Home >> United States & Canada >> Economics & Trade

     Email   Print 

Bernanke should encourage banks to adopt sounder business models

Prof. Peter Morici - 3/5/2008

Ben Bernanke, in recent testimony before the Senate Banking Committee, noted the shortages of credit, especially the reluctance of banks to extend credit to one another.

He also noted the banks' inability to securitize alt-A, subprime and jumbo mortgages.

The latter makes all but Fannie Mae conforming mortgages and home equity loans scarce.

In plainer terms, if you are not a prime borrower seeking a first mortgage of less than $417,000, you are having a tough time finding financing. The stimulus package will raise that limit, but only for prime borrowers.

Since September, the Federal Reserve has lowered the target federal funds rate 2.25 percentage points but to little avail, because the bond market no longer trusts the major New York banks to package mortgages into securities.

Bernanke has not addressed this fundamental structural problem that frustrates his monetary policy.

The large New York commercial and investment banks are operating with a flawed business model. Essentially, compensation for executives is based on the volume of securities transactions and is lavish. Those bankers are encouraged to slice, dice and puree mortgages into unintelligibly complex securities, to support the high profits and compensation packages of recent years.

Recently, even securities backed by fairly safe student loans have been greeted with skepticism, because of their arcane structures, intended to generate big bonuses for their engineers.

Historically, mortgage banking and the business loan activities of commercial banks did not support the kinds of profits and salaries earned at investment banks. The combination of commercial and investment banking in the last two decades has raised the expectations that those that underwrite mortgages and business loans should be compensated at levels comparable to those facilitating more complex merger, acquisition and investment activities. This has motivated the development of arcane, engineered mortgage- and other loan-backed securities.

The hard reality is that banks borrowing at 5 percent and lending at 7 percent cannot reward those who underwrite mortgage- and other loan-backed securities at the levels comparable to traditional investment banking. All the financial engineering under the stars can't change that math.

Bond buyers have figured out the value added in those complex securities is negative and risky. Such banks as Goldman Sachs that sold those securities to clients while shorting the market are now viewed with great suspicion.

So far the banks, flush with infusions of capital from sovereign wealth funds, have not had to make necessary adjustments in their business practices. Those sources of capital see no problem with the business practices of banks that managed to lose their stockholders 1 percent of GDP, because those funds have nonprofit motivations for investing.

Bernanke needs to speak to those issues and encourage the adoption of sounder business models. If he does not, the recession will be long and hard.

Bernanke has responsibility for encouraging the sound functioning of credit markets.

He is ignoring this task through silence, and he may have to be shown the door.