Housing Boom, Bubble and Bust

Posted by PITHOCRATES - April 15th, 2013

Economics 101

Building and Furnishing Houses creates Great Economic Activity

Central to any booming economy are healthy home sales.  For home sales unleash great economic activity.  From the first surveys of a new subdivision.  To the new sewers and water systems.  Gas and telephone.  Cable television and broadband Internet.  Concrete for basements, driveways and sidewalks.  Structural steel (that beam in the basement and steel poles holding up the house).  Rough carpentry.  Electrical work and plumbing.  Drywall, windows and roofing.  Painting, flooring, doors and hardware.  Heating and air conditioning.  Lighting and plumbing fixtures.  Brick, siding and landscaping.  Etc.

All of this takes manufacturing to make these construction products.  All these manufacturers need raw materials.  And raw material extraction needs heavy equipment and energy.  At all of these stages of production are jobs.  Extracting raw materials.  Processing raw materials.  Manufacturing products out of these raw materials.  Building this production equipment.  Interconnecting these stages of production is every form of transportation.  Rail, Great Lake freighter, river barge and truck.  Requiring even more jobs to build locomotives, rolling stock, ships and trucks.  And jobs to operate and maintain them.  And build their infrastructure.  Filling all of these jobs are people.  Earning a paycheck that will let them buy a house one day.

Then even more economic activity follows.  As people buy these homes and furnish them.  Washers and dryers.  Refrigerators, stoves, microwaves, food processors and coffee makers.  Furniture and beds.  Light fixtures and ceiling fans.  Rugs, carpeting and vacuum cleaners.  Telephones, televisions, music systems, modems and computers.  Curtains, drapes, blinds and shades.  Shower curtains, bath mats, towels and clothes hampers.  Mops, buckets, cleaning supplies and waste baskets.  Lawnmowers, fertilizers, hoses and sprinklers.  Snow shovels and snow blowers.  Cribs, highchairs, diapers and baby food.  Etc.  All of these require manufacturers.  And all of these manufacturers require raw materials.  As well as transportation to move material and product between the stages of production.  And to our wholesalers and retailers.  More jobs.  More people earning a paycheck.  Who will one day buy their own home.  And create even more economic activity.

Bill Clinton pressured Lenders to Lower their Requirements and Subprime Lending took Off

This is why governments love housing.  And try to do everything within their power to increase home ownership.  Which is why they changed the path to home ownership.  After World War II when the building of subdivisions took off there was the 3-6-3 savings and loan.  Where savings and loan paid 3% interest on savings accounts.  Loaned money to home buyers at 6%.  And were on the golf course by 3 PM.  And the mortgage was the 30-year conventional mortgage with a 20% down payment.

The conventional mortgage was the mortgage of our parents.  Who had no problem putting off their wants to save money for that 20% down payment.  They prioritized.  And planned for the future.  But the conventional mortgage has an obvious drawback.  It limits home ownership to those who can save up a 20% down payment.  Pushing home ownership further out for some.  Or just taking that option away from a large percentage of the population.  So the government stepped in.  To help those who couldn’t save 20% of the house’s price.

Mortgage Qualification Decreasing Down Payment

As we lowered the down payment amount it allowed lower-income people the opportunity of home ownership.  But it didn’t get them a lot of house.  That is, those who could afford a 20% down payment could buy more house for the same monthly payment than those who couldn’t afford it.  And a house in a better neighborhood.  Which some said was unfair.  Some in government even called it discriminatory.  As Bill Clinton did.  Who pressured lenders to lower their lending requirements to qualify the unqualified.  His Policy Statement on Discrimination in Lending helped to fix that alleged problem.  And kicked off subprime lending in earnest.  Leading to the subprime mortgage crisis.  And the Great Recession.

