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Would you like some cheese with that whine, Wall Street?

Yes, I realize the title is very cliché, but I think it’s quite fitting – it’s used often when dealing with toddlers and young children who whine because they can’t get their way, and, in my opinion, that’s exactly what Wall Street is doing!

President Obama unveiled his administration’s plan to overhaul the financial industry today, and Wall Street isn’t happy about it. One of the points that has them throwing a tantrum is a measure that requires firms to “retain 5 percent of credit risk” whenever they package loans into bonds. A statement from the American Securitization Forum, which includes Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Citigroup, says this condition creates “undue restrictions” that may hamper “consumer and business lending via securitization” and “impair broader economic recovery”. Oh, puuhhleeeez!

To take a quick step back: most banks that issue loans (whether they are mortgage loans, credit card loans, home equity loans, or car loans) will take a bunch of loans they’ve issued and lump them together into a security that’s then sold to other investors. These securities are called mortgage backed securities (in the case of mortgages) and asset backed securities (in the case of the other loans types I mentioned). These securities then have a variety of payment structures – either they pass the payments from the loans directly on to the people that bought the securities (after the banks take their cut of the profit, of course), or have other exotic payment structures that are pretty complicated and aren’t really the point anyway. The point here is that the bank issued the loan, and then sold it as part of a pool to other investors. So, who’s really holding the credit risk (the risk that the borrowers won’t pay back the loan)? The investors. Since the banks themselves aren’t holding any of the risk, and since they collect fees for both issuing loans and selling the securitized product to investors, the banks are incentivized to issue as many loans as they can, regardless of credit risk. This is a part of what led to the whole mortgage problem in the first place – banks blindly turning an eye to whether the borrower is likely to repay the loan or not in the interest of earning fees.

So, the President’s plan would require banks to now hold 5% of the credit risk of these loans. Note, this doesn’t mean that banks have to hold 5% of the loan amount on their books, but just that they have to hold 5% of the risk exposure – a technicality that isn’t relevant here. The point is banks are unhappy because they can no longer blindly pass the risk on to others and collect fees. Now they will have exposure to the risk too (and it’s certainly debatable whether 5% is the right number or not).

What a minute, doesn’t this seem like a good thing? Well, I think so. Having the banks on the hook should result in them being more careful in who they issue loans to and thus result in fewer defaults, which ultimately protects the investors and homeowners since there would be fewer foreclosures. Sounds like a good structure to me, if you believe in the welfare of all over the profit of the banks.

It is true that there will be indirect costs to this. Loan processing costs may go up due to the additional scrutiny of each application (though I would argue that banks were already charging high fees and weren’t really doing any loan processing – having them do their jobs shouldn’t cost consumers more), and many people may not be able to buy homes. However, that may not be a bad thing. I’d rather pay a slightly higher cost (whether it’s buried in the interest rate or in up front fees) that is structured and known, rather than pay the very high costs associated with the financial distress we’ve seen for the last two years. It’s also sad that not every American can but a home, but then I don’t think every American should buy a home. If one can’t manage their credit or doesn’t have enough income to support the home they want, then they have no business buying the home and ultimately costing everyone else more when their loan defaults. I’d love to drive around in a Ferrari and have a Rolex glistening on my wrist, but I can’t afford it and so I shouldn’t have it.

So, yes, bank profits may fall a bit and yes the risk on bank balance sheets may go up a bit (though that’s debatable too – if banks are on the hook for the credit risk they are likely to be much more careful in which loans they issue, which in turn reduces the overall risk of the loan pool). But, Wall Street, I really think you should quit your whining and accept this gladly since it benefits all Americans, and ultimately you (since the banking sector is clearly benefited by a stable American financial system). And to those who would argue that such a measure is against all that capitalism stands for, I say: “so what?” Yes, this may be a bit socialistic. But I counter that a purely capitalistic society is not optimal for all its members. When people are motivated by profit alone, others suffer – that’s the bottom line.

Besides, such sweeping reforms were passed after the Great Depression and they were a boon to the country and helped us emerge ever-stronger. I think it’s hard to argue that such a social safety net would choke off capitalism.

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