The Opportunity Cost of Debt

Posted by PITHOCRATES - September 16th, 2013

Economics 101

Housing Sales drive the Economy because almost Everything for Sale is for the Household

Once upon a time the rule of thumb was to buy the most expensive house we could possibly afford.  We saved 20% for a down payment on a conventional mortgage.  We lived on a shoestring budget and paid our mortgage no matter what.  Even if we had to live on meatloaf and macaroni and cheese for the next five years.  Or longer.  We did this because we would be paying that mortgage payment for 30 years.  And though tough at first during those 30 years we advanced in our careers.  And made more money along the way.  Making that mortgage payment easier to pay as time went by.

So that was the way it used to be.  And it was that way for a long time.  Until the Federal Reserve started playing with interest rates to stimulate economic activity.  Altering the banking system forever.  Instead of encouraging people to save their money so banks could loan money to homebuyers they printed money.  Flooded the market with it.  Ignited inflation.  And caused housing bubbles.  Then the government took it up a notch.

Housing sales drive the economy.  Almost everything for sale is for the household.  Furniture and appliances.  Beds and ceiling fans.  Tile and paint.  Cleaning supplies and groceries.  Dishes and cutlery.  Pots and pans.  Towels and linen.  Lawnmowers and weed-whackers.  Decks and patio furniture.  When people buy a house they start buying all of these things.  And more.  Creating a lot of economic activity with every house sold.  So the government did everything they could to encourage home ownership.  And few governments did more than the Clinton administration.  By applying pressure on lenders to qualify the unqualified for mortgages.  Which gave us the subprime mortgage crisis.

Lenders used Subprime Lending to Qualify the Unqualified to Comply with the Clinton Administration

People in poor neighbors tended to be poor.  And unable to qualify for a mortgage because they couldn’t afford the house payments.  When these poor people happened to be black the Clinton administration said the banks were racist.  They were redlining.  And advised these lenders that if they don’t start qualifying these people who couldn’t afford a house that the full weight of the government will make things difficult for them to remain in the lending business.  So they complied with the Clinton administration.  Using subprime lending to put people into homes they couldn’t afford.

The main reason why people can’t afford to buy a house is the size of the mortgage payment.  Which can be pretty high if they can’t afford much of a down payment.  So these lenders used special mortgages to bring that monthly payment down.  The adjustable rate mortgage (ARM).  Which had a lower interest rate than conventional mortgages.  Because they could raise it later if interest rates rose.  Zero-down mortgages.  Which eliminated the need for a down payment.  Coupled with an ARM when interest rates were low could put a poor person into a good sized house.  No-documentation loans.  Which removed the trouble of having to document your earnings to prove you will be able to make your house payment.  Making it easier to approve applicants when you don’t have to question what they write on their application.  Interest-only loans where you only had to pay the interest for, say, 5 years.  Greatly reducing the size of the monthly payment.  But after those 5 years you had to pay that loan back in full with a new mortgage for the full value of the house.  Which may be more costly in 5 years.

So these lenders were able to meet the Clinton administration directive.  They were putting people into homes they couldn’t afford.  Just barely.  These people had house payments they could just barely afford.  Thanks to the low interest rate of their ARM.  But then interest rates rose.  Making those mortgage payments unaffordable.  With zero-down they had little to lose by walking away.  And a lot of them did.

The Interest on the Debt is so large we have to Borrow Money to Pay for the Cost of Borrowing Money

Buying a house is a huge investment.  One that we finance.  That is, we borrow money.  Sometimes a lot of it.  Because we don’t want to wait and save money for a down payment.  And because we want so much right now we buy as much as we can with those borrowings.  Doing whatever we can to lower the monthly payment.  With little regard to long-term costs.  For example, assume a fixed 30-year interest rate of 4.5%.  And we finance a $150,000 house with zero down.  Because we have saved nothing.  The monthly payment will be $790.03.  But if we waited until we saved enough for a 10% down payment that monthly payment will only be $684.03.  And if we saved enough for 20% down the monthly payment will only be $608.02.  That’s $182.01 less each month.  The total interest paid over the life of this mortgage for zero down, 10% down and 20% down is $123,610.07, $111,249.06 and $98,888.05, respectively.  Adding that to the price of the house brings the total cost for that house to $273,010.07, $246,249.06 and $218,888.05, respectively.  So if we wait until we save a 20% down payment we will be able to buy a $150,000 house and $54,723.02 of other stuff during those 30 years.  This is the opportunity cost of debt.

