September 2010 Country Credit: The New World Trumps the Old

... is the only region to suffer an overall decline in its creditworthiness rating over
the past year, not surprising given Greece’s recent debt crisis and the ...

... reforms, could condemn its members to poor economic performance and recurrent crises. ...
of bonds, like the Brady bonds used to resolve the Latin debt crisis. ...

2010 All-America Fixed-Income Research Team: The Incredible ...

... of securitized products, fears of sovereign-wealth crises spreading and a ... their views
on the sovereign-credit issue, he ... on the belief that the crisis will pass ...

Structured Market Ready To Grow, But ...

... the mechanism widely regarded as having triggered the financial crisis, but the ... there
was still some stigma attached to collateralized debt obligations and ...

2010 All-Brazil Research Team: Let the Gains Begin — Again

... 62,762.70 the following month amid investor concerns that the debt crisis in Dubai ...
Once it became apparent that those two crises could be contained, investors ...

Time to Celebrate the 70th Anniversary of the Investment Company ...

... asset-backed pools that receive high ratings from credit rating agencies ... hedge funds
contributed to over-speculation and the resulting 2008 financial crisis. ...

Research & Rankings

Click here for 62 benchmark research & rankings archives.

Latest Releases:

Latin America Research Team
BofA Merrill Lynch Global Research and J.P. Morgan share top honors in the 2010 ranking.

2010 All-Brazil Research Team
Itaú Securities leads annual ranking of Brazil's top equity and fixed-income analysts.

Coming in September:

Country Credit

Asia 100

Search by:

Region

Subject

SUBSCRIBE NOW to get instant, unrestricted access to current and archived research & rankings.

FREE TRIAL

Register today for a FREE 2 week trial including full online access and the latest issues of Institutional Investor magazine.

II Research Group

Credit Crisis Part Deux

E-MAIL PRINT

By Ann Lee, an expert on financial derivatives and the global financial system.
June 2009

Keywords: credit crisis, regulation, bank stress tests, FDIC, real estate, inventory, defaulting subprime loans, commercial loans, Ann Lee

Ann Lee June 22, 2009 - Ben Bernanke has announced green shoots, and Tim Geithner has completed the bank stress tests. Unfortunately, all this good news amounts to little more than a public relations stunt pulled by the government, and it remains to be seen how long they can continue to fool the public. If one simply looks at the monthly call reports published by the government reporting the financial health of our nation’s banks, one will see a vastly different picture.

The balance sheet of Colorado’s New Frontier Bank, a bank that was recently shut down by the FDIC due to financial insolvency, is virtually identical to those of thousands of other zombie banks across the country. The problem is that construction lending as a percentage of the banks’ loan portfolios is more than 20 percent in many cases, and developers are defaulting left and right at this point in time. Many may have applied for the loans back in 2004 and are just finishing the projects now with no buyers.

There are thousands of acres of developed lots across the country in which no one is living in these properties and no one wants them. These loans are effectively worth zero because no one will take these properties even if the banks gave them away because of the taxes owed on them, but most of the banks have yet to mark them down on their books. If they did, all the equity in the banks would be wiped out. The banks have no negotiating power in most of these cases. The FDIC unfortunately can’t handle all these asset sales from the banks at the same time so they have artificially slowed down the pace of shutting down these banks to a very quiet orderly manner so as to stall the collapse of the banking system.

So far, the fire hose of debt has been limited to a trickle by the Fed and the government since they know there is no market for all the debt outstanding. The Fed has absorbed much of it on its balance sheet, and they have yet to explain to the public how they plan to unwind them. But in addition to all the defaulting subprime loans, these commercial loans will have to be recognized as non-performing at some point in the near future which will cause a second avalanche of loan defaults around the corner. Will the government also bailout all the commercial developers? It will be extremely difficult given the dollar amount, nor should they from a moral and fairness perspective.

The only way out of this problem is to create a huge demand for all the real estate inventory. Unfortunately, as the government keeps printing money to stop deflation, the rising interest rates will keep buyers from stepping into the real estate market. Other buyers like hedge funds cannot help the market because they have a trading mentality. They may buy something at ten cents on the dollar and try to flip it at forty cents on the dollar. In the meantime, these properties will deteriorate in value as they sit languishing without owners. What we need are buyers who will manage these properties with a long-term perspective until real demand returns. Managing these assets could take years, but in today’s short-term trading culture, such managers are hard to come by.

Obama’s administration should focus on how to solve this problem rather than on extraneous, ill-conceived notions of how to regulate the hedge fund industry. America doesn’t need larger, more inefficient government wasting taxpayer dollars on useless regulation. The government couldn’t even regulate the banks, so spreading themselves out too thin to regulate hedge funds will be a colossal waste of money and time. Simply passing legislation that requires all hedge funds with at least $25 million in assets to register with the SEC will not reduce fraud in the system. Many hedge funds would either relocate to another jurisdiction or find loopholes. Rather, the government should figure out how to fix the banks, and the gargantuan bad debt that overhangs the American economy.

For starters, the government should force banks to provide full electronic transparency to the public. The Fed should also require companies to report their true value at risk (VAR), their solutions to it, their top 25 counterparty exposure, the kind of products to which they have exposure, and transaction documentation for all material transactions. Only with up-to-the minute information can the government develop a rapid response system that could minimize damage if another systemic market failure should occur.

