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Credit Crisis Part Deux

Green shoots and bank stress tests are little more than PR stunts.

Ann Lee

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.

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