User 228271

How High Leverage Has Brought Down the Whole Banking Industry

The big question to me is why the Fed allowed banks to loan money to people who were securitizing mortgages. The whole point of securitizing the mortgage was to get the bank out of the transaction. These loans brought the banks right back into the equation. This was especially a problem since no one did a proper risk evaluation of these mortgages.

For the future, the system needs to be fixed so that this risk is more contained. To my mind, the simplest solution would be to ban banks from using funds from guaranteed deposits to loan to financial companies. There is a lower standard on stocks than on loans -- why then allow stocks to be used as an asset against loans? If mortgage securitization had been funded by equity funds, then at worst the fund would have gone bankrupt and lost investor money. We wouldn't have the domino effect of fractional reserve lending.

The Fed's current ability to loan money to investment banks is completely the wrong solution in my opinion. The problem was that investment banks were accessing guaranteed funds. We should fix that rather than offer new ways to bail out bad investor decisions. Perhaps these loans are necessary in the short term, but we need to move to a system where they aren't necessary.

The Fed's primary focus should be on price stability. Currently it's trying to handle both price stability and economic growth, which is causing it to fail at both (not as badly as in the '70s, but it's early yet). It needs to refocus on price stability and let other actors handle economic growth (possibly by going through a purging recession). Low interest rates should be a tool to avoid deflation, not to try to grow the economy.