Politicians + Banking Reform = Financial Disaster

Anyone who doesn't harbor some degree of animosity for the bankers who, through a combination of stupidity, short-sightedness and avarice, caused the global financial crisis is a better person than I am.  That said, financial reform should not be tantamount to financial dismemberment.  And there's a little known accounting rule winding its way through financial reform that may be just that.
My writer husband and I often discuss our finances.  He is a brilliant man, one whose brilliance is primarily that of adept observations and the facility with which he uses language to share them.  His writer friends, many of whom are dear to me, share a trait with him:  they hate math.
Consequently, when the business channel drones on about FASB's consideration of mark-to-market accounting for mortgages held by banks, his eyes glaze over like a weary parent listening to his two-year-old blathering unending baby talk.  I imagine many others do as well.
This bill, however, is important.  And I believe that a combination of me speaking English and you being smart will result in your understanding that this is a big deal, and something you should tell your Congressional representatives to stop.
Here goes.
Let's pretend you lend money in the form of buying a bond from the ABC company.  They pay you interest and agree to repay you on a certain date.  Let's say your bond is worth $10,000 (the amount you lend them), your interest rate is 3% and the bond is due (repayable to you in full) on June 1, 2013.  Unless ABC company files for bankruptcy protection before your loan is due, you can expect to be paid $150 twice each year (3% on $10,000), and the full amount you lent them, $10,000, in three years.
Now let's say interest rates go up this Summer.  Now companies like ABC have to pay 4% for borrowed money, 1% more than the amount they're paying you.  If you sell your bond to someone else after rates go up, it will now be worth less than the $10,000 you paid for it, because anyone can now get 4% for their money, and your bond only pays 3%.  If you mark your bond's value to the current market price (mark-to-market), your bond will be worth less after rates go up than it was what you bought it.
But, what if you don't sell it?  What if you hold your bond until June 1, 2013, collect your 3% per year, and get all your money back?
While you hold your bond from now until 2013, what is it worth?

• Is it worth what you could sell it for after rates go up?
• Is it worth what you know you'll receive what the bond is due?

With that in mind, let's pretend you're a bank.  You are now lending money to people to buy houses.  You don't sell your mortgages to investors.  You keep the loans, collect the payments and keep the interest your customers pay.  When rates go up, are these mortgages worth less?  When rates go down, are they worth more?
Yes, according to this new rule.  Why should you care?
If banks have no intention of selling their mortgages, then they probably will be very careful how they lend money.  Why?  If they keep the mortgages, they keep the risk that if borrowers don't pay them back, they'll take the loss.  They won't make crazy loans to people and sell them to investors.  That's good.
But, when rates go up (as they are sure to do), these loans will be worth less.  Then, the banks have to put more money aside for them, and will have less to loan to you.
Seems crazy, doesn't it?  Banks will be penalized for NOT selling their loans to investors, and you'll have a harder time getting a loan.
So, here's the English translation of what's going on.  FASB  (pronounced FAS-bee), is the Financial Accounting Standards Board.  They're considering marking-to-market (immediate sale to investors value, not repayment value) all mortgages that banks intend to keep.
FDIC Chair Ms. Bair is against it, as is former Chair Mr. Isaac.  So am I.  So should you, if you intend to borrow money from a bank who makes mortgages and doesn't sell them to investors.
Contact your Congressional Representatives if you agree, and tell them that you are against FASB Topic 220, 825 and 815.

Who's Most Guilty of Financial Malfeasance?

