COLUMN-Foreclosures, capital and sickening cures:James Saft

(James Saft is a Reuters columnist. The opinions expressed
are his own)

By James Saft

HUNTSVILLE, Alabama, October 28 (BestGrowthStock) – A dilemma at
the heart of the response to the financial crisis is that the
antidote to so many ills actually causes the symptoms to
worsen.

Take for examples bank capital levels and the chaos
surrounding home mortgage foreclosures.

Both issues are the fruit of the same tree: the desire to
do things quickly, cheaply and with minimal safeguards.

And both, if you want to fix them, are probably going to
slow the economy and lower asset prices in the short term.

So over the long term, paradoxically, the economy will slow
and asset values fall anyway.

Being in possession of a hammer and sighting a nail,
Governor of the Bank of England Mervyn King put it bluntly on
Monday: “Of all the many ways of organising banking, the worst
is the one we have today.”

He’s not kidding and he’s probably not far wrong – the
current system has enshrined too big to fail and the upcoming
new banking regulations, Basel III, calculates the need for
capital based on losses during the last crisis.

This, as King points out, vastly understates the losses,
which would have been horrendously larger if governments had
not stepped in to support private banks.

“The broad answer to the problem is likely to be remarkably
simple. Banks should be financed much more heavily by equity
rather than short-term debt. Much, much more equity; much, much
less short-term debt,” King said.

“Risky investments cannot be financed in any other way.
What we cannot countenance is a continuation of the system in
which bank executives trade and take risks on their own
account, and yet those who finance them are protected from loss
by the implicit taxpayer guarantees.”

Here’s the amazing thing. Having diagnosed the emergency
King then goes on to say that he is fine with the fact that
banks are given until 2019 to fully comply with the new
regulations which he has trashed as being too weak. He
recognizes that the medicine of higher capital will make the
symptoms of deleveraging worse and so is willing to put
building up proper capital buffers off.

I guess we can call the policy we will run until decent
regulation is enforced “moral hazard in the public interest”,
but, as the label implies, everyone has huge incentive to game
the system to their own best interests, from bank executives,
to fund managers to savers themselves. Like Basel II, Basel III
may never be tested because it is overtaken by the next crisis
before it is even in place.

DETAILS, DETAILS

The evolving foreclosure crisis, centering around evidence
that major banks may have committed fraud during the process of
repossessing houses, is in a lot of ways a problem with a
similar origin to the problem of bank capital and regulation.

To grossly simplify, banks may have been testifying that
they have documents they have not found, or ones that were
never produced when the loans were originated back in the go-go
days.

This places not just the foreclosure in limbo, but
potentially the entire securitization of which a given loan is
a tiny part. Of course, many of the loan originators who wrote
and sold the loans no longer exist, having taken the money and
run when the crash came.

A proper accounting of who owns what, a concept at the
heart of the rule of law, would seem to be called for but is
unlikely to come. Why? Because the last thing the U.S. economy
needs is a nine month real estate market holiday.

Again, we have evidence of a system that operated, both on
the way up and on the way down, with public support and tried
to do so at the minimum possible cost.

There are two opposing ways to think about this. One is to
use the example of the first commercial jet airplane, the de
Havilland Comet, which suffered a series of catastrophic
failures in its early days.

The issue wasn’t that there was a fundamental problem with
commercial jet flight but simply that we had gotten a little
bit in front of the engineering. The engineering caught up, and
the jet age blossomed. On this viewing of history, banking has
suffered a saluatory crisis, “fixes” will be implemented and
the securitization machine and its “originate and distribute”
model will soon be up and working again.

The other view is that innovation in finance is not like
innovation in the rest of the economy, that the moral hazard
inherent in state insurance has provided incentive for
innovation that bears a striking resemblance to looting.

On this view, we’d be better off with a return to slow
banking, though that implies a period of slow growth and a hit
to asset prices.

(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. For
previous columns by James Saft, click on [SAFT/])

COLUMN-Foreclosures, capital and sickening cures:James Saft