Conventional Wisdom was to Pay the Most you could Possibly Afford when Buying a House

But lowering the down payment wasn’t enough.  Even eliminating it all together.  The people needed something else to help them into home ownership. And to generate all of that economic activity.  And this was something the government could fix, too.  By printing a lot of money.  So banks had a lot of it to lend.  Thus keeping interest rates artificially low.  And we can see the effect this had on home ownership combined with a zero down payment.  It allowed people to buy more house for the same given monthly payment.  Even more than those buying with the 3-6-3 conventional mortgage.

Mortgage Qualification Decreasing Mortgage Rate

Falling interest rates bring in a lot more people into the housing market.  Which is good for sellers.  And good for the economy.  A lot more people than just those who could afford a 20% down payment can now buy your house.  As people bid against each other to buy your house they bid up your price.  Raising home prices everywhere.  Increasing the demand for new housing.  Which builders responded to.  Creating a housing boom.  As builders flood the market with more houses.  At higher prices.  That new homeowners move into.  And max out their credit cards to furnish.  Creating a lot of debt people are servicing at these artificially low interest rates.  But then the economy begins to overheat.  And other prices begin to rise.  Leaving people with less disposable income.  The housing boom turns into a housing bubble.  House prices are overvalued.  Those artificially low interest rates created a lot of artificial demand.  Bringing people into the market who weren’t planning on buying a house.  But decided to buy only to take advantage of those low interest rates.

Conventional wisdom was to pay the most you could possibly afford when buying a house.  For all houses gained value.  You may struggle in the beginning and have to make some sacrifices.  Say cut out steak night each week.  But in time you will earn more money.  That house payment will become more affordable.  And your house will become more valuable.  Which will let you sell it for more at a later date letting you buy an even bigger house in an even nicer neighborhood.  But when it’s cheap interest rates driving all of this activity there is another problem.  For printing money creates inflation.  And inflation raises prices.  Gasoline is more expensive.  Groceries are more expensive.  As prices rise households have less disposable income.  And have to cut out things like vacations.  And any discretionary spending on things they like but don’t need.  Which destroys a lot of economic activity.  The very thing the government was trying to create more of by printing money.  So there is a limit to the good economic times you create by printing money.  And when the bad consequences of printing money start filtering through the rest of economy the government has no choice but to contract the money supply to limit the economic damage.  And steer the economy into what they call a soft landing.  Which means a recession that isn’t that painful or long.

The Price of Artificially Low Interest Rates is Inflationary Booms, Bubbles and Great Recessions

As interest rates rise home buying falls.  Leaving a lot of newly built homes unsold on the market.  And that housing bubble bursts.  Causing home values to fall back down from the stratosphere.  Leaving a lot of people owing more on their mortgage than their houses are now worth.  What we call being ‘underwater’.  And as interest rates rise so do the APRs on their credit cards.  As well as their monthly payments.  And those people who paid the most they could possible afford for a house with an adjustable rate mortgage saw their mortgage interest rates rise.  As well as their monthly payment.  By a lot.  So much that these people could no longer afford to pay their mortgage payment anymore.  As a half-point increase could raise a mortgage payment by about $50.  A full-point could raise it close to $100.  And so on.

Increasing Monthly Payment dur to Increasing Mortgage Rate

With the fall in economic activity unemployment rises.  So a lot of people who have crushing credit card debt and a house payment they can no longer afford lost their job as well.  Causing a rash of mortgage foreclosures.  And the subprime mortgage crisis.  As well as a great many personal bankruptcies.  Causing the banking system to struggle under the weight of all this bad debt.  Add all of this together and you get the Great Recession.

This is the price of artificially low interest rates.  You get inflationary booms.  And bubbles.  That burst into recessions.  That are often deep and long.  Something that didn’t happen during the days of 3-6-3 mortgage lending.  And the primary reason for that was that the U.S. was still on a quasi gold standard.  Which prevented the government from printing money at will.  The inflationary booms and busts that come with printing money.  And Great Recessions.

