If the U.S. was on a Gold Standard there would NOT have been a Financial Crisis in 2007

Posted by PITHOCRATES - June 9th, 2013

Week in Review

Counterfeiting money is against the law.  We all know this.  But do we understand why?  Today’s money is just fiat money.  The Federal Reserve prints it and simply says it is money.  So why is it okay for them to print money but not for anyone else?  Because the amount of money in circulation matters.

The goods and services that make up our economy grow at a given rate.  You hear numbers like GDP of 2%, 3% or more.  In China they had GDP numbers in excess of 8%.  The goods and services in our economy are what have value.  Not the money.  It just temporarily holds the value of these goods and services as they change hands in the economy.  So the amount of money in circulation should be close to the value of goods and services in the economy.  Think of a balancing scale.  Where on the one side you have the value of all goods and services in the economy.  And on the other you have the amount of money in circulation.  If you increase the amount of money on the one side it doesn’t increase the amount of goods and services on the other side.  But it still must balance.  So as we increase the amount of money in circulation the value of each dollar must fall to keep the scale in balance.

Now when we put our money into the bank for our retirement we don’t want the value of those individual dollars grow less over time.  Because that would reduce the purchasing power of our money in the bank.  Making for an uncomfortable retirement.  This is why we want a stable dollar.  One that won’t depreciate away the value of our retirement savings, our investments or the homes we live in.  We’d prefer these to increase in value.  But we can stomach if they just hold their value.  For awhile, perhaps.  But we cannot tolerate it when they lose their value.  Because when they do years of our hard work just goes ‘poof’ and disappears.  Leaving us to work longer and harder to make up for these losses.  Perhaps delaying our retirements.  Perhaps having to work until the day we die.  So we want a stable currency.  Like the gold standard gave us (see Advance Look: What The New Gold Standard Will Look Like by Steve Forbes posted 5/8/2013 on Forbes).

The financial crisis that began in 2007 would never have happened had the Federal Reserve kept the value of the dollar stable. A housing bubble of the proportions that unfolded–not to mention bubbles in commodities and farmland–would not have been possible with a stable dollar. The Fed has also created a unique bubble this time: bonds. It hasn’t popped yet (nor has the farmland bubble), but it will.

The American dollar was linked to gold from the time of George Washington until the early 1970s. If the world’s people are to realize their full economic potential, relinking the dollar to gold is essential. Without it we will experience more debilitating financial disasters and economic stagnation.

What should a new gold standard look like? Representative Ted Poe (R-Tex.) has introduced an original and practical version. Unlike in days of old we don’t need piles of the yellow metal for a new standard to operate. Under Poe’s plan–an approach I have long favored–the dollar would be fixed to gold at a specific price. For argument’s sake let’s say the peg is $1,300. If the price of gold were to go above that, the Federal Reserve would sell bonds from its portfolio, thereby removing dollars from the economy to maintain the $1,300 level. Conversely, if the gold price were to drop below $1,300, the Fed would “print” new money by buying bonds, thereby injecting cash into the banking system.

Yes, the subprime mortgage crisis and the Great Recession would not have happened if the Federal Reserve kept the dollar stable.  Instead, they kept printing and putting more money into circulation.  Why?  To keep interest rates low.  To encourage more and more people to buy a house.  Even people who weren’t planning to buy a house.  Even people who couldn’t afford to buy a house.  Until, that is, subprime lending took off.  Because of those low interest rates.  With all of these people added to the housing market who otherwise would not have been there (because of the Federal Reserve’s monetary policies of printing money to keep interest rates artificially low) the demand for new houses exploded.  As people tried to buy these before others could house prices soared.  Creating a great housing bubble.  Houses worth far greater than they should have been.  And when the bubble burst those housing prices fell back to earth.  Often well below the value of the outstanding balance of the mortgage on the house.  Leaving people underwater in their mortgages.  And when the Great Recession took hold a lot of two-income families went to one-income.  And had a mortgage payment far greater than a single earner could afford to pay.

