Did Washington Learn Anything About Bad Loans?

by Odysseas Papadimitriou on December 17, 2009

bad-loansOn December 14, 2009, President Obama met with CEOs of the largest banks to urge them to approve more loans, to lower interest rates, and to curb fees.  The meeting was obviously in response to Federal lawmakers’ feeling that, having bailed out the banks, the nation has a right to expect concessions from its financial institutions.  This feeling is fueled by the belief that America’s banks, having received federal funds, have since failed to adequately return to the business of loaning money.

To put this in perspective, we should remember that one of the large contributors to the current recession was the practice of giving out home loans to people whose incomes and credit histories did not justify those loans.  The assumption was, of course, that any loan was essentially a good investment since the value of the house was expected to appreciate astronomically.

Of course, it was a flawed assumption.  The abundance of loans caused the housing market to over-inflate.  The over-inflated housing market caused home values to drop.  As home values began to drop, the loans revealed themselves as unsound.  The more loans that failed, the worse the housing market became.  What did we learn from this?  What did the banks learn?

After all is said and done, what we all should have learned is that a bad loan is a bad loan, and pretending otherwise is an invitation to disaster.  People who cannot make their mortgage payments will be forced to foreclose.  As taxpayers, we were forced to come to the aid of large financial institutions when these loans could not be paid back.   At the same time, we found it difficult to sell our own homes in a market glutted with competition.  The fire-sale prices that followed from the foreclosures depreciated housing prices across the board.   We should have learned that we don’t want lenders to give out loans to people who can’t pay them back, and the lenders themselves should have learned that they shouldn’t loan money on unsound assumptions.  Because lenders learned their lesson, banks now give out less loans and are more careful about what loans they approve.  In short, they’re now doing business in a way that is not only good for them, but for all of us as well.

The problem is that the federal government, having bailed out these banks with tax payer money, isn’t happy with the bank’s newly found caution.  The government bailed out the banks so that they could continue “business as usual,” and now that they’re healthy enough to not need assistance anymore, the federal government expects the banks to make loans like they did during the bubble.  In short, the current administration wants the banks to go back to the poor business practices that caused the recession in the first place.  Obama’s meeting with the banking CEOs is his opportunity to tell them that they should throw caution to the wind, and begin making unsound loans once again.

According to what White House senior adviser David Axelrod said on ABC’s Good Morning America, “What the president’s going to say to the bankers is, you guys were part of the problem, you helped create an economic crisis here that cost 7 million Americans their jobs and now you have to be part of the solution.”  But Axelrod and the President need to realize that, in fact, by being cautious, the banks are being part of the solution:  they’re no longer giving out frivolous loans with such abandon that their practices are a threat to the American economy.  They’re basing interest rates and loan approval on real credit risk and not on assumptions about markets or political special interests (including the urging/bullying of the President).  In short, they are acting the way banks ought to act, giving out loans only to those who deserve them.

The solution to America’s recession is not the creation of more housing and credit bubbles but must be based on a realistic assessment of the situation at hand.  While we can all agree with the Obama administration that part of the economic devastation was caused by the banks’ unsound lending practices, we should understand that the problem had nothing to do with the banks being too cautious—quite the opposite.  As Obama asks the nation’s banking leaders to throw caution to the wind, he has to realize that it was precisely this lack of restraint that created this recession.  Nonetheless, someone needs to inform the President of the lessons that we all learned from the fiasco.  In particular, that bad lending practices cause banks to fail and should be avoided rather than given the President’s seal of approval, and that the tax payers who were put on the hook to bail out the banks don’t want those banks to fail again.

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