Madeline Schnapp is director of macroeconomic research with TrimTabs Investment Research Inc. She edits the firm's Weekly Macro Analysis and Employment NewsFlash publications. Schnapp tracks the cash side of the liquidity equation using proprietary real-time economic indicators. She recently spoke to HousingWire about the current state of U.S. banks.

HousingWire: Why are so many banks failing? What must banks do to remain competitive?

Madeline Schnapp: I can't answer your specific questions but I can provide an opinion based on a conceptual framework as follows: First of all, in my opinion, you have to start with our fractional banking system. A depositor puts $100,000 into a bank (let's assume the bank has a good reputation and has been around for a long time), the bank keeps $10,000 and lends out the rest.  The depositor now has a claim on $100,000, but that $100,000 no longer exists at the bank site because it has been lent to other businesses. The bank has created money out of thin air and will not run into trouble so long as you don't withdraw your $100,000 anytime soon.

The reason this works is the depositor trusts the banker to make a good decision about how and to whom to lend the depositors money. And since a bank is in business to make a profit, traditionally bankers were careful whom they lent to, ensuring there was sufficient collateral to back the loan and that the borrower was a good credit risk.

HW: But extending home loans to borrowers with poor credit doesn't sound like being careful with those deposits. Why did so many banks take that risk and write so many subprime mortgages?

MS: Let's change the rules on one sector of the economy, housing, and give the power to a quasi-government entity to buy as many loans from banks as banks can legally generate because of a political mandate to expand home ownership. The banker no longer has to hold the loan, and instead of making money on the interest on the loan, makes money on fees based on how many loans are shoveled to the government entity.  The banker no longer has to worry about the quality of the borrower. This worked for awhile because potential homeowners had to make a 20% downpayment — meaning they had skin in the game, they had to demonstrate they had a good job, and they had to have a good credit history.

Now let's change another law and add a mortgage deduction which incents people to buy homes. The mortgage deduction increases demand causing prices go up, essentially negating the benefit from the home mortgage deduction. Now let's change the laws again and allow non-bank entities like Countrywide financial to create and sell loans to Fannie Mae and Freddie Mac. Because they make money on the volume of paper pushed out the door, and not on interest, they don't care who they lend to.

Let's change the rules again and allow people to buy homes with little or no money down. For example, the Federal Housing Administration loans require only 3% down. That increases the moral hazard of people walking away from a home, for whatever reason, because they have little or no skin in the game.

Then lets fuse government with big banks, eg. Citi, etc., and people like Robert Rubin, Christopher Dodd, Franklin Raines, Hank Paulsen, and the government/corporate fusion gets pretty thick and pretty toxic because homeownership is not accessible to a broad enough sector of the economy, politicians pass coercive laws that create agencies to inspect bank mortgage loans and fine banks for not lending to homeowner with credit scores less than 650.

Finally, lets have another quasi-government entity, the Federal Reserve, lower interest rates to below inflation which makes borrowed money essentially free. With free money available for low interest loans, and no down payments required, demand for houses skyrockets, taking prices with it.

HW: So how'd this housing bubble ultimately burst?

MS: Who is at fault here? The regional banks or government? Government agencies offered banks the opportunity to offload their loans thereby increasing profits while reducing risk, government agencies created programs allowing homeowners to purchase homes with little or no money down, the Federal Reserve created essentially free money?

In my opinion, it was government (and the fusion of government with big corporate banking entities) that created programs that artificially stimulated demand which then created the environment for malinvestment which, in turn, fueled the bubble.

Canada doesn't have a Fannie or Freddie, neither do many countries in Europe and their housing markets function just fine.

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