Truth about the Credit Crises

The economy is, by far, the most important issue of this election. The credit market is tight, housing market has lost nearly half its value, and the stock market is down 30%. Before you cast your vote, I urge you to understand what is fact, and what is myth.

Credit Crises

Banks - and other financial institutions - are the world's most profitable middle-man. They are a marketplace where people who have money can lend it to people who don't have money. When you deposit your money with a bank, they lend it to another customer and charge them a higher interest rate than they pay you.

Banking regulations require banks to keep 10% of their risk-adjusted asset values available in cash - this is known as the Capital Requirement. The capital requirement ensures banks have enough cash on hand so depositors can withdraw their own money. If a bank distributed 100% of its deposits to lenders, you could never withdraw from your account. Each night, banks who exceed their capital requirement lend their surplus of funds to banks who are below their capital requirement.

Loans are listed on a bank's books as an asset. When a loan defaults, banks remove the loan from their list of assets and replace it with the value of the house. When the housing market began to slump, and asset values plummeted, another bank regulation - Mark to Market Accounting - forced the banks to adjust downward the value of the asset on their books. This left most banks in a capital requirement deficit - and there were not enough banks left with a capital requirement surplus to lend money to the deficient banks. Concisely, the "credit crises" we are facing is illiquidity - meaning, banks don't have money to lend.

How did this happen?

Banks began deviating from their fundamental lending practices - assessing the risk of the borrower and conservatively valuing the asset. Banks knowingly lent money to individuals who did not have the capacity to pay it back. Banks also began creating very exotic lending packages - like, no payments, no interest for one year with a large balloon payment in year two. Deregulation enabled this.

Why would a bank take such a risk?

Two reasons:

1) The interest rates on these packages made them very profitable as long as borrowers made payments.

2) Community organizations, with major support from the Democratic party, would publicly accuse financial institutions of racism or other malfeasance if they did not lend money to low-income individuals who did not have the capacity to repay the loan.

Solutions

Every problem has several potential solutions each with varying degrees of efficacy, impact, and longevity. This situation is no different.

Capitalism-Based Solution: Government does nothing or minimally intervenes by providing low-interest loans to banks who need to cover their capital requirements. Banks that became too highly leveraged with risky loans fail. Banks with a smarter business model survive. This is painful but effective and insures only companies with solid business practices continue doing business.

Socialism-Based Solution: Government enacts a series of reforms and regulations that reduce or eliminate a financial institution's ability to assume risk. This minimizes the likelihood of a repeat of the crises, but also limits an institution's ability to differentiate from its competitors. Lack of differentiation means slow or no growth in the sector as banking services become a commodity.

Communism-Based Solution: Government assumes ownership and control of banking institutions. While likely to prevent any future collapse, it also eliminates choice in the marketplace and creates a government monopoly.


What scares me most about this crises, isn't the protracted recession I'm sure we're headed for. It isn't the 30% drop in my investment portfolio. It's not even that people I know could lose their jobs. All of those are temporary. What scares me most, is BOTH Republicans and Democrats have offered nothing but Socialist and Communist solutions to this crises.

If I were calling the shots, here is what I would do:

1) Make funds available to lending institutions so they can maintain their Capital Requirement.
2) Provide independent valuations of struggling banks and tax breaks on merger/acquisition related expenses. This would encourage strong banks to buy struggling banks.
3) Increase the FDIC insurance amount to $500,000. This encourages existing depositors to keep their money in their bank so we don't further stress the Capital Requirements.
4) Cut government spending so the US government is not in the business of borrowing money. We need all available funds in the private sector.
5) Initiate a nationwide savings campaign. Abolish the personal income tax on interest earned. Abolishing the tax on interest earned effectively adds 1-2% points to the effective rate and encourages people to save, reducing the impact Capital Requirement burden on banks.

Unfortunately, the train left the station on this one. We're already down the path of socialism at best, communism at worst. If this doesn't prove that the Republican party no longer believes in small government then you are blind to the truth.

I will always be a conservative (small government, personal choice/accountability, low taxes), but I no longer consider myself a Republican. The RNC is no longer conservative.