Insights from the FDR Framework on why banks are not lending

Four years after the beginning of the credit crisis, policy makers, economists and other market participants are asking the question of "why are banks not lending".

Historically, banks are senior secured lenders.  This role implies that they only make loans that have the following characteristics:

• The borrower has the proven financial capacity to perform on the terms of the loan; and

• The value of the collateral pledged to back the loan exceeds the amount of the loan.

If either of these two characteristics is not present, then banks are not suppose to make the loan.

Clearly, banks demonstrated in the years leading up to the credit crisis that they were willing to make loans that did not satisfy both of these criteria.  No Income, No Job loans stand out as an example of this willingness.

However, and this is a major caveat, in the years leading up to the crisis, banks viewed their balance sheet as a place to "park" the loan for a short interval prior to repackaging and selling the loan to the capital markets.  Bankers were originating loans that conformed to what could be distributed to investors.

This was different than originating loans that would be held to maturity on the bank's balance sheet.

The simple fact is that there are investors who are willing to take more "risk" than banks.  Hedge funds come to mind.

With the collapse of the securitization market and the ability to distribute credit risk, knowing that they were going to have to hold the loans on their balance sheets, banks had to make an adjustment in their lending practices so that only loans that have both characteristics are made.  In the best of times, this would have reduced bank willingness to lend.

Looked at through the prism of the FDR Framework, the lack of disclosure by financial institutions and structured finance securities of all useful, relevant information further reduces bank willingness to lend.

The mechanism by which the lack of disclosure reduces bank willingness to lend is the feedback loop between the requirement that the borrower pledge collateral in excess of the loan amount and the bank's ability to value the pledged collateral.  The lack of disclosure negatively impacts a bank's ability to value the collateral and as a result reduces bank willingness to lend.

How does a lack of disclosure impact a bank's ability to value the collateral?

The largest source of collateral is real estate and there are significant doubts about what residential or commercial real estate is worth.

Bankers know by looking at their own balance sheet that they have a sizable number of loans secured by real estate that are experiencing performance problems.  To date, these loans have received regulatory forbearance in the form of extend and pretend.

The question that bankers have to ask themselves is what would happen to the price of real estate should regulatory forbearance end and they and all of their competitors needed to sell all the underlying real estate collateral to repay the loans.  Would real estate prices drop 10%? 30%? More?

If the bank thinks prices would drop 30%, then the maximum loan amount against the real estate collateral is going to be less than 70% of current valuation.  This represents a substantial reduction from pre-credit crisis lending standards that were closer to 100% loan to value.

Most of this guesswork by the bank could be eliminated with disclosure under the FDR Framework.  With disclosure, market participants could help in the valuation of the collateral by valuing similar properties and establishing market clearing prices that are not artificially distorted by government policies.