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If you Missed the U.S. Subprime Mortgage Crisis you might be able to catch one in South Korea

Posted by PITHOCRATES - February 23rd, 2013

Week in Review

Stop me if you heard this one before (see S. Korea’s Poisoned Chalice of Household Debt Restricts Park by Sangwon Yoon posted 2/21/2013 on Bloomberg).

Park [Geun Hye, Korea’s incoming president] suggested state institutions could buy stakes in mortgaged apartments that have fallen in value, such as Kwon’s. The stakes would then be used as collateral for asset-backed securities, using rent from homeowners to pay interest to investors…

South Korean regulators have been working on a “soft landing” policy since June 2011, including limits on bank lending and tax breaks for homeowners switching to fixed-rate loans. About 85.8 percent of mortgages are currently adjustable…

“The quality of household debt is worsening,” said Lee Eun Mi, senior research fellow at Samsung Economic Research Institute in Seoul. Park needs “measures to stymie the rising danger of a massive default crisis…”

Some borrowers have staved off default by taking out further loans to pay mortgage interest…

Irresponsible household borrowing began after the 1997-1998 Asian financial crisis, said Kim Mi Sun, a debt counselor at a non-profit organization called Edu Money in Seoul. In the wake of corporate defaults during the crisis, the government curbed companies’ ability to sell credit, prompting banks to expand lending to consumers, including a rapid increase in home loans.

“It became so much easier to get loans after the crisis and everyone started taking out debts and mortgages they couldn’t afford,” said Kim. “The crux of the issue is that people simply don’t know how to manage their finances.”

The credit boom early in the last decade caused house prices to soar and left many Koreans with large loan obligations.

Sound familiar?  Sounds a lot like the subprime mortgage crisis, doesn’t it?  Easy credit encouraged a lot of people to buy houses they couldn’t afford with adjustable rate mortgages (ARM).  Just like in the United States following President Clinton’s Policy Statement on Discrimination in Lending.  Where the president told lenders that they had better find a way to qualify the unqualified or else.  Which they did.  With subprime lending.  And the ARM.  And when the interest rates reset at higher rates there was a massive default crisis.

Interestingly Park Geun Hye is suggesting a solution to help underwater mortgages that the U.S. used to spread the subprime mortgage crisis contagion around the world.  The collateralized debt obligation (CDO).  Fannie Mae and Freddie Mac bought the toxic subprime mortgages and packaged them into CDOs.  And unloaded them on unsuspecting investors.  Telling them that they were high yield.  And low risk.  Because their return came from the cash flows of homeowners making mortgage payments.  And what was less risky than mortgage payments?  Of course, what they failed to mention was that these were ARMs sold to low-income people who had no hope of paying their mortgage payments if interest rates ever rose.  Which they did.  Sending the fallout of the subprime mortgage crisis around the world.

No.  CDOs may not be the best solution to their problems.  And chances are that investors may not buy these.  For they were burned once by Fannie Mae and Freddie Mac.  And they’re probably not going to fall for the old ‘investment backed by cash flows from subprime mortgages’ trick again.

Amazing how some things never change.  Different place.  Different people.  But the same bad government policies.  Producing the same massive default crisis.  This is what you get when you interfere in the free market economy.  But some people never learn this lesson.  Despite the numerous examples of what not to do.  And if anyone taught people what NOT to do was the U.S. in the run-up to the subprime mortgage crisis.  Even the Americans can’t learn from their own lesson as President Obama is already talking about bringing back the policies that caused the subprime mortgage crisis in the first place.  Putting more people into houses that they can’t afford.

