A long term solution?

As of now the $700bn plan for the government to purchase questionable assets from troubled banks is on hold. This may be a good thing seeing as how the short term effectiveness and the long term results of this plan are cloudy at best. To find the answer to this crisis we have to isolate the inherent flaws in the current system. The first major flaw resides in the incentive structure in the asset backed security chain, while the second flaw is in the regulation of the banking industry. By solving these two problems we will significantly strengthen the US economy and the new rules will help insulate industries against future bubbles.

 

The problem of flawed incentives arises from the ability of the loan originator to pass off the credit risk of the security to the next party. This credit risk is passed off at each link in the chain until it rests wholly with the final investor. In the current system, by the time the final investor has purchased the end security, the loan originator has already been paid and is in the process of making more loans. The originator couldn’t care less if the borrower defaults because he carries none of the credit risk. This selling of the credit risk happens all down the chain so the only one concerned with the borrower defaulting is the end holder of the security in which the loan resides. Sometimes that final investor doesn’t want to take on the credit risk so he hedges himself by trading it off in the credit default swap market. The fix for this problem would be to somehow force the loan originator to retain some of the credit risk associated with loans they write. This will make lenders think twice before writing another NINJA loan and would solve the problem at its source.

 

The second problem, the one of inadequate regulation, is a bit more difficult to solve. If we just shove more rules and regulations at the banking industry we will eventually bog it down with so much red tape that the industry will be too inefficient to be productive. The proper way to solve this is to look at the current regulations, keep what is effective and cut what isn't working. Instead of piling legislation on top of legislation we need to streamline the regulatory process so it is both efficient and effective. The first area to tackle is the set of accounting rules that deal with what does and doesn't appear on company's balance sheets. The idea that a public firm can own an asset that isn't recorded on its financial statements is utterly ridiculous. In the end the regulations must provide more transparency in the marketplace while still allowing the industry to function properly.

 

By tackling these 2 problems at their source we will have built a fairly solid base on which we can rebuild our economy. The banking industry is the most important industry by far so it is only fitting that we start there. Saying this and actually accomplishing it are two completely different tasks so put your ideas out there and lets put this past us.