The Real Victim of the Great Credit Crunch

NEW YORK ( TheStreet) -- The Federal Reserve's survey on wealth, released earlier in the week, is real evidence that the "Great Credit Crunch" caused pain on Main Street while Wall Street was bailed out.

In my opinion, Federal Reserve policy influenced this great divide.

The Federal Reserve survey on wealth shows that the median net worth of an average American family plunged by $49,100, or 39%, from $126,400 to $77,300 between 2007 and 2010.

This takes the wealth of the average U.S. family to its lowest level since 1992. The "Great Credit Crunch" thus destroyed 18 years of gains in net worth. Leading this dramatic decline was the housing market. There was a 42.3% loss of equity in Americans' homes.

Wall Street and the larger regional banks helped create the euphoria that owning a home was easy and affordable. The greed on Wall Street resulted in the creation of mortgage-back derivative securities, because the sum of the parts, from a basket of mortgages that were sliced and diced, is worth more in trading profits than the whole of the original mortgages.

Community banks were not involved in these mortgages that turned toxic, but they did participate in the bubble by lending way too much money to homebuilders and developers creating a glut in new communities and new homes.

There are thousands of incomplete communities around the country.

As I have shown in previous stories, community banks extended construction and development loans, and other commercial real estate loans in excess of regulatory guidelines.

Instead of monitoring this risk, banking regulators ignored it as the banking system was booming with profits.

Then the housing bubble popped, mortgage securities became toxic and the credit markets froze over. The "Great Credit Crunch" shocked the U.S. Treasury, the Federal Reserve and the Federal Deposit Insurance Corp. Toxic assets were clogging the arteries of the banking system.

The solution, according former Treasury Secretary Hank Paulson, was the $700 billion Troubled Asset Relief Fund, which was supposed to buy the troubled assets from Wall Street and regional banks.

Since troubled assets could not be marked to market, TARP instead became a bailout fund for Wall Street and the banking system. Americans with mortgages were left out in the cold as the consensus was "moral hazard."

Wall Street and the bigger banks were bailed out, while homeowners on Main Street lost 39% of their wealth. And consider this: Those homeowners are the taxpayers who paid for the bailout.

Between 2007 and 2010, the height of the "Great Credit Crunch", Wall Street was making record bonuses thanks to the taxpayer bailout, while Main Street homeowners net worth was fading fast.

Residential mortgages on the books of our nations' banks fell by $347.8 billion between 2007 and 2010, the period covered by the Federal Reserve survey on wealth. Most of this decline represents foreclosures and short sales, where homeowners lost their homes. This is evidence that homeowners were the victims.

Some foreclosed properties became "other real estate owned" on the balance sheets of banks. This $40.7 billion increase is a rise of 334.9% during the Fed survey period. This is additional evidence that homeowners were the victims.

Notional amount of derivatives is the category the shows the increasing Wall Street greed during the 2007 to 2010 period of the Fed study on wealth.

I have been saying that time bombs (in the form of derivatives) are ticking for Wall Street and the "too big to fail" banks. JPMorgan Chase's ( JPM) CEO Jamie Dimon testified before the Senate Banking Committee on Wednesday, and answered many questions concerning his company's surprise $2 billion-plus trading loss in derivatives.

While the average American family was losing 39% of its net worth between 2007 and 2010, the large financial institutions on Wall Street were increasing their exposures to derivatives by a staggering $67.4 trillion, a 40.9% gain to $232.2 trillion. During this period, the banking system was supposed to be deleveraging, but clearly it was not.

Since 2008, I have proposed several mortgage programs that would help all homeowners with mortgages.

What if the $700 billion TARP was a fund offering all homeowners a "mortgage mulligan"? How much of the wealth destruction could have been avoided by allowing all homeowners who were current on their mortgages to refinance with a 3%, 30-year fixed rate mortgage.

This would have paid off some of those mortgages that filtered into the toxic mortgage derivatives. As toxic assets were removed via refinancings, the arteries of the banking system would have gradually become unclogged.

Lastly, risky over-the-counter derivatives should be banned. The mathematical models associated with derivative structures are subject to the biases of their designers.

If a designer's assumptions are wrong, big losses can occur. Any derivative that does not have a transparent market is not worth the risk it poses to the banking system.

Any derivative structure that cannot be marked to market, and is marked to myth, should be banned, because managing the risk of these securities is next to impossible.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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