Monday, March 30, 2009

Why the banks won't lend

I still do not believe people know how banks operate. People expect to get money from banks for nothing. But the thing about banks is, they will do everything in their power to protect themselves from loss.

Assets, especially real estate assets are way overvalued for an economy that is going to survive on lower consumption. Banks know this. Therefore, they are only participating in loans that are financed with a lot of equity through the form of down payments or with insurance in the form of government subsidies.

Let's say I want to buy a $200,000 house. In reality, the bank knows that housing prices can fall another 10-30% or $20-60K. In this situation they will try to underwrite the loan to have a small likelihood of loss. After collection, sales commissions, legal fees, and a foreclosure discount the costs of reclaiming a home can be well into the tens of thousands of dollars. So this $200,000 house is now only loanable on a basis of $140,000. The bank thinks that they can get $140K on it if it goes into foreclosure, or they think on average, loans like this will be profitable only if there is that amount of equity involved.

The problem the US currently faces is not many people have a lot of equity in the form of liquidity these days. Most of their wealth was tied up in their personal homes. So we face an environment where banks need a lower loan amount to be profitable but few people have the money to put down. So, in steps the government to insure loan values through FHA, VA, etc. This closes the gap and artificially inflates home values by creating more leverage. When these properties go into foreclosure the FHA and VA, aka the taxpayer, takes the hit while the banks collect most of the value of the sold real estate. If it sounds like a crooked scam cooked up by Wall Street to generate fees, you are right.

What needs to happen to make this situation more viable is increased cash liquidity and savings as well as lower more affordable home prices. So the banks won't lend until asset prices are more in line with their ability to collect on their loans. Unfortunately, I don't think this will happen for another few years. So now Wall Street has the cash and we're stuck holding the underwater mortgage.

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