America's banks are broken, and the U.S. economy cannot be pulled out of recession until they are fixed.
Thirty years ago, mortgages were straightforward. Homebuyers went to banks, which checked incomes, purchased independent appraisals and loaned buyers the money. The bank held notes or sold them to Fannie Mae or perhaps insurance companies.
Loan officers had strong incentives to be certain loan applications were accurate. Bad loans came back to them.
Today, loans go through complicated chains. Loan agents hang around real estate offices, take applications and forward those to mortgage companies or regional banks. Those sell the notes to large Wall Street banks or securities firms that increasingly do most of the things banks do.
Until recently, Wall Street banks bundled mortgages into bonds, and sold bonds to insurance companies, hedge funds and other investors. As mortgages vary significantly in quality, mortgage-backed bonds were rated by Standard & Poor's and other rating agencies.
At each step, information could be lost and temptations built up to understate risks of default. Agents got fees only for loans that were approved, and appraisers whose assessments came in too low didn't get business from agents.
Mortgage companies got their cut from origination fees and were able to push off the risk of default onto the ultimate purchasers of the bonds. Hence, they were inclined to be lenient with agents.
Wall Street bankers were rewarded for writing very complicated securities intended to do the impossible: make inherently more risky bonds less likely to impose losses on investors when mortgages defaulted.
Wall Street banks paid the rating agencies for evaluations of mortgage-backed securities. In turn, those agencies assigned high ratings to inherently risky bonds.
Last year, we learned the banks were writing adjustable-rate loans and other esoteric mortgage products that many homeowners could never repay. They were slicing, dicing and reassembling loans into incomprehensibly arcane bonds, and then they sold, bought, resold and insured those contraptions to generate big fees and profits.
Many loans failed, and mortgage-backed bonds plummeted in value. Wall Street banks got stuck with unsold bonds, and are being forced to write down billions of dollars in losses.
Now investors ranging from American insurance companies to the Saudi royals are not much interested in buying bonds created by U.S. banks, and banks cannot make enough loans to credit-worthy consumers. Without enough credit, housing prices plummet and the economy sinks into recession.
The Federal Reserve has cut interest rates and loaned banks $600 billion against bonds on their books, but those steps help little because the bond market is closed to banks.
The whole lending chain must be fixed. Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Chairman Ben S. Bernanke propose tighter regulations of mortgage brokers and steps to ensure independent real estate appraisals. Accurate statements of borrowers' income and credit histories, and honest appraisals, are essential for creating loans that may be bundled into bonds that investors will buy.
That said, the big Wall Street banks must be willing to create simple bonds from mortgages that are easy for investors to understand and whose risks can be accurately accessed.
This is less profitable than the complex bonds and derivatives that were being sold prior to the credit market meltdown.
It is up to Mr. Paulson and Mr. Bernanke to bring together the largest banks and fixed-income investors, among insurance companies and the like, to lay out the requirements for such bonds, and to require the banks to stick to them. Bond raters should be paid by investors, not the banks that create the bonds.
Today, banks are often part of large financial empires, and plain vanilla mortgage underwriting doesn't pay outsized fees, profits and bonuses. Bankers look to other markets for opportunities to sell derivatives.
However, Americans need the banks to make mortgages and other loans to get the economy back on track. Mr. Bernanke and Mr. Paulson have the leverage to bring them to the table - the $600 billion the Federal Reserve is lending banks to keep them afloat.
Individual banks that won't cooperate don't have to get their loans.
If Mr. Paulson and Mr. Bernanke lead, the banks will follow.
Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.