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The Great Housing Bubble and The Subprime Mortgage Crisis

Posted by PITHOCRATES - December 27th, 2011

History 101

Putting People into Houses trumped Sound Monetary Policy, a Sound Currency and good Lending Practices

Housing has for a long time been the key to economic prosperity.  Because to build a house you need a lot of economic activity.  Industries produce lumber, concrete, sheetrock, brick, shingles, door frames, doors, windows, glass, flooring, plumbing pipes, plumbing fixtures, sump pumps, furnaces, heating ducts, insulation, air conditioners, electrical wiring and fixtures, carpeting, tile, linoleum, etc.  The bigger the house the more of this stuff there is.  Once built people have to buy them (stimulating the mortgage banking industry) and then furnish them.  This triggers a monsoon of economic activity.  Drapes, shades, blinds, paint, washers, dryers, stoves, refrigerators, freezers, microwave ovens, toasters, blenders, food processers, plates, dishes, knives, silverware, ceiling fans, televisions, home theaters, sound systems, computers, cable and internet services, utilities, shelving, furniture, beds, cribs, art, etc.  And, of course, the exterior of the house creates further economic activity.

This is why one of the most important economic indicators is new housing starts.  For each new house we build we create a whirlwind of economic activity.  So much that it boggles the mind trying to think about it.  That’s why governments do whatever they can to stimulate this particular economic activity.  They encourage borrowing by allowing us to deduct the interest we pay on our mortgages.  They use monetary policy to keep interest rates as low as possible.  They’ve created federal programs to help veterans.  To help low income people.  And to remove risk from lenders to encourage more risky lending (as in Fannie Mae and Freddie Mac).  They’ve even used the power of government to force mortgage lenders to qualify the unqualified (Policy Statement on Discrimination in Lending).

You see, putting people into houses trumped everything else.  Sound monetary policy.  A sound currency.  Good lending practices.  Everything.  Because that was the key to a healthy economy.  A happy constituent.  And healthy tax revenue.  Not to mention you can score a lot of points with the poor and minorities by helping them into houses they can’t afford.  So this coordinated effort to put people into houses did two things.  Made money cheap and easy to borrow.  And created a boom in new housing starts.  Which resulted in a third thing.  A housing bubble.

Subprime Mortgages were for those who didn’t have Good Credit or Stable Employment with Reliable Income

Builders couldn’t build enough houses.  People were buying them faster than they built them.  And the houses they bought were getting bigger and bigger.  As they qualified for ever larger mortgages.  Poor people and people with bad credit could walk into a bank and get approved without documenting income.  House flippers could walk in day after day and get loans to buy houses.  Fix them up.  And put them back on the market.  Without using any of their own money. The market was soon flooded with new McMansions.  And refurbished smaller homes that people were moving out of.  Demand for homes was high.  And interest rates were low.  So the supply of homes swelled.  As did home prices.

Interest rates were low.  But they didn’t stay low.  All this coordinated effort to put as many people into homes as possible created a lot of artificial demand.  Heating up the economy.  Increasing prices higher than they had been.  Leading to inflationary worries.  So the Federal Reserve began to raise interest rates.  To temper that inflation.  Which didn’t sit well with those low income house owners.  Who got into their homes with the help of the Policy Statement on Discrimination in Lending.  Which forced lenders to get creative in qualifying the unqualified.  To avoid undo federal attention.  And legal actions against them.  So a lot of poor people had subprime mortgages.  As did all of those house flippers.  People who used little of their own money.  Who put little down.  And had little to lose.

What is a subprime mortgage?  In a word, risky.  It isn’t a 30-year fixed-rate mortgage at a good interest rate.  No, for those you need a good credit score and years of stable employment with reliable income.  And enough money saved up to put close to 20% down.  Subprime mortgages were for those who didn’t have a good credit score.  Years of stable employment with reliable income.  Or any savings.  These people didn’t get the ‘prime’ mortgages.  They got the expensive ones.  The ones with the higher interest rates.  And the higher monthly payments.  Why?  Because risk determined the interest rate.  And the higher the risk the higher the interest rate.