We are better off the less we finance.  Because long-term debts are with us for a long time.  And they don’t go away if we lose our job.  Or if interest rates go up.  Like with an ARM.  A large driver of the subprime mortgage crisis.  Let’s see what was happening before the housing bubble burst.  Let’s say we could buy that $150,000 house with a zero down mortgage with an adjustable interest rate of 2%.  Giving us a monthly payment of $554.43.  Very affordable.  Which helped get a lot of people into houses they couldn’t afford.  But then the interest rate went up.  And what did that do to someone who could just barely pay their house payment when it was $554.43?  Well, if it reset to 4% that payment increased to $716.12 ($161.69 more per month).  If it reset to 6% that payment increased to $899.33 ($344.90 more per month).  Bringing the total cost of the house to $323,757.28 ($150,000 principle + 173,757.28 interest).  Which is why a lot of these people walked away from these houses.  There was just no way they could afford them at these higher interest rates.

Interest payments on long-term debt at high interest rates can overwhelm a borrower.  Making the Clinton administration’s Policy Statement on Discrimination in Lending insidious.  It destroyed people’s lives.  Putting them into houses they couldn’t afford with subprime lending.  But if you think that’s bad consider the national debt.  These are long-term obligations just like mortgages.  And currently we owe $16,738,533,025,135.63 (as of 9/13/2013).  At an interest rate of 3.9% the annual interest we must pay on this debt comes to $652,802,787,980.29.  That’s $652.8 billion.  Which is more than we spend on welfare ($430.4 billion).  Almost what we spend on Social Security ($866.3 billion).  And more than half of the federal deficit ($972.9 billion).  This is the opportunity cost of debt.  It limits what we can spend elsewhere.  On welfare.  Social Security.  Etc.  The interest on the debt has grown so large that we even have to borrow money to pay for the cost of borrowing money.  And there is only one way this can end.  Just like the subprime mortgage crisis.  Only worse.

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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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Without a Bill Clinton the Bursting of the Canadian Housing Bubble will be less Painful than in the US

Posted by PITHOCRATES - November 10th, 2012

Week in Review

The subprime mortgage crisis caused the Great Recession.  And bad government policy caused the subprime mortgage policy.  First with artificially low interest rates to encourage everyone to borrow money and take on enormous amounts of debt.  Then the Clinton administration took it up a notch.  By charging lenders with discrimination in their lending practices.  And if they didn’t find a away to qualify the unqualified for mortgages they would soon find themselves out of the mortgage business.  So they came up with subprime lending.  Adjustable rate mortgages (ARM).  No documentation mortgages.  Anything to get the government off of their backs.  And the government was so pleased with what they saw they started to buy (and/or guarantee) those toxic mortgages with their Government Sponsored Enterprises Fannie Mae and Freddie Mac.  Clearing those toxic mortgages from the lenders balance sheet by unloading them onto unsuspecting investors.  Clearing the way for even more toxic subprime lending.  The government was pleased.  And the bankers were making money with bad lending practices.  Something they normally would have avoided because it is very risky.  But when the government was transferring that risk to the taxpayer what did they have to lose?

Governments like a hot real estate market.  Because housing sales drives so much economic activity.  Because people put a lot of stuff into those houses.  Which is why governments are always quick to use their monetary authority to lower interest rates.  Which is what they did in the US.  Cheap money to borrow.  Lax lending practices thanks to the Clinton administration.  Creating a housing boom.  And a housing bubble.  It was a perfect storm brewing.  The only thing that it needed was a raise in the interest rates.  Which came.  Causing the subprime mortgage crisis as those ARMS reset at higher interest rates.  Leading to a wave of subprime mortgage defaults.  And the Great Recession.  Which raced around the world thanks to those toxic mortgages Fannie Mae and Freddie Mac unloaded on unsuspecting investors.

