23 September 2008

the banking business model is dead

In the upside-down economic universe America finds itself in these days, banks can no longer be viable businesses. Due to the government intervention in mortgage finance (e.g. ownership of the Governmental Special Entities like Fannie/Freddie/FHA) it has become impossible for private finance to compete with the artificially low interest rates that the government has on offer. Who would want to get a mortgage from a private bank for 8% when they would qualify for a government backed loan at 5%?

Banks simply don't have access to capital as cheaply as the government, and are therefore unable to lend at a profitable rate. The only market left to banks is lending to those who wouldn't qualify for a government loan, which pretty much means people who are virtually certain to default (i.e. even people with 620 credit scores can get 3% down FHA backed loans).

Sure, US banks are still making loans, but if you look closely the vast majority of those loans are government backed, in one way or another (GSE/FHA). Banks have simply stopped putting their own money at risk. Why should they, since they can't possibly get the rates they need that is commensurate with the true risk? This leaves banks with nothing much more than a transaction fee.

It is hard to see how any banks can possibly heal themselves, restoring their balance sheets, as long as the government continues to subsidize lending.

Ironically, the more the government bails out, or seizes, struggling financial instutions, the more difficult it becomes for the banking industry make money and establish a firm footing.

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