Monday, July 21, 2008

Government Isn't God: FDIC Sticks Banks With Bad Loans and Sticks Borrowers With Subprime Junk

Those who call for regulators to supervise the financial industry fail to get that government is spelled g-o-v-e-r-n-m-e-n-t, not g-o-d.

In 2004, New York Federal Reserve economists Jonathan McCarthy and Richard W. Peach wrote a paper Are Home  Prices the Next Bubble?? Their answer was decidedly, "No".

I issued a reply to their paper, at that time writing under a pen name because of other business commitments:

...the record climb in housing prices is, indeed, a bubble... the Federal Reserve study fails to consider past declining interest rates as a cause of the bubble. The faulty conclusions reached by Federal Reserve economists Jonathan McCarthy and Richard W. Peach may make many potential new home buyers comfortable about a purchase, when, in fact, we are very near the top of a housing market that will experience substantial declines in prices...

They reach the conclusion that because of ....[the] "fundamental factor" of low nominal interest rates, higher housing prices are justified.

But does this mean real estate prices will not drop? Our answer is decidedly no. Indeed, McCarthy-Peach report that "since 1995, real home prices have increased about 36 percent, roughly double the increase of previous home price booms in the late 1970's and late 1980''s." We view this increase as largely the result of the Federal Reserve's lowering of interest rates and the pumping of liquidity into the banking system, thus producing the byproduct of higher housing prices. But by incorporating falling nominal interest rates as a "fundamental factor" that can not be a cause of a bubble, McCarthy-Peach have literally defined the cause of the current bubble from being taken into consideration....

Further, the current structure of many mortgage loans whereby no money down is acceptable and/or adjustable rate mortgages are popular, sets up the possibility that many may walk away from current mortgage commitments down the road as interest rates begin to climb. Indeed, as ARM's rates become more and more burdensome and as housing prices begin to decline, walk away situations are likely to become quite prevalent, thus adding even more downward pressure to the housing market.

It is our conclusion, then, that by defining nominal interest rates as a fundamental factor and not as the Fed induced causal factor of the real estate boom, and by completely ignoring the structual features of current mortgage loans, McCarthy and Peach have blinded themselves to the real estate bubble that does exist. They have set themselves up for perhaps making the worst economic prediction since Irving Fisher declared in 1929, just prior to the stock market crash, that "stocks prices have reached what looks to be a permanently high plateau."

Apparently, McCarthy and Peach thought my reply was funny and included this quote from me in their power point presentation, when they went around the country declaring there was no housing bubble. Under the headline Opposing View, they would flash this quote from me:

The faulty analysis by Federal Reserve economists McCarthy and Peach may go down in financial history as the greatest forecasting error since Irving Fisher declared in 1929, just prior to the stock market crash, that stocks prices looked to be at a permanently high plateau.

Last I heard, they aren't using that power point presentation anymore.

The point being that regulators do not have a magic wand that makes their beliefs 100% accurate. But, the problem is that regulators will direct regulation in the direction of what they believe and not, "Opposing Views". Thus, any crashes under heavy regulation become greater, because regulators have driven ALL market participants in that direction.

Regulators aren't gods. As we learn today in a WSJ report even the FDIC got caught up in te sub prime madness:

It turns out that the U.S. government itself was one of the lenders giving out high-interest, subprime mortgages, some of them predatory, according to government documents filed in federal court.

The unusual situation, which is still bedeviling bank regulators, stems from the 2001 seizure by federal officials of Superior Bank FSB, then a national subprime lender based in Hinsdale, Ill. Rather than immediately shuttering or selling Superior, as it normally does with failed banks, the Federal Deposit Insurance Corp. continued to run the bank's subprime-mortgage business for months as it looked for a buyer. With FDIC people supervising day-to-day operations, Superior funded more than 6,700 new subprime loans worth more than $550 million, according to federal mortgage data.

The FDIC then sold a big chunk of the loans to another bank. That loan pool was afflicted by the same problems for which regulators have faulted the industry: lending to unqualified borrowers, inflated appraisals and poor verification of borrowers' incomes, according to a written report from a government-hired expert. The report said that many of the loans never should have been made in the first place.

Hundreds of borrowers who took out Superior subprime loans on the FDIC's watch -- some with initial interest rates higher than 12% -- have lost their homes to foreclosure, data on the loans indicate...

The Superior situation could be costly for the FDIC. Texas-based Beal Bank SSB, which bought a portfolio of Superior loans, about half of them originated under the FDIC, is suing the agency in U.S. District Court in Washington. The suit claims many of the loans were made improperly and are plagued with problems.

An internal FDIC legal assessment, obtained by Beal Bank and filed in court last month, acknowledged "numerous appraisal deficiencies" in the portfolio and a "small number of loans that appear to be fraudulent from inception." Calling the FDIC's legal position poor, the undated 26-page assessment suggested that the agency's liability could be as much as $70 million. Another FDIC official, in a deposition, estimated that the cost of settling the case could be less than one-third that amount.

In a recent court filing, the FDIC estimated that about 1,500 of the 5,315 loans it sold to Beal either have defaulted or are nonperforming. The FDIC already has bought back another 247 of the mortgages, most of them for violations of federal anti-predatory-lending laws intended to protect borrowers from unreasonably high fees or deceptive practices. Beal Bank has said in court filings that 73 of the repurchased loans were originated while the FDIC was running Superior...

Meanwhile, a separate portfolio of Superior subprime loans that the FDIC sold to Bank of America Corp. -- which the bank in turn sold to investors -- also has been troubled. As of April, investors had suffered "realized losses" -- which generally occur after foreclosures -- on 511 of the 3,964 loans in that pool, according to data provided to investors...

FDIC Chairman Sheila Bair has been unusually forthright in putting part of the blame for the mortgage mess on regulators, who she has said should have acted earlier

And Paulson wants to put Fannie Mae and Freddie Mac under the control of the Federal Reserve, and the likes of McCarthy and Peach? I'd rather see Randal Quarles and Carlyle Group in there right now competing against other private equity firms--as long as others are also allowed to compete for the banks and their assets.

What's going to happen, though, is that, at a minimum, new regulation will be instituted so that no one but Quarles will understand what the hell is really going on. At worst, Paulson will takeover Freddie Mac and Fannie Mae and carve it up in some way that Quarles and other private equity firms will be able to pick off the juicy meat. And at the same time new regs will be saddled on the banking industry overall, making it more difficult to operate, especially for those survivors who were smart enough to stay away from the subprime wacky loan business in the first place.

That's government at work, not God.

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