In their Effort to sustain Economic Activity the Government caused the Worst Recession since the Great Depression

But this posed a problem.  Because of the Policy Statement on Discrimination in Lending.  Making loans available to the unqualified was no good if the unqualified couldn’t afford them.  Enter the adjustable rate mortgage (ARM).  These mortgages had lower interest rates.  And lower monthly payments.  How you ask?  By making them adjustable.  A fixed-rate mortgage has to account for inflation.  And adjustable-rate mortgage doesn’t.  Because if there is inflation and the interest rates go up the ARM resets to a higher value.  Which is what happened right about the time housing prices peaked.

When the ARMs reset a lot of people couldn’t make their monthly payments anymore.  Having put little down and having made few monthly payments, these homeowners had little to lose by walking away from their homes.  And a lot of them did.  Including those house flippers.  And that was just the beginning.  With higher interest rates the new home market contracted.  Those artificially high house prices began to fall.  And when the ARMs reset they caused an avalanche of defaults and foreclosures.  The market was correcting.  There were far more houses for sale than there were buyers looking to buy.  Home values began to fall to reflect this real demand.  People who bought the biggest house they could afford because they thought real estate prices always went up soon discovered that wasn’t true.  People were making monthly payments on a mortgage that was greater than the value of their house.  Some walked away.  Some got out with short sales.  Where the lender agreed to eat the loss equity.

The housing market was imploding.  Thanks to a great real estate bubble created by the government.  In their quest to put as many people into houses as possible.  By making mortgages cheap and easy to get.  Relaxing lending standards.  And encouraging risky lending.  None of which would have happened had they left the housing market to market forces.  Where the market sets interest rates.  And housing prices.  The irony of the subprime mortgage crisis is that in their effort to sustain economic activity the government caused the worst recession since the Great Depression.  The Great Recession.

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LESSONS LEARNED #35: “Not only is ignorance bliss, but it’s a godsend to Big Government.” -Old Pithy

Posted by PITHOCRATES - October 14th, 2010

If Jefferson Could Talk from the Grave He’d Be Hoarse from Shouting by Now

Politicians.  They’re all the same.  Well, most of them.  They enter politics for one thing.  For a career.  And what do people want from a career?  Great success.  Great prestige.  Great wealth.  Great power.  And a little revenge.  The pencil-neck, computer-nerd geek takes great pleasure in seeing a jock from his high school days emptying his trash while boarding his private jet. “Those wedgies and swirlies were a bitch but look at us now.”  It’s true.  The best revenge is living well.

But some people lack any talent or ability.  Some of them will never amount to anything.  They’ll never know the joy of looking down on people better than them with sweet condescension.  So these people go into politics.  Where people with no talent or ability can live well.  It’s a simple formula.  Sell your soul.  Whore yourself out.  Shake down businesses with taxation and regulation (and get even with all those people who have far more talent and ability than you ever had).  Collect tribute.  Consolidate power.  Hold those you serve in contempt.

Lord Acton wrote in 1887, “Power tends to corrupt, and absolute power corrupts absolutely.”  A century earlier, Thomas Jefferson fought tirelessly to prevent great money and federal power from conjoining.  The Old World capitals consolidated money and power.  And this concentrated the money and power into fewer and fewer hands.  Kings ruled by whim.  And oppressed their hapless subjects.  It’s a story as old as time.  And is still true today.  To the great chagrin of Jefferson.

Go West, Young Man

The transcontinental railroad was making poor progress during the Civil War.  Because it was starved for capital.  No one would invest.  Few doubted that they could build it.  Even if they could, few doubted it would ever make money.  The West was mostly raw, unsettled land.  There was nothing to transport.  Nothing to earn revenue.  It was a huge investment with a huge risk.  Investors are smart when it comes to money.  And they saw the transcontinental railroad as a one-way road that their money would go down and never return.  They needed something.  Big Government.

