March 01, 2009

Back to Banking Basics: Learning from Canada

After the American Century

Once upon a time, mortgages were simple. The home buyer went to a bank, which (1) decided whether the house was worth its price, (2) whether the purchaser looked like a good risk, (3) what rate of interest to offer, and (4) how big a down payment was needed to seal the deal. Furthermore, (5) banks kept on hand a decent reserve of capital, in case some buyers defaulted on their loans. In those simpler days, all the risk was divided between just two parties: the customer and the bank. But all five of these elements of the simple mortgage have changed over time, and the disastrous results emerged in the present crisis.

(1) Houses were bought and sold for irrationally high prices. There were years when home prices rose by 20% or more. But salaries were not shooting up that fast, and banks should have considered the potential resale price to be less than the irrationally soaring market price. In Britain, for example, by 2005 people were buying houses for as much as five times their annual salary, but a good rule of thumb in the industry has long been that people cannot afford a house that is more than c. three times their salary. To find a way for ordinary people to pay extraordinary prices, banks invented all sorts of new kinds of loans, including some where the buyer only paid off on interest, without making any attempt to pay down on the loan itself. And so the bubble grew.

(2) Banks failed to make hard-nosed evaluations of whether customers were good risks. In fact, as has been documented again and again, lenders encouraged people to purchase homes that they really could not afford, secure in the knowledge that they would repackage and sell these dodgy mortgages to others. In many cases, banks divided up mortgages, repackaged them, and spread the (as it turns out toxic) risk, and so distributed these risky loans all over the world. By 2008 millions of people were defaulting on their loans, the rate of foreclosures shot up, house prices began to fall, the whole house of cards came tumbling down. In the United States, in January of 2009 alone the number of foreclosures was 274,399. Assuming an average of four occupants per home, that means more than 1 million people lost their house and all they had invested in it, in just one month.

(3) During the years of bad practices, banks also played games with interest rates. In Britain, for example, many banks offered quite low rates for the first years of a mortgage, whose cost then increased dramatically. Borrowers would then go out and pay some high fees to refinance the house and start the process over again, without ever managing to pay off much on the house itself. As a result of such practices and many other manipulation of interest rates, it became quite difficult for consumers to understand what they were really paying for a mortgage. so that "supply and demand" were not as important as (mis)perceptions of capital supply that stimulated irrational demand.

(4) Down payments have fallen over the last century. Back in c. 1920 it was not unusual to demand one third to one half of the total value of a house as a down payment. I am not suggesting that one should return to that standard, but it does put in perspective the developments since that time. After World War II, in the US, veterans could buy a house with a down payment of only $1, as the federal government insured the contract, making it risk free for the banks. Veterans did prove to be good credit risks during the expansive 1950s and 1960s. But the great success of such programs suggested that enormous economic growth could be achieved by extending more credit to more people, notably by asking for smaller down payments. Today, few people put up more than 20% as a down payment, the amount necessary to obtain the best interest rates. In some cases, cash payments were not made, as many people used their pension plans as collateral, putting their old age at risk. Thus there are people in the present crisis who are losing not only their homes but their pensions as well. Others paid higher interest rates but put up as little as a 5% down payment or in some cases even 0%.

(5) As the number of loan defaults snowballed, it quickly became apparent that banks were not prepared. They had not kept decent sized reserves on hand. In many cases, they had purchased mortgage insurance, from companies such as AIG, that is now the dead weight threatening to drown the whole banking system. For AIG became a global player in the mortgage business, giving the appearance of safety and solvency to all sorts of schemes, each of which helped banks to escape from the irritating demand that they actually have some money in their vaults. US banks on average have only about 4% of their capital value on hand in the form of actual money.

President Obama is trying to clean up this enormous mess, but it will not be easy, because the simple borrower-lender relationship has become so complex, with so much division and sale of risk, insurance schemes, and arbitrage that only accountants who specialize in this field can understand the billion dollar details. In the short term, it seems impossible to avoid pumping billions more into the under-regulated industry, to rescue the economic system as a whole. Meanwhile, the public is understandably furious that bankers should continue to be well paid.

Fortunately, there is a model for a better banking system: Canada. There, banks were kept under tighter control, and as a result the Canadians have weathered the world financial storm without much damage. Theie banks did not have so many dodgy mortgages and they had an average of 9.8% capital on hand, more than twice the US average. Canadians did not forget the five essential features to mortgage lending discussed above. In 2008 the Geneva-based World Economic Forum rated Canada's banking system as world's best. Not incidentally, the Canadian dollar today is far stronger against the American dollar than it has been historically.