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Op-Ed: Desperate Times, Desperate Measures, Part 2


Economic crisis demands radical changes in our way of life.

Editor's Note: This article was written by Leonard A. Spivak. Len is currently Minyanville's outside legal consultant and a member of its Advisory Board. He recently retired as partner of the law firm of Cahill Gordon & Reindel LLP in New York. See Len's Desperate Times, Desperate Measures, Part 1 here.

Let's turn to the crises: Housing, mortgage-backed securities and credit. They're all part of the same network of problems. Some may recall Penn Square Bank, whose insolvency (declared by the Comptroller of the Currency on July 15, 1982) marked the beginning of the bank crisis of the 1980s - which nearly brought the nation's banking system to its knees.

Penn Square Bank was located in a strip mall in Oklahoma City. During the course of an oil and gas play (which turned out to be a bust - but that's another story) Penn Square generated billions of dollars in loans which it then sold upstream to the aforementioned banks (one of which was Chase, now a part of JPMorgan Chase (JPM)).

The borrowers were unable to pay, and the collateral was found to be extremely overvalued ot worthless - in some cases, it had already been pledged numerous times to secure multiple loans from Penn Square. The Bank's president, Bill Patterson, loaned millions to anyone who could spell the words "oil" or "gas," along with some who couldn't. The banks purchasing participations in these loans did little or nothing to review borrowers' history or Penn Square's collateral valuation procedures. A joke that made the rounds after the collapse summed it up: "You can call a Penn Square Bank loan, but it won't come." For more on this, see Phillip L. Zweig's Belly Up: The Collapse of the Penn Square Bank.

Those old enough to remember the Penn Square fiasco must be amazed and saddened to see it all happening again, though it now poses an even greater threat to the stability of the financial system.

The equation for extending credit is not complex. Lending is supposed to involve taking a measured risk on a return that takes the extent of the risk into account. Although risk can never be measured orecisely, the age-old formula involves an assessment of the value of any collateral and the ability of the borrower to repay.

In the current situation, mortgages were extended to borrowers who weren't required to put up any equity or substantiate their ability to pay. In the case of "liar loans," borrowers were actually encouraged to report fictitious earnings.

Low "teaser" rates would convert to higher market rates at the end of a specified period. Is it any wonder that purchasers attempted to sell their houses for exorbitant sums, or defaulted on mortgages, or simply abandoned their homes when they discovered that they could not in fact afford them" In the absence of any equity, they had no "skin in the game," and no reason to do otherwise.

Although I haven't seen any of the models used by those who valued these mortgage packages when they were included in bundles and the bundles securitized as bonds, I would wager that those who created this concept failed to take the "snowball effect" into account when estimating risk. When a home buyer finds he cannot pay the original amount of his mortgage, and learns that others in the same predicament are selling or defaulting on or abandoning their houses, he has no compunction -- and maybe no choice -- but to do the same thing.

3 things happened at about the same time: First, the value of bonds collateralized by these mortgages decreased substantially such that their value became undeterminable. This caused hundreds of billions in write-offs by the institutions that purchased them or held them in inventory (sometimes in off-balance-sheet special purpose entities).

Second, tens of thousands of houses came onto the market in a short period of time, dragging down the value of residential properties nationwide - but particularly in Southern Florida, Las Vegas, San Diego, and Arizona, where the mortgage origination practices described above were especially prevalent.

Third, the home construction industry went into hibernation. Acting in their speediest post hoc manner, federal and state governments are investigating everything and everyone, as well as endlessly debating the prohibition of certain mortgage lending practices.

And the lawyers, bless their hearts (I'm one of them), are having a field day. I'm not suggesting legal liability on the part of anyone involved -- I don't know enough of the facts -- but I'm disappointed by the ignorance that allowed these fiascos to recur across successive generations of banking management. I'm disappointed that the leaders of our financial institutions apparently were unaware of the very substantial risks to which their shareholders and entities were exposed.

And, of course, the regulators were sleeping.

An uncomfortably high rate of inflation will be with us for quite some time. The only thing that could substantially lower it is a real decline in consumer purchasing. Perish the thought: Consumer purchasing is the engine that keeps our economy afloat even when other parts are sinking.

Inflation will return to "normal" rates when the price of fuel either falls or stabilizes. It's that simple. It also wouldn't hurt to repeal the absurd law requiring increased percentages of ethanol in auto fuel.

The financial sector can only sink so far. We may not have seen all the fallout from the mortgage-backed bonds as yet, but we've probably seen most of it. These institutions are in business to make money, and they'll find ways to raise additional capital to allow them to make loans once again. If they stick to the basic lending formula -- which they used to be good at, before the fees to be made on subprime bonds addled their judgment -- the financial sector could eventually make a substantial recovery.

The housing crisis, however, is a bit of an enigma. It's been reported that there's a 2-year inventory of existing houses waiting to be sold. But figure is misleading: While it may be the case in the most affected areas, it isn't true everywhere. Gimmick-free mortgage loans to those who can afford them, where available, will help improve the picture.

But overall, it'll be a long time before the home construction industry recovers - and it may never again reach the levels it enjoyed at the height of the housing bubble.
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