Brian27

New Bank Data: Latest Lending

The basic problem is that banks are under capitalized because the value of MBS have fallen, in varying amounts. This has lead to an adverse selection problem that if banks attempt to raise equity, cut dividends or borrow from other banks it is believed that they are a bad bank and lending is refused. So no firm tainted by MBS can raise capital. Good banks are driven out of the loan market by bad banks.

Banks, of course, know this and attempt to move MBS off their balance sheets. But the problem of asymmetric information, where sellers have more information on the MBS than buyers causes the prices on MBS to implode. Buyers believe the securities offered for sale are low quality and offer prices that are below the true value or the ‘hold to maturity price’.

The obvious solution is to independently verify the value of MBS, but this is costly, tedious and time consuming. So what can the government do?

The Paulson plan is for the government take on the bad MBS. This saddles the government with the mortgage problems but does not convey any information to distinguish between the good banks and the bad banks. The same problem that good banks are indistinguishable from bad banks remains. Plus does anyone think the government can fix the mortgages underlying MBS? Those issues are best solved by the firms who created the mortgages.

The solution is for the government is to impose rules on firms that eliminate the adverse selection problem that only bad banks raise capital. 1) All banks must suspend dividends. 2) All banks must raise equity capital. 3) Improve FDIC insurance to prevent bank runs. 4) Allow hold to maturity rules. Require MBS holders to provide the data and model used to value MSB to maturity so that investors can compare prices using various models. This will increase transparency for investors who can run the data through their own models to estimate prices.

To directly improve liquidity to banking the government can take preferred equity stakes to improve banks balance sheets. Preferred stock becomes part of the company’s capital stock which increases the company’s capitalization. Also capital gains taxes on MBS can be eliminated so that investors are encouraged to take more risk in the MBS markets and corporate taxes can be reduced to encourage investment.