So that’s how that mess came about.  Because the Federal Reserve devalued the dollar to stimulate the housing market (and any other market of big-ticket items that required borrowed money).  If we re-link the dollar to gold things like this couldn’t happen anymore.  For if it would put a short leash on the Federal Reserve and their ability to print dollars.  How?  As they print more dollars the value of the dollar falls.  Causing the value of gold priced in dollars to rise.  So they would have to stop printing money to keep the value of gold priced in dollars from rising beyond the established gold price.  Or they would have to remove dollars from circulation to decreases the value of gold priced in dollars back down to the established price.  Thereby giving us a stable currency.  And stable housing prices.  For having a stable currency limits the size of bubbles the Federal Reserve can make.

But governments love to print money.  Because they love to spend money.  As well as manipulate it.  For example, depreciating the dollar makes our exports cheaper.  But those export sales help fewer people than the depreciated dollar harms.  But helping a large exporter may result in a large campaign contribution.  Which helps the politicians.  You see, a stable dollar helps everyone but the politicians and their friends.  For printing money helps Wall Street, K Street (where the lobbyists are in Washington DC) and Pennsylvania Avenue.  While hurting Main Street.  The very people the politicians work for.



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The UAW and Public Sector Unions devastate Three Michigan Cities

Posted by PITHOCRATES - February 24th, 2013

Week in Review

It’s not been a good year for Detroit.  Well, it’s been more than a year.  It’s been a few bad years.  Actually, it’s been a great many bad years.  Since 1970.  When Ford Motor Company Chairman Henry Ford II joined with other business leaders to form Detroit Renaissance.  To revitalize the City of Detroit.  And some 42 years later, the City of Detroit is still struggling (see Detroit’s Misery Can Be Its Turning Point by Micheline Maynard posted 2/23/2013 on Forbes).

Detroit boosters were dealt a one-two blow this week by the kind of outsiders they have come to resent.

First, a state review panel declared that a financial emergency existed in the city, making it likely that Michigan Gov. Rick Snyder will appoint an emergency financial manager with sweeping powers.

Then, Forbes weighed in by declaring Detroit the nation’s most miserable city, based on a series of criteria that include crime, unemployment, foreclosures and home value…

Although General Motors is based in Detroit, and Chrysler recently opened an office there, the automobile industry is not going to provide the vast numbers of jobs the city needs to become solvent.

And there lies the problem for Detroit.  A city that grew big and rich off of the automobile industry saw a steady exodus and a declining tax base when the automobile industry declined.  Live by the automobile.  Die by the automobile.  And it’s just not Detroit.  A couple of other Michigan cities broke into the top 10 of Forbes’ America’s Most Miserable Cities 2013.

#7 Warren, Mich.

Troy and Farmington Hills are part of the government-defined Warren metro division. Like Detroit, the Warren metro has seen home prices collapse–off 53% the past five years.

#2 Flint, Mich.

Flint has been demolishing homes as the city shrinks with residents leaving in search of jobs. Only Detroit has a higher net out-migration rate. Flint ranks third worst for violent crime, behind Detroit and Memphis.

#1 Detroit, Mich.

Violent crime in the Detroit metro was down 5% in 2011, but it remains the highest in the country with 1,052 violent crimes per 100,000 people, according to the FBI. Home prices were off 35% the past 3 years, which is the biggest drop in the U.S.

If you seek a pleasant peninsula* you’d do better looking for one where the UAW isn’t dominant.  Perhaps Florida.  For the UAW is a city killer based on these Michigan cities.  (*The official state motto of Michigan is “If you seek a pleasant peninsula, look about you.”)

The Big Three dominated these cities.  Where fat pay and benefit packages were passed on to consumers in overpriced vehicles.  The Big Three’s monopoly on car sales allowed them to make fat profits.  And pay enormous amounts of taxes to the cities that had the factories that assembled their cars.  City coffers were so flush with cash city governments grew.  And city workers enjoyed fat pay and benefit packages.  This was the high water mark of the UAW.  Just after public sector unions had joined them on the gravy train.  But then something happened that devastated the UAW.  Consumers got choice.  They no longer had to buy overpriced ‘rust buckets’ the Big Three was putting out during the Seventies.  For the Japanese gave them choice.

And so began the great decline of the Big Three.  Quality and value did them in.  It’s what the people wanted.  While the UAW wanted consumers to pay more and get less.  So they could continue to enjoy their fat pay and benefit packages.  As the jobs went away so do did the taxes.  The cities bloated with all those government workers with their fat pay and benefit packages tried to maintain the size of their governments even while the tax base was declining.  Reducing other government services as they had little money left over after paying those fat pay and benefit packages.

