RealEstateEconomyWatch.com

The U.S. banking system is ailing and further deterioration could have serious negative implications for the economy and housing sector. To date, the Treasury has injected $196 billion into the nation’s top banks by purchasing preferred bank stock. In addition, the Federal Reserve has increased its lending facilities, including the Term Auction Facility, which offers $150 billion in secured loans to banks per auction.

After two initial injections of capital, the Treasury will convert up to $27.5 billion of preferred Citigroup shares into common stock issued under the Capital Purchase Program, on top of the $45 billion allocated to Citigroup in 2008 to aid the troubled bank. This latest government effort increases Citigroup’s tangible common equity from $29.7 billion to $81 billion, strengthening its capital position. The stark reality is that the U.S. government now has a 36 percent ownership stake in the nation’s third largest financial institution. Some are labeling the government’s involvement in the banking industry as partial nationalization.

The banking industry is literally the heart of our economy—it pumps money into consumers and businesses via lending by extending credit. If the pump stops, consumers and businesses suffer; jobs are lost and the economy sinks deeper into recession. That is why the Federal Reserve and the Treasury are paying so much attention to our banks. They have been on center stage during this financial and economic crisis. Their survival is critical to the economic recovery.

But there are unintended consequences of the government’s efforts in restoring confidence in the banking system. First, it is now clear that large banks are too big to fail and that creates perverse incentives. Second, taxpayers via government injections are paying for the bailout of banks and that brings up fairness issues. Third, banks are now being positioned to be the primary focus of mortgage lending and that could stifle competition at some point.

Today, the large banks have literally shut off business to mortgage brokers and are keeping the business for themselves. Rather than utilize the mortgage broker network where thousands of mortgage brokers are competitively shopping mortgage loans to bank wholesale operations on behalf of consumers, the banks are permitting their retail operations to do the entire mortgage lending business. Competition for mortgage lending is among a handful of large banks rather than among thousands of mortgage brokers competing for business. In the long run, consumers may not get competitive pricing.

Putting competition and fairness issues aside, the immediate issue today is how to stabilize the nation’s banking system. Federal Reserve Chairman Ben Bernanke outlined a 3-step plan for the largest, most troubled banks to accomplish that objective.

Stress Test: The government will run stress tests to evaluate the financial conditions of the 19 largest banks under a severe economic downturn to see if they can survive. Rather than a pass of fail grade, the regulators are more interested in determining how much capital each bank needs from the government, to give them a cushion while they restructure during the recession.

Recapitalization: The Treasury will inject money into these troubled institutions in the form of preferred or convertible preferred stock. These shares usually do not have voting rights so recapitalization does not give the appearance that the government is nationalizing these banks.

Exit: Bernanke said that the end game will come when these banks can raise private capital and repay the government. Although there is no guarantee that taxpayers will get their money back, the hope is that the government will actually make money on the deal.

There is no magic formula or secret sauce to make the banking mess go away. The government is doing the best it can do under trying times. The fate of our nation’s economy and housing markets depend on it. For the housing sector to fully recover, we need a stable banking system pumping money/credit back into the economy once again.