You may have heard Warren Buffett has said that he has no problem with the Goldman Sachs deal that has resulted in charges of client misrepresentation by the Security and Exchange Commission (and is being considered for criminal charges by the Justice Department).  As discussed in a previous article, I agree.  If not the banks, than who is most responsible for the financial meltdown?
1.  The Players  
The Quants
First, there were the "Quants," the quantitative analysts, fresh from Ivy League graduate schools, who prepared studies showing the extreme unlikelihood of all regions of the US housing market dropping in value at the same time.  As these were academically gifted young people with virtually no practical experience, I hesitate to lay blame here.
The Quants' Bosses
It started at JP Morgan.  The bosses, seasoned professionals, read the analysis, looked at the commercial banks' and thrifts' mortgage profits, and decided to get into the business.  The big question is, "Did they understand that the increase in demand that would result from broadening the real estate market would result in a crash?"  While the answer to this question is unknowable, there are two issues that may point to the truth.
The first, is the recent "Internet bubble."  Anyone could have seen that the amount of money that was invested in Internet stocks would have pushed their valuation to ridiculous levels.  Surely, an analogous investment in the real estate market would do the same.
The second, is the fact that the risk to increasing the number of real estate owners was mitigated by selling that risk to investors, instead of holding those investments on their books.
The Banks
Once JP Morgan entered the real estate business, it had to offer terms that would be more attractive to borrowers than commercial banks and thrifts.  So, underwriting standards were decreased.  So what if you didn't technically qualify for a mortgage?  A rising real estate market would allow you to sell your property at a profit, and a low "teaser" rate would result in low initial payments.  After five years, you'd be making more money at your job, wouldn't you?  Then you could afford the payments.
For banks and thrifts to compete, they, too, must lower their underwriting standards, or risk losing their loan portfolios to those banks that offered better refinancing opportunities.
So, we're off to the races.
The Borrowers 
The fact that borrowers were not required to prove their income did not force them to lie on applications.  Even if the borrowing terms were difficult to understand, people who earned $50,000 knew they could not afford a $500,000 house.
A lie is a lie.  Lies have consequences, and I am not in the camp that says, "Poor little borrowers didn't know what they were doing."
I don't think people are that stupid.
The Rating Agencies
Rating agencies are paid by the companies that generate the securities that they rate.  That is inherently insane.
If I have a security I want to sell to the general public and it's inherently risky, it is the job of the rating agencies to say "That is risky."
The problem is, if one agency declined to rate the security as "not risky," all the issuer had to do is take it to another and say, "Here's my fee.  See if you can rate this as 'not risky'."  And they did.
Packages of loans, geographically diversified in the US were sold to the general public as AAA - the same rating given to ultra-safe US Treasuries.  "Widows and orphans" could safely buy them.  Why?  Because, even if the underwriting standards were lax, there was good evidence provided by the Quants, verified by the Quants' Bosses (who paid big, fat fees for safe ratings), that a majority of the loans would be good, even if there were regional difficulties at times.
2.  Common Thread
If the Quants hadn't come up with the studies about the general safety of the US mortgage market, someone would have figured it out.  Maybe the Quants' bosses would have done it themselves, as they saw quarter after quarter of real estate lenders' profits.
Some percentage of borrowers have always lied on mortgage applications.  Underwriters catch some, but not all of them, but the number that squeak through the system were never significant.
But, this bubble could never have grown unless the issuers of laxly underwritten mortgages could have sold them to a "greater fool."  If they'd kept these mortgages on their books, the banks who lent the money would have had to acknowledge the losses.
That leaves the rating agencies.
3.  The Rating Agency Issue
There is no excuse for the ratings agencies giving AAA rating to risky securities.  Taking money to do so is effectively the same as taking a bribe.
Ratings agencies are charged with the responsibility of analyzing underlying securities and giving the public an easily understood way to know the level of risk they have.  This is the one place where, "I didn't know" isn't an excuse.  Maybe the Quants didn't know.  Maybe the Quants' Bosses didn't know.  Maybe the banks didn't know.
But the ratings agencies can't claim stupidity.  Rating securities is their reason for existing.  If they can't do that, they don't deserve to exist.
4.  Blame
Maybe the Quants should have known.  Probably the Quants bosses should have known.  Likely the banks should have know.  The borrowers should not have lied.  But, most definitely, the ratings agencies should have known.
So, the next time you hear that a security is rated AAA, what will you think?
It's time to hold the ratings agencies' feet to the fire.  Either rate securities by using generally accepted accounting principals or rename yourselves as, "Bribe Takers."
Perhaps a little something in this regard should be passed in Financial Regulatory Reform.  And, if it isn't, I wonder. 
Will it be because someone has been paid to ignore it?