With fewer and fewer jobs available people left these cities.  Empty houses dotted the horizon.  And housing prices fell.  With the tax base continuing to decline.  Poverty rates rose.  As did city services for the impoverished.  Leaving even less for other city services.  Causing a further exodus from the city.  Urban blight followed.  As did crime.  Causing a further decline in property values.

Low interest rates helped boost housing prices.  For awhile.  President Clinton’s Policy Statement on Discrimination in Lending kicked off subprime lending in earnest as lenders bowed to the Clinton Justice Department to put more low-income and minorities into homes they couldn’t afford.  Creating a huge housing bubble.  Built on easy credit.  Artificially low interest rates.  And the adjustable rate mortgage (ARM).  When rates went up all those low-income and minorities who bought houses they couldn’t afford defaulted on their higher mortgage payments.  Creating the subprime mortgage crisis.  Giving us the Great Recession.  Creating a flood of foreclosures.  A free fall in housing prices.  And more of the same that helped put those three Michigan cities into the top ten of Forbes’ America’s Most Miserable Cities 2013.

Michigan recently opted to become a Right-to-Work state.  Greatly angering the UAW and those public sector unions.  But it may be just what Michigan needs to reverse the great decline caused by the UAW and the public sector unions that devastated some of Michigan’s greatest cities.  One thing for sure it can’t get any worse.  Not when being a union state for so long secured three places in the top ten of Forbes’ America’s Most Miserable Cities 2013.



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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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Versailles Treaty, Marshall Plan, Post-War Japan, MITI, Asian Tigers, Japan Inc., Asset Bubbles, Deflationary Spiral and Lost Decade

Posted by PITHOCRATES - February 21st, 2012

History 101

Douglas MacArthur brought some American Institutions into Japan and unleashed a lot of Human Capital

At the end of World War I the allies really screwed the Germans.  The Treaty of Versailles made for an impossible peace.  In a war that had no innocents the Allies heaped all blame onto Germany in the end.  And the bankrupt Allies wanted Germany to pay.  Placing impossible demands on the Germans.  Which could do nothing but bankrupt Germany.  Because, of course, to the victors go the spoils.  But such a policy doesn’t necessarily lead to a lasting peace.  And the peace following the war to end all wars wasn’t all that long lasting.  Worse, the peace was ended by a war that was worse than the war to end all wars.  World War II.  All because some corporal with delusions of grandeur held a grudge.

The Americans wouldn’t repeat the same mistake the Allies made after World War II.  Instead of another Versailles Treaty there was the Marshal Plan.  Instead of punishing the vanquished the Americans helped rebuild them.  The peace was so easy in Japan that the Japanese grew to admire their conqueror.  General Douglas MacArthur.  The easy peace proved to be a long lasting peace.  In fact the two big enemies of World War II became good friends and allies of the United States.  And strong industrial powers.  Their resulting economic prosperity fostered peace and stability in their countries.  And their surrounding regions.

MacArthur changed Japan.  Where once the people served the military the nation now served the people.  With a strong emphasis on education.  And not just for the boys.  For girls, too.  And men AND women got the right to vote in a representative government.   This was new.  It unleashed a lot of human capital.  Throw in a disciplined work force, low wages and a high domestic savings rate and this country was going places.  It quickly rebuilt its war-torn industries.  And produced a booming export market.  Helped in part by some protectionist policies.  And a lot of U.S. investment.  Especially during the Korean War.  Japan was back.  The Fifties were good.  And the Sixties were even better. 

By the End of the Seventies the Miracle was Over and Japan was just another First World Economy 

Helping along the way was the Ministry of International Trade and Industry (MITI).  The government agency that partnered with business.  Shut out imports.  Except the high-tech stuff.  Played with exchange rates.  Built up the old heavy industries (shipbuilding, electric power, coal, steel, chemicals, etc.).  And built a lot of infrastructure.  Sound familiar?  It’s very similar to the Chinese economic explosion.  All made possible by, of course, a disciplined workforce and low wages.