Canada did not suffer as much from the Great Recession.  Because they did not pressure their lenders to qualify the unqualified like Bill Clinton did in the US.  But they still used their monetary authority to keep interest rates artificially low.  So while they escaped the great damage the Americans suffered in their subprime mortgage they still have a housing bubble.  And it looks like it may be time for it to burst (see Analysis: Canada braces as housing slowdown takes hold by Andrea Hopkins posted 11/10/2012 on Reuters).

Long convinced the country’s housing boom would never end in a crash, Canadians have watched this autumn as a sharp slowdown in real estate spreads across the country, leaving would-be home buyers hopeful and sellers scared…

Signs are everywhere that Canada’s long run-up in house prices is over, hit by a combination of tighter mortgage lending rules and growing consumer reluctance to take on more debt. Sales of existing homes are down steeply, with condo sales hit especially hard, and some long-booming prices have started to fall…

Canadian households hold more debt than American families did before the U.S. housing bubble burst, which has led the government to tighten mortgage lending rules four times in four years…

Tal believes slower sales activity will be followed by falling prices in many cities. But he says Canadian lending standards have been higher, and borrowers more cautious, than in the United States before its crash, which will prevent large-scale mortgage defaults and plunging prices.

Mindful of what happened in the United States, the Canadian government has tightened mortgage rules to prevent home buyers from taking on too much debt. While interest rates are low and expected to stay low into 2013, the fear is that eventual rate hikes will drive borrowers out of their homes or into bankruptcy…

The last round of mortgage rule changes took effect in July, forcing home buyers to cut back on their budget and pushing many prospective first-time buyers out of the market entirely.

The Canadians may escape the damage the US suffered as Bill Clinton was an American and not a Canadian.  So they only have to suffer the effects of bad monetary policy.  Not the effects of government enforced bad lending practices.  So housing prices will fall in Canada.  And there will probably be a recession to correct those inflated real estate prices.  But housing prices probably will not fall as far as they did in the US.  For the Canadians were more responsible with their irresponsible monetary policy than the Americans were.

The lesson here is that when markets determine interest rates housing bubbles are smaller and recessions are less painful.  If you don’t believe that just ask an American with an underwater mortgage.

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The Left still attacks Free Market Capitalism and the Invisible Hand despite the Left’s Record of Economic Failure

Posted by PITHOCRATES - April 14th, 2012

Week in Review

No matter how many times their policies fail those on the left never give up.  The free market capitalism that gave us the Industrial Revolution was not as good as the mercantilism it replaced.  The free market capitalism that won World War II was not as good as Nazi Germany’s National Socialism.  The free market capitalism that won the Cold War was not as good as the Soviet Union’s communism.   No, any economic system that doesn’t place smart people in the government (and from our most prestigious universities) in charge is an inferior economic system.  At least, according to those on the Left (see There Is No Invisible Hand by Jonathan Schlefer posted 4/10/2012 on the Harvard Business Review).

One of the best-kept secrets in economics is that there is no case for the invisible hand. After more than a century trying to prove the opposite, economic theorists investigating the matter finally concluded in the 1970s that there is no reason to believe markets are led, as if by an invisible hand, to an optimal equilibrium — or any equilibrium at all. But the message never got through to their supposedly practical colleagues who so eagerly push advice about almost anything. Most never even heard what the theorists said, or else resolutely ignored it.

Interesting.  Using the economists of the Seventies as the authoritative position for government interventionism into the economy.  Why, that would be like having the captain of the Titanic being the authority on how to miss icebergs in the North Atlantic. 

The Seventies were the heyday of Keynesian economics.  Where the government was aggressively intervening into things economic.  And the results of their policies were so bad that we had to create new words to describe it.  Like stagflation.  A heretofore unheard of phenomenon.  And something that just wasn’t supposed to happen when the Keynesians used inflation to lower unemployment.  But it did.  Even though you weren’t supposed to get inflation and high unemployment at the same time.  Stagflation.  Like we did.  In the Seventies.

Believing far too credulously in an invisible hand, the Federal Reserve failed to see the subprime crisis coming. The principal models it used literally assumed that markets are always in instantaneous equilibrium, so how could a crisis occur? But after the crisis exploded, the Fed dropped its high-tech invisible-hand models and responded with full force to support the economy.

