November 24, 2008 09:15 pm
—
By Konrad Heid
Globe guest columnist
My wife suggests it doesn’t do any good to argue with the pundits of financial wisdom on television or yell to the interviewing news host to ask the hard questions and get straight answers to the ones they do ask.
Alan Greenspan may be an economic hero in some quarters, but I still think he was so far removed from the real world he didn’t understand how he was helping engineer our economy and the economies of the world into the current mess.
What I think he didn’t understand is human nature, “Show me money, I’ll take it whether or not I have the capacity to repay.”
Low interest rates over lengthy periods of time can wreak havoc on an economy; they create excesses all across the spectrum, in business expansion and personal-credit usage. The Federal Reserve lowered interest rates to those sub-basement levels of 3 percent and 4 percent in 2001-03 and left them there for months on end.
However, before Greenspan’s faux pas, Congress wreaked its own havoc. In the late 1990s Congress created the “easy avenue to personal credit disaster.” It mandated the leading mortgage providers, Fannie Mae and Freddie Mac, lending to folks who really couldn’t afford — subprime — any of the many repayment schemes that were devised in response to the congressional mandate. Add the low mortgage interest rate offerings and already excessive credit-use levels as acceptable to qualify for a residential loan. It was a disastrous combination.
A third disarraying factor that currently has huge effects on financial institution balance sheets was the decision in the 1970s to change accounting standards led by accounting oversight folks, requiring “mark-to-market.” Asset values were no longer what was paid for them; each month-end value was to be marked to what the market said they were worth on that day.
I believe these were the three major ingredients playing off of each other as to how we got here — mark-to-market accounting, subprime loan mandate and low interest rates for extended time.
Now, what suddenly kicked off this turmoil in the credit markets? Reports of higher residential loan delinquencies, more defaults expected, probable declining home prices, higher number of homes for sale — these headlines began the roll of an ever enlarging snowball.
Banks and other investors in home mortgages, even though the customers were still paying as agreed, suddenly found the market value of that asset had declined significantly — enter “mark-to-market.” As mortgage holders marked down their investment portfolios to current market value, their balance sheets suddenly were void of capital. How can this be just a paper entry? Welcome to the world of accounting!
“What? You have no capital on your balance sheet,” bank to bank suddenly said. “I can’t continue doing business with you since you have no capital.” Huge amounts of funds move from bank to bank daily or at least they did. Individual investors and depositors said, “I can’t continue doing business with you since you have no capital, give me my money!” Some mortgage banks were leveraged up to 40 to 1 — less than 2 percent capital — and they were dead in the water. When forced to sell assets (mortgages) at 70 cents and 80 cents on the dollar to meet investor demands mortgage banks were immediately broke. The effects of the collapse of Bear Stearns rippled around the world, waves quickly followed — there are still more to come. Banks are no longer willing to lend to each other. This is the liquidity crisis that we keep reading about. Some banks are so strapped they can no longer lend to non-banks either.
Banks in the U.S. traditionally have been required to have 5 percent to 8 percent capital with 8 percent to 10 percent capital common with community banks, lessor with the large banks.
Something you may not have heard too much about yet, but it’s out there, is the collapse of the Auction Rate Securities market. Many banks and brokerage firms were offering this avenue of investment to increase earnings for their customers. I had not heard anyone raise the issue of undue risk before the collapse and I didn’t know it had become such a huge investment vehicle. The lack of willingness to make additional investments or to continue lending between large financial institutions around the world, also, led to the collapse of the ARS auction leaving hundreds of investors with limited recovery options.
Governments around the world are scrambling to infuse capital into their economies.
Here in the United States we’ve heard a lot about the $700 billion Congress approved to assist our banks and other finance-providing entities. Mark-to-market accounting, lack of interchange between institutions and mounting loan losses are wiping out banks across this country.
Keeping in mind financial institutions often reflect the communities where they do business, what does this tell us about our economy and the economic health around this globe? Our financial experts are charting in new waters. Does anyone know the direction of the wind from one day or one hour to the next? We can guess, but that’s about the best we can do. I hope someone gets it right. Soon.
Barbara, can I still yell at Barney and Alan?
Konrad Heid is a former Joplin bank president. He lives in Joplin.
Copyright © 1999-2008 cnhi, inc.