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Who should bear the risk? who should be the judge of value?

December 18, 2011 Leave a comment

Banking District

Image by bsterling via Flickr

If we have decied that our banks are too large to fail, then how about the following idea?

1. When an individual and a bank agree on a loan, its based on a shared estimate of the value of the home.

2. When a bank decides to underwrote a speculation then both the individual and the bank are betting that the price will go up and allow them to take on more downside risk

3. The individual takes the risk because they think they wont get stuck (greater fool theory plus tactical liquidity)

4. The bank takes the risk because they know there are greater fools to buy the house, tactically, or because the government (the greatest fool) will bail them out (strategic greater fool theory)

5. when there is tactical failure the individual loses all, the bank gets the cushion of the down payment or the property top resell

6. when there is strategic failure, all the risky individuals are crushed, and banks get bailed out with the money taken from prudent banks and individuals who didnt speculate.  This is the moral hazard problem.

7. Even in strategic failure, the banks dont lose, and cant lose, unless the entire world’s financial edifice is removed, but then we have total anarchy and bankers arent worse off than anyone else, plus they can live off the real assets they squirreled away along the wya. No real risk at all.

What we need is a way to put the risk on the banks up front, so that we shift the cost of failure from the prudent banks and individuals.

So, I am thinking that the bank needs to be the appraiser, and quote a price at which they guarantee they will repurchase the house from the borrower at any point in the lifecycle of the loan, at the individual’s demand. They can require a 20% down payment, so that they have a pool of capital to loan to others.  They will be conservative in their estimates of value, and will therefore be a brake on speculation.

This prevents individuals from eating all the cost of their own speculation alone.  banks wont let them speculate without skin in the game. Speculation will be inhibited. Banks will do a better job of appraising, since they will have to own their decision for the life of the loan. If there is a meltdown in housing prices, individuals, who are least capable of making those kinds of forecasts and judgments, dont get smoked on their loans because they can always demand the bank buy them out at the negotiated price. Now prudent individuals arent stuck with the cost of the bad speculative loans. Then if banks fail for having poorly estimated housing value, prudent banks get to buy their books at a discount.

This would serve to stabilize a conservatively priced housing market and prevent the socialization of costs  incurred by the worst risk takers at the expense of the prudent individuals and banks. Virtue will be rewarded

 

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