The subprime mortgage crisis was a government-made crisis.  Precisely because government refused to allow the Invisible Hand to guide the market place.  Instead they stepped in.  Forced lenders to make risky subprime loans to people who couldn’t qualify for a mortgage.  With tools like the infamous Adjustable Rate Mortgage (ARM).  And then they had Fannie Mae and Freddie Mac buy those risky mortgages.  To get them off the lenders’ balance sheets so they would make more risky loans.  Then Freddie and Fannie chopped up these risky loans and repackaged them into ‘safe’ investments to unload them to unsuspecting investors.  Getting these toxic mortgages off of their balance sheets.  (In case you don’t know, Fannie and Freddie are Government Sponsored Enterprises (GSE).  Which are for all intents and purposes the government.)  This house of cards imploded when the Fed raised interest rates.  After keeping them below what the Invisible Hand would have set them at for far too long.  The government created the real estate bubble.  Then blew it up when those higher interest rates reset all the AMR mortgage payments beyond the homeowner’s ability to pay.

There are many economists in the world.  And the consensus of economic thought tends to be one that supports large government intervention.  Which proves the economic consensus is wrong.  For if history supported this consensus the Soviet Union would have won the Cold War.  East Germany would have absorbed West Germany.  China would not be experimenting in ‘Invisible Hand’ capitalism.  And Cuba wouldn’t be experimenting with a little capitalism themselves to fix their broken government command economy.

All these market failures economists like to point to aren’t market failures.  They are the unintended consequences of government intervention into the market.  As the subprime mortgage crisis clearly proved.  Which never would have happened in the first place if the government didn’t try to be smarter than the Invisible Hand.

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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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Keynesian Economics gave us the Subprime Mortgage Crisis, but the Government blames S&P

Posted by PITHOCRATES - August 20th, 2011

We call it the Subprime Mortgage Crisis, not the Mortgage-Backed Securities Crisis 

When responsible for a problem you can accept blame.  Or you can blame the messenger.  Or better yet, you can attack the messenger (see Criticism of Standard & Poor’s over U.S. credit rating compounds its troubles in Washington by Jim Puzzanghera, Los Angeles Times, posted 8/18/2011 on WGNtv).

The backlash against Standard & Poor’s for downgrading the U.S. credit rating adds to the company’s problems in the nation’s capital, where it faces investigations for its role in fueling the financial crisis with faulty assessments of mortgage-backed securities.

S&P and the other credit-rating firms are widely believed to have enabled the near market meltdown by giving AAA ratings to many securities backed by risky subprime mortgages.

So the credit-rating firms enabled the subprime mortgage crisis.  Interesting.  Because the bad subprime mortgages already existed by the time those mortgage-backed securities came to them for review.  And it was those preexisting mortgages that people defaulted on and caused the near market meltdown.  So I don’t think you can blame this all on S&P.  And remember, we call it the subprime mortgage crisis.  Not the mortgage-backed securities crisis.  Ergo, the cause was the subprime mortgages.  And S&P didn’t write those mortgages.

Subprime Mortgages:  Creative Financing to Qualify the Unqualified

Once upon a time you saved up 20% for the down payment on a new house.  Then you went to a savings and loan to get a mortgage.  Or a bank.  In those days, people saved their money.  They deposited it into their savings accounts and earned 3% interest.  The banks and savings and loans then loaned it at 6%.  And the bankers were on the golf course by 3 PM.  Hence the joke about the 3-6-3 industry.  It wasn’t very sexy.  But it was reliable.  Few defaulted.  Because a new home owner had a lot to lose from day 1 thanks to that 20% down payment.

But there was a problem with this.  Home ownership was restricted to only those people who could afford to buy houses.  Those who could put down a 20% down payment.  And who had a job with sufficient income to qualify for a mortgage.  Well, you can see the problem with this.  What about the poor people who couldn’t come up with the 20% down payment nor had a job with sufficient income to qualify for a mortgage?