When it comes to throwing money away on a losing investment there is but one place to go.  Uncle Sam.  With the power to tax, the federal government has huge piles of money to play with.  So here’s what happened to build that railroad.  Union Pacific (UP) created a shell company called Crédit Mobilier (CM) to finance and build the railroad.  These companies were one and the same.  Without getting too complicated, UP sold their ‘worthless’ stock to CM at par.  Now, CM being a finance and construction company, a train never had to run over the road they were building to make a profit.  Union Pacific, on the other hand, needed trains running on that new track.  They were a transportation company.  They earned a profit from transporting goods on their trains.  This meant it could take years before UP could even hope to earn a profit on the new transcontinental railroad.  CM, on the other hand, could start earning a profit with the first invoice they submitted for construction.  And they did.

CM had strong revenues.  They submitted grossly inflated construction invoices to UP.  UP added a small construction management fee and submitted them to the government.  The government paid UP.  UP paid CM.  With revenues far exceeding their costs, CM made obscene profits.  CM stock took off into the stratosphere.  Some of which was sold to Congressmen at a deep discount who in turn realized obscene capital gains if they sold their stock.  Or collected obscene dividends if they held onto their stock.  In return for this sweetheart deal, they approved all cost overruns.  Killed any legislation unfavorable to UP/CM.  Provided lucrative incentives to build track on the worst ground in the most indirect path (to maximize the railroad’s mineral rights).  Provided little to no oversight on the construction of the road (some track was built on ice, with cheap steel and flimsy wooden trestles wherever possible).  When east met west the different railroads kept on building, parallel to each other to keep billing Uncle Sam.  All paid by the public treasury.  By the taxpayer.  The little guy.  Being raped and pillaged by their own representatives.

Affordable Housing for Those Who Vote Democrat

Politicians buy votes.  Pad the federal payroll.  Steal from the treasury.  Break the law.  Violate our trust.  You know, politician stuff.  Because of the inconvenience of elections, they can’t be too blatant about their rape and pillage.  So they do things that are in the best interest of the public.  Or so they say.  Like affordable housing.  You see, the Left buys the votes of the poor and minorities by throwing bones to them.  And there are a lot of minorities in the inner cities of the bluest of blue cities.  So they threw big bones to them.  Houses.

Despite their War on Poverty, the Left just can’t help these people.  The truth is, of course, that they don’t want to help them.  If they’re poor and dependent on the government, the Left can count on their vote.  If they escape poverty and don’t need Big Government to provide for them, these people are of no use to the Left.  Ergo, they never escape poverty.

Of course, the problem of remaining in abject poverty is that you can’t qualify for a mortgage.  Banks are funny that way.  They only loan money to people who can pay them back.  So they declined a lot of mortgages to these poor inner city minorities.  Well, this was just too good for Big Government to pass up.  A large group of minorities (i.e., a large Democrat voting bloc) being denied mortgages?  Why, that’s racism.  So they drafted a lot of legislation and unleashed their justice department with extreme prejudice.  The message?  Approve these loans.  Or face the consequences (revoking a bank’s charter, a federal lawsuit, a public demonstration headed by Jesse Jackson, Charlie Rangel, et al, etc.).  So they found creative ways to approve loans.  And they got a little help from Uncle Sam.

The Subprime Mortgage Crisis is a Lot Like the Crédit Mobilier Scandal

By a little I mean a lot.  Uncle Sam screwed the mortgage bankers by making them approve extremely risky loans.  So, to help the mortgage bankers, Uncle Sam screwed the American people.  They guaranteed those highly risky mortgages, thus transferring the risk from them to us, the taxpayer.  And to further mitigate the bankers’ risks, they purchased a lot of those highly risky mortgages to remove them from the banks’ balance sheets.  It’s called the secondary mortgage market.  And the primary players are none other than Fannie Mae and Freddie Mac, ground zero of the subprime mortgage crisis.

