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Wednesday, July 09, 2008

Source of Value

Well gosh, you can't hardly look at a newspaper or business magazine these days without being inundated with bad news about the global financial markets. The mortgage sub prime mess, the meltdown in banking, credit crisis and other buzzwords seem to have taken over our vernacular as of late.

Of course, Congress is looking for someone to blame. Inquisitions, hearings, and other initiatives are being undertaken to try and "find the source of this mess." People are asking, "What's the cause?" Others are wondering, "How can we prevent it from ever happening again?" To be sure, legislation is being passed at the federal and state levels to try and deal with both questions.

I've been involved in financial services since 1978. It's long been my primary livelihood. So I've got a view, based on how I understand the global financial services industries to function. And I think I have a pretty clear answer. Unfortunately, it's not an answer that anyone would want to hear. Even worse, it's probably not an answer that could be legislated. That notwithstanding, I'm pretty sure that it's the right answer.

Why are we in this financial mess? It's really simple, you see. Our mortgage industry, which consumes the bulk of the financial services industry in terms of dollars and employment, had a fundamental problem. Back at the end of the World Wars, the U.S. government created securitization - by creating organizations like Fannie Mae, Freddie Mac and Ginnie Mae. There was a shortage of housing in our country and a shortage of capital with which to build houses. Securitization provided it then - and the houses got built.

This mortgage banking industry cruised along for several decades, until America became fully housed. By that I mean that we had adequate housing supply for our population. Unfortunately, we had an industry that had to keep churning out loans. It had been built and structured around creating loans - versus financing houses. I believe there is a difference. And I think that difference makes the difference. Let me explain.

When housing is needed and housing finance facilitates it, a true human need is met. But when housing stock is sufficient and housing is not needed, then the loans we make are funding something else. What else? How about greed? Or folly? Luxuries that we can't afford? And those are the good scenarios! The worse ones are predatory lending, taking advantage of people who are too ignorant to know it.

This is what happened, we constrained our housing finance system so that it could only operate in the U.S. (Fannie Mae and Freddie Mac, for example, are not allowed to fund loans secured by homes in other countries). So when the model matured and the needs had been met, the machine had no where to go and started devouring itself.

There's an old fable about a farmer who wanted his field cut. He brought in a few sheep and noticed that they ate the grass and kept the field cut and looking nice. So he kept adding sheep (capacity), thinking that more would be better. Unfortunately, when he continued to grow beyond the ability of the field to feed the sheep, the sheep turned on each other. The result was not pretty!

If we're going to have a healthy, sustainable housing finance system in this country, it is going to have to limit itself to doing what's really needed ... what really creates value for Americans. To the extent that it is unwilling to do that, then this financial Armageddon is what we'll have.

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