After World War II home ownership became a national goal.  Home ownership equaled economic growth.  It became the American dream (no longer was it the liberty that the Founding Fathers gave us).  As the years went by some saw that the poor were being left out.  Included in that long list of those who could not qualify for a mortgage were a lot of blacks.  Activists claimed that banks were redlining.  Disapproving a larger percentage of black applicants than white.  There were protests.  Investigations.  Banks had to figure out a way to qualify the unqualified and fast.  To prove that they weren’t being racist.

And the subprime mortgage was born.   Adjustable Interest Rate (ARM).  No documentation.  Zero down.  Interest only.  All kinds of creative financing to qualify the unqualified for mortgages.  And it was a hit.  Poor people liked them.  But banks were still reluctant to issue many of them.  Because they were far more risky than a conventional mortgage.  And it was dangerous to have too many of them on their books.  But then federal government solved that problem.

Fannie and Freddie enabled the Mortgage Lenders to Approve Risky Mortgages

Enter Fannie Mae and Freddie MacGovernment Sponsored Enterprises.  They would buy (or guarantee) those risky mortgages from the banks.  The banks breathed a huge sigh of relief.  Then started selling the crap out of subprime mortgages.  Because they were exposed to no risk thanks to Fannie and Freddie.  And the housing market took off.  The government urged Fannie and Freddie to lower their standards and buy even more risky mortgages.  To keep the housing boom alive.  And they did.  Not only were home owners snatching them up.  But speculators, too.  And the term ‘house flipping‘ entered the American lexicon.

Fannie and Freddie then repackaged the subprime mortgages they bought and resold them.  Into so-called ‘safe’ investments.  Thanks to being tied to a mortgage, historically one of the safest investments in America.  Well, they were when people were putting 20% down, at least.  So these mortgage back securities were created.  Reviewed by the credit-rating agencies.  And sold to investors, mutual funds, pension funds, 401(k)s, etc.  Who bought them with abandon.  Because they were rated AAA.  Long after those risky mortgages were written.

They were time bombs just waiting to go off.  Not because of the credit rating agencies.  But because of Fannie and Freddie.  Who enabled the mortgage lenders to approve risky mortgages with no risk to themselves.  And a long standing government policy to put as many people as possible into homes.  Because economic growth all came from home ownership.  And then it happened.  There was a housing bubble thanks to easy monetary policy.  The economy was heating up.  Worried about inflation, the Fed tapped the brakes.  Raised interest rates.  And all of those ARMs reset at higher rates.  People couldn’t afford the new higher monthly payments.  The higher interest rates left the speculators with lots of houses.  That they bought with no money down.  That no one was buying.  And, well, the rest you know.

The Greatest Threat to American Fiscal Solvency is the Government’s growing Health Care Tab 

So S&P didn’t cause the subprime mortgage crisis.  Whether they gave those securities AAA ratings or not those subprime mortgage holders were going to default anyway.  The origins of the subprime mortgage crisis reach a lot further back than S&P.  But their credibility did take a hit.  So they’re trying to be a little more cautious these days.  And if anyone paid attention during the debt ceiling debates, they know the country’s long-term finances are in some serious trouble.

Jeffrey Miron wrote a paper about the health of the U.S. states.  He starts in the introduction by going over the state of affairs in the federal government (see The Fiscal Health of U.S. States by Jeffrey Miron posted 8/15/2011 on Mercatus Center).

As the worldwide financial crisis has eased, economic policy debates have shifted from the short-term issue of stabilization to the log-term issue of fiscal imbalance.  Current projections suggests that the U.S. federal government faces an exploding ratio of debt to GDP, driven in large part by spending on health insurance1.  If this trend continues, the United States will soon find itself unable to roll over its debt and be force to default, generating a fiscal crisis.

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1  U.S. Congressional Budget Office, “CBO’s 2011 Long-Term Budget Outlook” (Washington, DC: CBO, June 2011)

Perhaps this is why S&P downgraded U.S. debt.  Because that debt ceiling deal did nothing to address the greatest threat to American fiscal solvency.  The government’s growing health care tab.  The nation indeed may be seeing some difficult times.  As will the states.