Once upon a time, a mortgage was one of the safest investments.  People saved up to pay a 20% down payment.  With their life savings invested, people paid their mortgage payment and they paid them on time.  And if you could afford a 20% down payment, mortgage bankers had a lot of confidence that you would be able to service your mortgage.  But in the day of 5%, 3% and 0% down, a person doesn’t have a whole lot to lose.  This makes the first few years of these mortgages especially risky.  The introduction of ‘no documentation’ mortgages meant people could lie about their income (or include overtime earnings).  Add to that the Adjustable Rate Mortgage (ARM) and the interest-only mortgage and you just made these especially risky mortgages even more risky.  Sure, these will get almost anyone into a home, but they get in by the skin of their teeth.  But if they lose their overtime due to a weakened economy, if their interest rate on their ARM resets at a higher rate or a balloon payment is due on their interest-only loan, guess what?  That stream of mortgage payments could very well stop.

Now that would be a BIG problem.  Because of what Freddie and Fannie did with those mortgages they bought.  They sliced them up and built creative investment vehicles.  Derivatives.  Mortgage backed securities called collateralized debt obligations.  Wall Street repackaged all these risky mortgages into highly profitable investments.  Everybody bought them.  Pension funds.  Trust funds.  In America.  And throughout the world.  Big gains with a low risk.  Or so it would seem.  You see, they never eliminated the risk.  They only transferred it to someone else.  And once people couldn’t pay their mortgage payments anymore, the house of cards came crashing down.  We call it the subprime mortgage crisis of 2008.  It caused a worldwide recession.  And cost the American taxpayer dearly.  Even those not born yet.

Yes We Can…Screw the American Taxpayer

The subprime mortgage crisis of 2008 is a government creation.  Their quest of affordable housing to buy votes put more and more people into houses they couldn’t afford.  They created legislation akin to extortion of the banking industry.  They used the Justice Department to apply the muscle for that extortion.  They had their friends in the media and the activists for racial equality to further pressure the banking industry.  Their lack of oversight of Fannie and Freddie (thank you Barney Frank and Chris Dodd) let them make extremely risky loans.  And their policies of buying extremely risky mortgages ultimately transferred all risk to the taxpayer.  Why?  Because like all good government scandals, the seekers of favors rewarded our representatives well for their complicity with sweetheart mortgage deals, vacation junkets, fat contributions to their campaign war chests, etc.  In other words, politics as usual.  But on a grand scale.

Why do they do it?  Because they can.  They count on you being ignorant of history.  And accepting every lie they tell you.  Because they hold you in contempt.  They look down on you with sweet condescension.  These pencil-neck geeks who could never amount to anything on their own merit or ability.  But some sold souls later and they have finally gotten even with those who were better than them.  And here they are.  Still living well.  Even during the worst recession since the Great Depression.

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LESSONS LEARNED #8: “Of course Social Security will fail; that’s what Ponzi Schemes do.” –Old Pithy

Posted by PITHOCRATES - April 8th, 2010

IT’S ONE OF the oldest scams in the book.  The Ponzi scheme.  It takes some creative lying.  Or a cold heart that can stab trusted friends in the back.  Like Bernie Madoff did.

When it comes to investing large sums of money, people would rather do so with someone they know and trust.  And so it is in the Jewish community.  Madoff’s investment funds were very profitable.  And hard to get into.  So when he worked his Jewish circles, the response was favorable.  Everyone wanted in.

Madoff targeted Jewish charities.  Not for the philanthropy in his heart, but for something characteristic about charities who invest.  Charities work on the interest earned on the principal of their investments.  The principal is parked and rarely withdrawn.  And this is ideal for a Ponzi scheme. 

With all that ‘parked’ money it was easy to sustain the lie.  It was easy to write small checks; the payouts for the returns on investment were only a fraction of the total fund.  When an individual wanted to withdraw his money, it was easy to write that check, too.  Those big investments could sustain the fraud for years without worry.  Madoff was happy.  The investors were happy.

MADOFF CONFOUNDED ANALYSTS who could not understand how he could be so consistently profitable, even when other investment funds were showing losses in bad economic times.  Of course, when you have nothing invested, it is easy to avoid market fluctuations.  As long as your pile of money doesn’t run out.

