How To Turn An Asset Toxic

Yesterday I asked, How did banks and their assets get so toxic? I didn’t answer it then or that blog might have gone on forever. Today is the time to try to answer that question and to try to figure out how to prevent the current banking collapse from happening again.
“Greed did it!” Everyone including President Obama repeats over and over again, “Greed!” As a real answer to our problem that’s about as useful as calling someone a “communist”. It sounds horrid, but it doesn’t mean anything. We’re all greedy, after all—starting with the day we punched a kid for taking too big a piece of the birthday cake.
What really caused this big banking mess?
Four major factors come to mind immediately. All of them rather technical. One, we forced banks into the charity business. Two, we repealed Glass-Steagall. Three, some clever chap invented the art of bundling and let banks get in on the speculation. Four, bundling eliminated the ancient bank duty of acting with “due diligence”.
Before we gave any more banks a cent more in bailout money, we should reverse and/or outlaw all of these four causes. There should be the kind of nasty legal penalties for doing (or not doing) these things that send high level individuals to prison. Or any bailout will do nothing to cure the actual problem.
We cannot change the altered investment realities of a global economy or what other nations may do on their own exchange floors, but we can make our own banks go back to sound banking. Let’s go through these four causes point by point.
One, decades ago, banks redlined. This means they refused to loan to anyone who lived in a section of a city deemed too unsafe, too poor or occupied by classes and races of persons who were believed to be universally unreliable. This, justifiably, was outlawed.
But then we got a tad too proactive. From saying, Hey, you have to look at each applicant as an individual and evaluate his potential to repay on a case by case basis, we jumped an imprudent step further. We decreed that, REGARDLESS OF INDIVIDUAL MERIT, banks make loans in poor and undesirable sections. They were essentially put on a quota basis.
They were threatened with legal action—for discrimination—if they didn’t come up with lots of loans in those neighborhoods. Equal opportunity lending is a very bad idea if, by that, you mean that the irresponsible citizen with a horrible credit record must be given equal opportunity for a mortgage with someone with a sterling credit record and high income.
The question of, Can this guy ever repay—or will he even try to repay—gets totally lost. And that is the only rational basis for sound banking. Anything else produces very, very toxic mortgage paper—by which I mean paper that is essentially worthless because nobody is ever going to pay it back.
Once we start doing that, banks reasoned, why not give $400,000 mortgages to people who show they can reliably handle a $200,000 mortgage, but have only a fantasy chance of repaying the bigger one. There are lots of ways to do this—many of them learned in the old red line districts.
You fudge on the applicant’s income (which in some cases may not even exist). You give him zero down to get him in the door. You give him ludicrously low interest for the first few years (so that he’s not even lowering his mortgage each year, but actually increasing what he owes), and then zap him with an enormous increase in his monthly payment so you can start collecting on what he actually owes. Profits on this were, initially, huge.
That’s as toxic as Love Canal ever got. And, on the way to this La La Land, you get the fusty old law that Roosevelt put in place—Glass-Steagall—repealed. When FDR took office, banks were failing by the thousand, often because of foolish investments. So Glass-Steagall was passed to keep banks from speculating on air. They had to stick to taking deposits and lending money for things like homes and cars. Nothing speculative.
After 1999 and the repeal, banks were free to get back into speculation with a vengeance. Only they weren’t speculating with their own money, they were speculating with yours. One of the really fun ways to make money speculatively was bundling (Two).
Bundling for banks wasn’t all that different than Bundling in Puritan New England. (You crawled into bed with someone you didn’t know and took your chances with VD and paternity.) A bank out in Missouri or Iowa bundled all kinds of mortgages—from those on executive homes actually bought by high income executives, to mortgages made to middle class owners who could never hope to pay them off at real rates, to mortgages on homes occupied by the poor, the feckless and the addicted.
Then you took these bundles and sold them to big banks in New York—who put them on their books as sound investments, as assets. The big banks often made bigger bundles and sold them to other big banks all over the world. All listed as on the sheet as sound investments.
Very quickly much of the wealth of the planet, like an inverted pyramid, was based on the entirely speculative assumption that somebody making $30,000 a year could be expected to repay a $300,000 mortgage—PLUS the debt on the fourteen credit cards he had been offered. And, of course, plus payments on two new cars.
From the little bank in Missouri to the big bank in New York or London, the little guy with the little income was carrying a massive load. At some point, very like a Ponzi scheme, too many of those little guys at once couldn’t go on. The music stopped and there were nowhere near enough chairs.
Change this way of doing business BEFORE you bail them out, or we’ll be right back here in a few more years—or months. Tomorrow we’ll look at “due diligence” and a few other things that need changing before any bailout goes through.