This paper offers five conclusions. First, state government finances are not on a stable path; if spending patterns continue to follow those of recent decades, the ratio of state debt to output will increase without bound. Second, the key driver of increasing state and local expenditures is health-care costs, especially Medicaid and subsidies for health-insurance exchanges under the Patient Protection and Affordable Care Act of 2009. Third, states have large implicit debts for unfunded pension liabilities, making their net debt positions substantially worse than official debt statistics indicate. Fourth, if spending trends continue and tax revenues remain near their historical levels relative to output, most states will reach dangerous ratios of debt to GDP within 20 to 30 years. Fifth, states differ in their degrees of fiscal imbalance, but the overriding fact is that all states face fiscal meltdown in the foreseeable future.

Not a pretty picture.  This whole European Socialism model is pushing both the states and the country to default.  Like it is currently pushing European nations toward default in the Eurozone.  Whose financial crisis is worst than America’s.  So far.

Keynesian Economics stimulated the Housing Market into the Granddaddy of all Housing Bubbles 

Social engineering.  Tax and spend liberalism.  Keynesian economics.   These are what gave us the subprime mortgage crisis.  Putting people into houses who couldn’t afford them.  And keeping interest rates artificially low to stimulate the housing market into the granddaddy of all housing bubbles.  The subprime mortgage crisis.  And more of the same will only push us further down the Eurozone road.  Sadly, a road often taken throughout history.  As once great nations fell, littering this road.  The Road to Serfdom.

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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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Who’s a Bigger Crook? Christine O’Donnell or Your Typical Senator?

Posted by PITHOCRATES - September 22nd, 2010

Christine O’Donnell, Republican candidate for the Joe Biden’s Senate seat in Delaware, is apparently a crook.  Or so says Melanie Sloan, executive director of the nonpartisan Citizens for Responsibility and Ethics in Washington (CREW).  According to Sloan she embezzled campaign funds and evaded taxes.  Like Timmy Giethner.  Charlie Rangel.  And [enter any Democrat or RINO here].  Oh my.

Sloan said, “…Republicans and Democrats don’t agree on much these days, but both sides should agree on one point: Thieves belong in jail, not the United States Senate.”  (See O’Donnell embezzlement accusation called ‘frivolous’ on the Washington Times website).   She’s a little late.  The Senate is a den of thieves.  If O’Donnell is a crook, she’ll fit right in.  If not, maybe she can make a difference.  Make the business of the Senate about the people and not the Senators’ pockets.

Yes, embezzlement is bad.  But the rape and pillage of a nation is a tad bit worse.  And by a ‘tad’ I mean whole frickin’ lot.

Perhaps I’m not being fair.  I mean, both congressional chambers are corrupt.  It was their legislation, after all, that caused the current recession/depression.  The subprime mortgage crisis.  Putting people into houses who had no chance in hell of paying off their mortgages.  The whole point of a subprime mortgage was to help unqualified people get qualified for a mortgage.  Why?  The government was reviewing their books.  And if they didn’t like what they saw, well, they made it known.  And, of course, any deficiency in minority approvals guaranteed a visit from Jesse Jackson or some other fair housing advocate.  The message was clear.  Approve.  Or else.  And they did. Then all those ARM interest rates reset.  And, well, you know the rest of the story.

It’s kind of funny.  Not in a ‘ha ha’ kind of way but more of a tragic, ironic way.  By trying to put more people into houses we may end up making more people homeless.  Which sometimes happens when a long-ass recession turns into depression.  Funny.  That wacky government.

I don’t know much about Christine O’Donnell.  But she has an ‘R’ next to her name.  And if we get enough ‘R’s in the Senate perhaps we’ll be able to return to the good old days.  When gridlock ruled.  Remember those days?  Good times.  One thing you can say about gridlock.  It’ll be a whole lot harder to create another subprime mortgage crisis if the government can’t conspire against the people.

It’s hard to take an attack on a Republican serious anymore.  With the biased media and their talking points, the Hollywood elite and the college professors corrupting our youth, it’s worse than the fable of the boy who cried wolf.  After awhile you just lose credibility.  When you know what they will say before they say it, what they say just doesn’t matter anymore.  We get it.  Republican bad.  Why?  Because they’re Republican.  ‘Nuff said.

I don’t know about you, but that’s just a weak argument.

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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.

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