How to reform our financial system

A long time ago, when you wanted to buy a house you would go to a local bank and ask them for a home mortgage loan. The bank would usually ask that you put 20 percent down, look into your credit history, income and assets. The bank would appraise the property to be purchased and mortgaged. If they loaned you the money, they would service the mortgage themselves, receiving that monthly mortgage payment from you.

We can see why this mortgage would be worth more money to the originating bank than another bank as we watch this credit crisis unfold before us. If the originating bank believes it is going to hold on to the mortgage and receive the monthly payments, it is going to make sure that (a) the property is worth what the borrow is paying, since the mortgage value is tied to the property value (b) the borrower does have a good credit history, income and is bringing his or her own assets to the closing. If the originator of the mortgage is going to immediately sell this mortgage to another financial institution, there is an incentive to have the property appraised at a value higher than market value. There is also an incentive to accept claims of income and assets without verifiction.

The FDIC actually encourages banks to hold mortgage backed securities backed by mortgages originated by other financial institutions rather than originate its own mortgages. This is done by the way the FDIC assigns a risk score to an FDIC member bank’s assets. As amazing as it sounds, a mortgage with a 20 percent down payment orignated by the bank holding the mortgage is considered an asset of higher risk than a mortgage backed security backed by mortgages made to borrowers who put less than 10 percent downpayments on their purchases.

Like Fannie Mae and Freddie Mac, the FDIC provides a system where risk is placed on the taxpayer while profits are enjoyed by private investors. Should a seriers of bank loans go bad, resulting in a series of bank failures, the federal taxpayer has to pick up the tab if the FDIC reserve is not sufficient to pay depositors. Socialization of risk, privitization of profit.

A superior system would be as follows:

(a) FDIC bank membership would be voluntary. Banks could choose to be FDIC memmbers or choose not to be FDIC members.

(b) FDIC bank membership would require that 80 percent of bank deposits be invested in short term federal debt, among the lowest risk debt instruments available. This would protect the federal taxpayer and minimize the federal government’s subsidization of risk in the financial markets.

(c) Banks that choose not to be members of the FDIC would not have their deposits insured by the federal government. These banks would be required to notify all of their depositors upon opening an account that their deposits are subject to market risk, similar to the risk of investing in the stock market. Also, non FDIC banks would have inform their depositors of the riskiness of their deposits on a semi-annual basis.

(d) Non FDIC member banks would be allowed to lend their deposits with limited regulation by the federal government.

Other important reforms would include the privatization of Fannie Mae and Freddie Mac and a reduction, if not outright elimination, of Federally insured mortgages. The purpose of these reforms would, again, be to limit the exposure of the federal taxpayer for delinquent mortgage loans.

Secretary Henry Paulson responded to criticisms regarding the 700 billion dollar bailout by saying, “The taxpayer is already on the hook.” This is true and this is the fundamental problem. The federal taxpayer should not be liable for investments that do not turn out the way the investor/bank hoped.

These reforms would probably put an end to the industry of secrutizing mortgages. Instead, we would probably see mortgages serviced by the originating bank.

The fact of the matter is that mortgage securitization would never have become such a large part of our financial structure if the government had not heavily subsidized mortgage securitization through Fannie Mae, Freddie Mac and FDIC’s “risk scoring” of mortgage assets.

We sometimes wonder how we inherited a financial system that is fundamentally unsound and often in need of taxpayer cash to keep it operating. Now we know.