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article imageOp-Ed: Banks shift financing from real estate to consumers

By Anthony Mallgren     Jun 27, 2012 in Business
In the wake of the near collapse of our modern day financial system, banks are now financing consumers, continuing away from the 20 year trend of making business a priority.
The Federal Reserve, the institution responsible for ensuring that financial elasticity doesn't serve as a noose for our financial system, is reporting that while banks are shifting away from financing real estate, they are placing consumers at the forefront as a vehicle of value production for the US.
As seen in the chart above, banks in the United States had a 20 year run of making business financing a priority, placing it at the center of our economic engine. After this run, it seems that real estate financing came at the expense and ultimately the strangulation of the availability of funds for business, placing the burden of debt driven value production on consumers. Although funds are flowing out of real estate, banks are selecting to maintain the ratio between consumers and business, granting lines of credit to spenders rather than orchestrated production.
First started in the early 1900's, the Federal Reserve is charged with the task of maintaining financial elasticity. Left unregulated, one party can lend another party a sum of money, that party can take the same amount of money and loan it to another person and so on. When people account for how much currency they have "on the books" what was a $10,000 loan may appear to be more like $1,000,000 (given the same $10,000 is loaned 100 times over). This enables a credit worthy person to charge a higher interest rate to a less credit worthy person and generate additional income, essentially being free money where there is no cost to them. Eventually, it reaches someone who is not able to repay the loan, and that $1,000,000 is quickly realized to be the original $10,000. Everyone panics when the credit unworthy fail to pay back the $10,000.
Federal Reserve G20 Data Display in Ratio Line Chart
Federal Reserve G20 Data Display in Ratio Line Chart
At the height of the real estate financing fiasco, the Federal Reserve required that commercial banks maintain "a reserve", which resulted in a smaller loan amount each time the capital is re-loaned, ensuring the less credit worthy borrowers receive less and less capital. The thing is that they only regulated traditional loans from commercial banks. These traditional loans were then packaged up into investments for offer on public markets, escaping the financial jurisdiction of the Federal Reserve. So you could essentially provide a loan directly to a suburb.
When these securities came to market, everyone rushed to invest, it being the hot new item. More people were moving into houses, driving the prices up. Investors receiving a great return as people repaid their loans. Everything was going great for the economy. The only problem is that money was not flowing into business at the same rate, which meant that wages were not growing at the same rate as the availability of credit for homes. To get around this, loan originators placed teaser or introductory rates on the loans, much like consumer credit cards, only for a longer period and a larger amount of capital. Once these teaser rates were up (many were at a 2 year term), borrowers began defaulting. This allowed a two year lag time for any of these affects to be felt, amplifying the devastation of defaults.
Many investors were looking to rating agencies to determine whether they should invest. The rating agencies looked at the perception of the market, whether investors held enough confidence to continue investing, rather than the underlying value of the investment (a common approach to ratings). As the masses were happy to lend a helping hand to every person in securing a home, the rating agencies reported that investors held high confidence in the securities, awarding them top ratings. This drove more capital into the market. But perception isn't always reality. When the loan repayments stopped rolling in, people lost confidence quickly.
As this was essentially everyday citizens choosing to loan their money to potential home buyers, either through their financial advisor or by their own accord, the Federal Reserve had no say at the time of the crisis in requiring every citizen to hold a portion of their money instead of loaning loaned money out again and again in an attempt to gain interest on borrowed money. Thus, our currency reached it's financial stretch point and snapped back. When this happened, we realized there was much less currency actually in play, just as the scenario above.
Now that we are undergoing a reconciliation period, it seems that banks are trading real estate teaser rates for credit card teaser rates. While this is typically a much shorter period and an order of magnitude smaller in the amount of capital allowed to stretch, consumer debt typically is not collateralized, which means if and when they default, the bank is not able to collect any real value back. Much of the debt went toward food that was consumed, gas expenses, heat, water and other such expenditures. This again allows financial elasticity to mislead us, which is attractive as a short term bandage for banks, but is not a long term solution.
Business debt on the other hand is more true to it's face. When businesses go belly up, they commonly go into receivership, offering up equipment at discounted prices to people who are able to employ it in a more productive manner. It is less misleading and doesn't cause the snap back of financial elasticity that real estate, or even consumer debt results in. Prices of equipment generally does not undergo as dramatic valuation swings, being more diversified. For example, you would need a large part of the population to go into the bakery business for the valuation swings of bakery equipment to mislead us onto grounds that may lead to a financial snap back. Because people's passions for business are typically spread more thin than the need or want of a residence, this is typically a more sound approach for financing than direct real estate debt (cash purchases and down payments are not accounted for in financing). Because it is more collateralized than consumer debt, it is a better vehicle for financing our economic engine.
One proposed solution is to have the Federal Reserve require different reserves of cash on hand according to the balance or ratio of real estate to consumer to business debt. At any rate, it looks like the United States still has some reconciliation work ahead of it to sort out the great recession and turn to fuller days.
This opinion article was written by an independent writer. The opinions and views expressed herein are those of the author and are not necessarily intended to reflect those of
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