But with the financial crisis kicked off by the subprime mortgage crisis in 2008, that pile of money did run out.  Madoff’s investors were losing money elsewhere and needed to withdraw their money from his fund to cover those losses.  And when people start withdrawing their principal from a Ponzi scheme the house of cards comes crashing down.

And that’s what happened.  Madoff went to jail.  This is usually how a Ponzi scheme ends.  In case you’re thinking about trying this.  First crash.  Then jail.  It’s just a matter of time.  Eventually people start pulling out their principal.  For whatever reason.  Even if you got about as perfect a group of investors as possible.  As in Madoff’s case.  If you don’t believe me, you can ask Bernie.  During visiting hours.

AND SPEAKING OF the subprime mortgage crisis, there were elements in that crisis that were very Ponzie-like.  At the heart of this crisis was affordable housing for people with sh*tty credit. 

HUD was pressuring lenders to loan to people who could not qualify for loans.  Advocacy groups representing various ethnic groups and nationalities sued.  But no advocacy representing those who had no chance in hell of repaying a loan sued.  Funny, for the banks did discriminate against these people.

Anyway, new laws and regulatory pressure as well as lawsuits (and threats of lawsuits) eventually forced lenders to lend to the unqualified.  Then Fannie Mae and Freddie Mac bought the risky, subprime loans.  Problem solved.  All of them.  Right?

Wrong.  They used some creative financing to approve the unqualified.  The one thing to really come back and bite us in the ass was the Adjustable Rate Mortgage (ARM).  You can’t afford to make recurring mortgage payments?  Okay, no problem.  We’ll just make those payments smaller.  We’ll use an ARM which gives you a lower interest rate as well as a lower payment.  You just refinance later when rates go up.  After you’ve built up some equity in your home.

I’m approved?!?  Great!  Thank you!  Refinance?  What?

They may not have understood that part but they signed on the dotted line.  Interest rates at the time were very low.  As were their monthly payment.  They could just squeak by.  Everything was cool.  Until the interest rates went up.

ALL THIS PRESSURE to loan money to the unqualified and the low interest rates caused a housing boom.  The boom became a bubble.  Then the bubble burst.  House values fell.  Interest rates went up.  Then the interest rate on AMRs went up. 

With a lower house value, a new mortgage would have lower collateral (i.e., the house).  So even if they could qualify, they couldn’t borrow enough to pay off the original mortgage.  So they were stuck with a mortgage payment they could no longer afford.  And they couldn’t refinance.  Their only choice was to default.  And default they did.  Lots of them.  Perhaps most of them.  And the subprime mortgage industry imploded.

Why is this like a Ponzi scheme?  Well, looking back at it with hindsight, there was no other possible outcome of these governmental policies.  When you force institutions to loan money to people who don’t qualify for a loan chances are that they will default.  If two people ask you for a loan and one had good credit and the other did not, who are you going to loan your money too?  If it’s your money you’re going to be very careful.  If it’s not your money, you going to do what is politically expedient and give the money to people who will vote for you.

THE SUBPRIME MORTGAGE crisis resulted from governmental policies in place to raise political capital.  The unqualified got the houses so government got the political capital.  Fannie Mae and Freddie Mac were buying those subprime mortgages, repackaging them and reselling them.  They were making money and could make political contributions.  Everybody was getting something.  Before the house of cards fell, that is.

And all of this was based on the lie that people who couldn’t qualify to buy a house could somehow buy a house.  In other words, it was a fraudulent investment.  Like a Ponzi scheme, it would work as long as there was a net cash flow into the system.  A rising interest rate, though, changed all that. 

SWINDLERS OFTEN GET tripped up by things beyond their control.  The subprime mortgage crisis was the undoing of Bernie Madoff.  A rising interest rate was the undoing of the subprime mortgage scheme.  And a declining population growth rate will be the undoing of Social Security.  In time.  Because, in time, all Ponzi schemes fail.

www.PITHOCRATES.com

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