The Case For (and Against) Raising Interest Rates

One of the Federal Reserve Bank's most powerful tools is raising short term interest rates.  Why they should (and why they shouldn't) do just that now.
Short Term Interest Rates
Didn't the Fed just raise rates?  Yes, they raised the Discount Rate by 50 basis points (1/2%).  The Discount Rate is the rate that the local branch of the Federal Reserve Bank charges for short term loans.  There are three types of loans available from the "Discount Window."
There is also the Fed Funds Rate, which is the rate banks lend money to each other at the local branch of the Federal Reserve Bank, in order to meet the reserve requirements they must set aside for liquidity purposes.  This rate, currently .25%, was set on December 16, 2008, during the recent financial crisis.
Extraordinary Measures
The Federal Reserve undertook several extraordinary measures to assist financial institutions during the recent the financial crisis. Besides providing loans to banks through the discount window lending programs referenced above, the Fed established other ways to provide liquidity to financial institutions, including:

• Term Auction Facility,
• Primary Dealer Credit Facility, 
• Term Securities Lending Facility,
• Commercial Paper Funding Facility,
• Money Market Investor Funding Facility,
• Term Asset Backed Loan Facility, and 
• Section 13(3) of the Federal Reserve Act loans to support specific institutions to avert their disorderly failures.

In short, the Fed became "the lender of last resort," after effectively lowering the Fed Funds rate to zero.
Now, by most measures, the liquidity crisis has been averted, and many of the programs listed above have been suspended.  Some economists feel that it is now time for the Fed to raise the Fed Funds rate and unwind other extraordinary credit facilities, and some feel that it should wait.  Here are the pros and cons.
Raise Rates Now
Those in favor of raising rates now generally feel that by raising rates gradually, the economy will avoid creating future excesses like inflation caused by holding rates artificially low.  This position represents the free market philosophy that the economy must move through the process of recovery without intervention by the Fed. 
Such economists see the 3% - 3.5% projected US growth in Gross Domestic Production this year partially due to previously provided economic stimulus, but more importantly through sustainable growth in global demand.  Acknowledging the problem of high unemployment rates, they think that potential problems created by guaranteeing low rates for the foreseeable future will create more serious economic excesses in rate sensitive sectors in the future.  In effect, this policy is seen as "postponing the inevitable," and proponents of this philosophy favor no economic intervention unless absolutely necessary.
Keep Rates Low
Those in favor of keeping short term rates near zero generally agree with the 3% - 3.5% projected US growth in Gross Domestic Production this year, but feel that reliance on growth in global demand is more precarious.  Citing recent concerns with the sustainability of the current recovery, including high rates of US unemployment  and sovereign debt risk abroad, proponents of this philosophy feel that Fed intervention will lessen the risk of slipping back into recession, and see that risk as more probable than creating inflation by keeping rates artificially low.
Weighing the Probabilities
Those who participate in this discussion often do so by labeling their opinion as "capitalist" or "progressive."  To do so is to grossly oversimplify the issue.  Whether rates should be raised or not lies simply in the measurement of future global demand.  Should demand be sufficient to sustain US growth, then interest rates should be raised, and the growth in production will result in new hiring that will eventually lower unemployment.  The amount of projected global growth in 2010 depends upon whose data you rely.
The World Bank projects 2.7% growth this year, slightly more pessimistic than the International Monetary Fund's projection of 3%.  The two organizations use different methods in calculating GDP, which partly accounts for the disparity.
For comparison purposes, global GDP growth was 5% in 2004, 4.5% in 2005, 5.1% in 2006, 5.2% in 2007, 3% in 2008, and -1.1% in 2009. 
Those in favor of raising interest rates feel that relying on growth from global demand projections in an admittedly sub-par year present less risk than the potential inflationary excesses that may be caused by keeping rates low.
Those in favor of keeping rates low feel that the probability of damaging a fragile recovery by raising rates are higher than causing future inflation by not doing so.
Clearly, choosing the wrong course of action may result in significant economic problems. 
What is your opinion, and why?