Memo to Obama: time to break the refinance strike by the big banks
There are growing signs of unease bordering on desperation inside the Obama White House. Most of the O Team now understands that the real, private economy never got out of Dip Number One. The prospect of a permanent downward shift in â€śtrend growthâ€ť to a lower track, and continued double digit unemployment, are driving a search for alternative measures that has even touched conservatives in the worlds of finance and economics.
The Obama Administration and the Fed have taken the position that the crisis affecting the U.S. economy and the financial sector is slowly ending. In fact, the largest banks remain profoundly troubled by bad assets on their books as well as claims against these same banks for assets sold to investors. By allowing banks to â€śmuddle alongâ€ť and heal these wounds using low interest rates provided by the Fed, the Obama Administration is embracing a policy of deflation that has horrible consequences for U.S. workers and households.
In a post over the weekend on ZeroHedge –Â â€śBernanke Fed Drives Deflation With Zero Rate Policyâ€ť — I described the negative effects of the Fedâ€™s low interest rate policy on bank earnings, as well as consumer and corporate spending and saving. When interest rates are low, savers move their preference for liquidity to infinity, especially after the past several years of market breakdown. Retirees spend less because the interest earned on bonds and savings has plummeted.Â Hereâ€™s an excerpt:
When the Fed buys securities through QE, it is removing duration from the markets, pushing down yields and volatility. For a while this boosts the net interest margin (NIM) of leveraged investors such as banks, who are able to borrow at lower rates to fund current assets. As assets re-price to the low rates maintained by the Fed, however, NIM begins to disappear. Over the medium to longer term, think of duration and NIM as being linked, so obviously a sustained period of QE is bad for NIM. This is why NIM in the U.S. banking sector is starting to fall.
Just as the earnings of leveraged investors like banks are starting to suffer due to zero rate policy, so too the spending by all manner of savers, from retirees to companies and not-for-profits to municipalities, is falling too. Fed Chairman Bernanke and the other members of the FOMC are killing the real economy to save the banks — but none of the benefit flowing to the banks is reaching U.S. households. In fact, the Obama Administration has been providing political cover for the Fed to conduct a massive, reverse Robin Hood scheme, moving trillions of dollars in resources from savers and consumers to the big banks and their share and bond holders.
The first priority is to make clear to the largest banks, especially the top four institutions — JPMorganChase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C), that the party is over when it comes to providing credit to the real economy. Until President Obama and Fed Chairman Bernanke recognize that six institutions — FNM, FRE, BAC, C, JPM and Wells Fargo — have broken the mechanism which makes interest rate easing work, we will make little progress fixing the economy.
â€śIn every Fed easing event during my career in finance (1986, 1992, 1998, 2002), it was the wave of refinancing of debt after the Fed eased interest rates that put permanent disposable income into the hands of households,â€ť notes a former Fed official who worked in the banking industry for decades. â€śIn this last easing, however, FNM, FRE and the TBTF banks have conspired to break the transmission mechanism for monetary policy and are now strangling the U.S. economy to save themselves from past errors.â€ť
Rules changes made by FNM and FRE since the Treasuryâ€™s conservatorship began in 2008 have prevented millions of American consumers and business from refinancing their mortgage debts. The Bernanke Fed will attempt to compensate for this de facto freeze on refinancing with QE II, but this will fail.
So what should President Obama do?
First, the Obama Administration should use the power provided in the Dodd-Frank legislation to force an accelerated cleanup of bad assets and to mandate refinancing and principal reductions for performing loans with viable borrowers. If any banks resist, the Treasury should use the power under current federal law to remove recalcitrant officers and directors of these same banks.
Second, President Obama also needs to focus on the growing competitive problem in the U.S. mortgage sector. The mortgage banking industry suffered significant consolidation since 2007. In particular, the competitive, third part origination players went out of business via bankruptcy or by being taken over. The industry is now dominated by a cozy oligopoly of Too Big To Fail banks (TBTF).
The top three banks control 55% of all mortgage originations. The top 10 banks control 95%. The top five run the only surviving channels to sell loans to Fannie Mae (FNM) and Freddie Mac (FRE), and force their pricing upon the entire banking industry. Small banks give up half the economics of a typical loan to sell a loan to FNM or FRE indirectly, through WFC or JPM. Why is there no antitrust investigation of the top banks by the Department of Justice?
The Obama Administration should move to restructure FNM and FRE now, not in 2011. The Treasury should use its existing authority under the conservatorship to force FNM and FRE to make rules changes to allow for the refinancing of all existing residential mortgages, if only to reduce the current cost of the debt and increase disposable income for households.
By moving on reforming FNM and FRE, the Obama Administration can provide relief to home owners and also send a strong message to Wall Street and global investors that the practice of â€śtoo big to failâ€ť is at an end. We should always remember that the model of the government sponsored enterprises (GSEs) goes back to fascist Italy and Germany of the 1920s. The very public demise of these GSEs is an important part of ending TBTF for the large banks — but only part of the story.
President Obama should make some political hay over the fact that loan origination margins for the top four banks have gone from Â˝ point to over 4 points in the last two years. This is the subsidy for Wall Street above and beyond the zero interest rate policy of the Fed. The Obama Administrations needs to require changes in the way in which FNM and FRE do business with the banking sector and with mortgage holders, and use these changes to reform the mortgage market in preparation for legislation from the Congress.
By reducing barriers to refinancing by FNM and FRE, and aggressively forcing private banks to mark mortgages to market and accept principal write-downs or short sales to clear the backlog of bad debt, the Obama Administration can restore balance to the economy and create a healthy basis for new growth.