As for the debt, the government should let the market figure out how to extinguish the debt. The thousands, perhaps millions of minds who follow the debt markets everyday, have a much better idea of what to do with the bad debt than a few bureaucrats and bank regulators sitting in Washington. We’ve already seen what a command and control government has done to the economies of Communist countries. We can’t afford to ignore history.

Ann Lee is an expert on financial derivatives and the global financial system. Currently Lee teaches economics and finance at New York University. Click here for her profile.

Comments (12)

| Add Comments

SAC Aug 18, 2009

I read this lady's piece when it was published in June, and it was frightening. I read it again today, in a climate considerably more relaxed than it was in the Spring. I too am somewhat more relaxed today, but I am not sure why. Has the Government succeeded in building confidence, or has the absence of recent bad news lulled us into a false sense of security? Will a modification of the mark-to-market accounting rules enable banks to sweep these problems under the rug and keep them there until they go away, years from now? I'm not sure about any of this, but I am disinclined to bet against this lady -- she's a smart cookie.

AA Jul 08, 2009

At least the government has bought significant space between systemic financial system risk and the solution. Higher capital levels at banks and extended FDIC insurance are meaningful safety nets that are, in my opinion, being underestimated by most.

Rich Tullo Jun 26, 2009

We now know that Hedge Funds had little to do with the crisis. I seems to me the regulators after dropping the ball made the crisis worse by creating a panic in order to save thier political reputations. So how are regulations going to work when the SEC, the Federal Reserve and Treasury already have much of the tools they need.

systemBuilder Jun 25, 2009

I agree with just about everything in this article, and I think the conclusions are widely understood by many american. That is, everything EXCEPT for the unspported rant about the regulation of hedge funds and derivatives. These are a systemic and perpetual risk until they are regulated. they should have been regulated a decade ago!

TG Jun 25, 2009

This young, brilliant economist has a considerable amount of knowledge about what’s behind the façade and expresses it most cogently. We must intelligently review all existing regulations, remove the weeds and effectively enforce existing and perhaps new regulations, e.g., fiduciary responsibility for B/Ds. Persons manage corporations and the government; ALL persons MUST be held accountable. By the way, you might be interested in "U.N. to Emerge as Global IRS" in Accuracy In Media @ http://www.aim.org/aim-column/u.n.-to-emerge-as-global-irs

Just a nobody Jun 25, 2009

@george katopis I would love for government to "MEANINGFUL"lly regulate every aspect of my life. Then I could just sit my rump down and not fight for anything in this world. Aside from our military (which may be questionable in recent years), and varied public works, please enlighten me on how government has been able to "MEANINGFUL"ly regulate anything in a manner beneficial to us, the lowly proletariat.

Shawn Williams Jun 24, 2009

Financial literacy is a persons best friend right now. When you understand the benefits and the drawbacks of each decision, take into account articles like this any many others, it boils down to action. If it's doom and gloom you believe, then protect your assets from losses. If you see opportunity, research it and make a wise choice for yourself. I think cash flow is king and having assets that are protected and can produce cash flow will be the saviour to anyone who understands how to do it. Cash flow, not assets is the key to survival now and in the future.

WM Jun 24, 2009

The financial crisis is separate from the real estate crash, and the former is actually driving the latter these days, not vice versa. People like me do not want to buy investment properties because we are worried about whether or not we can get reliable tenants in this economic environment. It is just way too risky. And the reason the economic environment is horrible is because of the lingering effects of the financial crisis, fear of the financial overhaul legislation, and new accounting rules taking place later this year which will likely result in another round of write-downs. We need to get the government to sit down and shut up. They have caused enough problems as it is. In my opinion, our One Great Hope relies on whether the Supreme Court throws out Sarbanes-Oxley this upcoming session.

Bill Hocter Jun 24, 2009

An interesting, frightening article. I hope the author is wrong. I'm afraid she's probably right.

beachpaul Jun 24, 2009

The problems still are, and have always been, in the mortgages. They were not addressed by the Bush Administration and are still not being addressed by the Obama Administration. They are non-performing assets that grow monthly. The holders refuse to take the writedowns, especially those wrapped in Bond dressing. The problems are now spreading into prime time loans, those well north in shear numbers, though not the volume, of sub-prime mortgages. Then there are the re-sets for commercial properties coming due this summer and early fall. I have no idea what the real numbers are, I can't find them, no matter how much sifting I do. Everything is unclear no matter what the government does and that is the real problem we face.

Steve Jun 24, 2009

Wonderful article. Bankers tend to be herd animals, not the brightest folks on the planet; further down the evolutionary scale are the regulators, at the present moment exacerbating the crisis as opposed to solving it. The faith that many uncritical thinkers have in "regulation" is touching, given regulation will likely worsen the problem. I much prefer Ms. Lee's solutions. Transparency uber alles.

george katopis Jun 23, 2009

Trully, I am appreciative for the educated and well written warning of Dr. Lee. I even agree with her that a few bureaucrats can not solve the problems generated by the greed and " company sort term objectives" of thousands of the smarter people of our nation. Howeve, the current situation is also a history lesson that all these thousands of experts can generate extremely large problems to our social structure and economic system. This is also a history lesson that Dr. Lee appears to choose to ignore. Consequently the goverment has to impose on the different players in the market ( including hedge funds and derivatives) MEANINGFUL regulation that make apparent to the rest of us the risks and exposures that these players produce for the system. At least we know that the "free market" will not do so by itself.

Thursday September 02, 2010

SEARCH