The Banking System: A Bad Moon Rising

I was never that big of a Credence Clearwater fan, but I couldn't help thinking of "Bad Moon Rising" when I saw this tidbit in an article on the banking crisis from the Washington Post (via MSN).

The health of many banks is getting worse, not better, as the downturn makes it difficult for all kinds of consumers and businesses to pay back money they borrowed from these financial firms. Conservative estimates put bank losses yet to be declared at $1 trillion.

I think it's fair to say that the American economy doesn't need another trillion dollars in bad news.

Actually, it gets worse.

Author David Cho goes on to look at the credit crunch and argues that the ability of banks to make loans depended on the mortgage based securities that are now on the wrong side of worthlessness.

Some help from the TARP bailout, government officials said, may go to jump-starting the credit markets that finance roughly half the debt owned by businesses and households. During the boom years earlier this decade, investors bought pools of mortgages and other kinds of loans packaged into securities, providing fresh funding for bank lending. But this activity ceased after traders lost confidence that the market was accurately pricing the value of these securities and assessing their risk.

If "normal bank lending" was indeed contingent on the highly speculative market in derivatives and credit default swaps (CDS) that relied on mortgage backed securities, the banking system as a whole was profoundly distorted and unsustainable for any kind of long term.

No doubt following up on his sources in the Obama administration, Cho suggests that the solution would be to put the derivative and CDS markets on a "more solid grounding."

The Federal Reserve is poised to launch an initiative in coming weeks to restart a segment of these markets by offering to buy highly rated commercial paper, backed by assets such as credit card debt, student loans and auto loans. Officials are considering expanding this initiative to help free up loans for municipalities, small businesses, commercial real estate and other consumer debt.

I'm not an economist but this just sounds disastrous. On the surface, it looks like the fed is looking to build an economic castle on a new pile of quicksand. How much more reliable can "credit card debt, student loans, and auto loans" be as a backing for securities than home mortgages? Not very!

There's another problem. If the derivative and CDS markets are tied to things like credit cards, student loans and auto loans, then there will be pressure to offer flimsy loans as a way to keep priming the financial markets. Eventually, the banking system would start falling apart again because of the inability of credit instruments to provide an adequate grounding for the financial markets.

What the Obama administration needs to do is to build (or rebuild) a credit system that does not depend on the derivative and CDS market for the credit needed to make necessary commercial and consumer loans.

If the administration can't accomplish that goal through reconstructed private lending agencies, then they're going to have to do it through some sort of government system.

Good luck with that!