, and handling the volitility of the market and having pensions wiped out due to another 777 point plunge.

I personally oversaw the workout of several S&Ls in the mid-80s. I know the work that lies ahead to address the core issues. But, there are those in and out of government who also dealt with the S&L crisis which could have been a $1 trillion mess. Perhaps, instead of just a bailout, our leaders should use it to stop the bleeding, and then immediately move towards the steps outlined above.


author's copyright by Richard I. Isacoff, Esq 2008

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