Tuesday, September 23, 2008

It is quite clear that our current (September, 2008) mortgage market problems are directly traceable to the ONE simple fact that "existing lending rules allow banks to negligently sell off shaky house loans".
Unless those lending rules are changed, no government action will correct the problem.

Allowing banks to sell off shaky house loans protects the banks from any losses on those loans and encourages the negligence of the bank's responsibilities to run a fair, honest and equitable banking / lending system. But the system is bound to fail if banks are protected from losses on those loans. It is those losses that are supposed to keep the banks from making bad loans.

In 10th grade English: this is the way the system should work.
1) Banks create new money by lending money to people who (a) have some skin in the game (have made a down payment on the house they are buying and (b) put the house up as collateral for the loan.
2) The banks make money by collecting interest on the loan over the life of the loan.
3) If the loan go bad, the banks foreclose and sell off the house, thus limiting the bank's losses to the difference between the money they have lent and they money they collect from the selling the house.
4) If the loan was prudent, the bank's losses will be very small.
5) Thus the banks are pressured to make prudent loans.
6) It is that pressure that is supposed to make sure that the bank makes sensible loans that will not go bad
7) But -- if the bank sells off a loan to a another company before the loan goes bad, the bank obviously protects itself from the risk of loss on the loan. That risk of loss is transferred to the buyer of the loan.
8) Selling off the loan removes the pressure and incentive to make prudent loans.
9) Obviously the banking rules should state that the banks can't sell off loans they have made. If the loans go bad -- they should be forced to take whatever loss arises. That loss should make them more prudent in future lending.
10) Removing the risk encourages the making of risky loans.
11) The built-in risk is the primary thing that keep the banks prudent.
12) The system is bound to fail if banks are allowed to sell off loans.
13) The leverage that is built into fractional reserve banking practically guarantees that banks will never run out of money to lend. The banks do not have to sell off loans in order to raise more money to lend.
14) Selling off a loan simply exchanges one asset of the bank -- (a) the loan for another asset (b) the cash they get from the sale.
15) The selling off of a loan has ONLY ONE PURPOSE -- the avoidance of risk to the bank on a shaky loan. That should not be allowed.

I would be happy to correspond with anyone who thinks this message needs clarification.

Remember,
* "Existing lending rules allow banks controlled by the Federal Reserve System to negligently, and perhaps fraudulently, sell off shaky home loans."
* They are negligent because the banks have an obligation to make sound loans.
* They are fraudulent because the banks are purposefully avoiding their contractual obligations to Congress and thus to the American People.