Things went very well in Japan (and in China) during this emerging-economy phase.  But it is always easy to play catch-up.  For crony capitalism can work when playing catch-up.  When you’re not trying to reinvent the wheel.  But just trying to duplicate what others have already proven to work.  You can post remarkable GDP growth.  Especially when you have low wages for a strong export market.  But wages don’t always stay low, do they?  Because there is always another economy to emerge.  First it was the Japanese who worked for less than American workers.  Then it was the Mexicans.  Then the South Koreans.  The three other Asian Tigers (Hong Kong, Singapore and Taiwan).  China.  India.  Brazil.  Vietnam.  It just doesn’t end.  Which proves to be a problem for crony capitalism.  Which can work when economic systems are frozen in time.  But fails miserably in a dynamic economy.

But, alas, all emerging economies eventually emerge.  And mature.  By the end of the Seventies Japan had added automobiles and electronics to the mix.  But it couldn’t prevent the inevitable.  The miracle was over.  It was just another first world economy.  Competing with other first world economies.  Number two behind the Americans.  Very impressive.  But being more like the Americans meant the record growth days were over.  And it was time to settle for okay growth instead of fantastic growth.  But the Japanese government was tighter with business than it ever was.  In fact, corporate Japan was rather incestuous.  Corporations invested in other corporations.  Creating large vertical and horizontal conglomerates.  And the banks were right there, too.  Making questionable loans to corporations.  To feed Japan Inc.  To prop up this vast government/business machine.  With the government right behind the banks to bail them out if anyone got in trouble.    

Low Interest Rates caused Irrational Exuberance in the Stock and Real Estate Markets

As the Eighties dawned the service-oriented sector (wholesaling, retailing, finance, insurance, real estate, transportation, communications, etc.) grew.  As did government.  With a mature economy and loads of new jobs for highly educated college graduates consumption took off.  And led the economy in the Eighties.  Everyone was buying.  And investing.  Businesses were borrowing money at cheap rates and expanding capacity.  And buying stocks.  As was everyone.  Banks were approving just about any loan regardless of risk.  All that cheap money led to a boom in housing.  Stock and house prices soared.  As did debt.  It was Keynesian economics at its best.  Low interest rates encouraged massive consumption (which Keynesians absolutely love) and high investment.  Government was partnering with business and produced the best of all possible worlds.

But those stock prices were getting way too high.  As were those real estate prices.  And it was all financed with massive amounts of debt.  Massive bubbles financed by massive debt.  A big problem.  For those high prices weren’t based on value.  It was inflation.  Too much money in the economy.  Which raised prices.  And created a lot of irrational exuberance.  Causing people to bid up prices for stocks and real estate into the stratosphere.  Something Alan Greenspan would be saying a decade later during the dot-com boom in the United States.  Bubbles are bombs just waiting to go off.  And this one was a big one.  Before it got too big the government tried to disarm it.  By increasing interest rates. But it was too late.

We call it the business cycle.  The boom-bust cycle between good times and bad.  During the good times prices go up and supply rushes in to fill that demand.  Eventually too many people rush in and supply exceeds demand.  And prices then fall.  The recession part of the business cycle.  All normal and necessary in economics.  And the quicker this happens the less painful the recession will be.  But the higher you inflate prices the farther they must fall.  And the Japanese really inflated those prices.  So they had a long way to fall.  And fall they did.  For a decade.  And counting.  What the Japanese call their Lost Decade.  A deflationary spiral that may still be continuing to this day.

As asset prices fell out of the stratosphere they became worth less than the debt used to buy them.  (Sound familiar?  This is what happened in the Subprime Mortgage Crisis.)  Played hell with balance sheets throughout Japan Inc.  A lot of debt went bad.  And unpaid.  Causing a lot problems for banks.  As they injected capital into businesses too big to fail.  To help them service the debt used for their bad investments.  To keep them from defaulting on their loans.  Consumption fell, too.  Making all that corporate investment nothing but idle excess capacity.  The government tried to stop the deflation by lowering interest rates.  To stimulate some economic activity.  And a lot of inflation.  But the economy was in full freefall.  (Albeit a slow freefall.  Taking two decades and counting.)  Bringing supply and prices back in line with real demand.  Which no amount of cheap money was going to change.  Even loans at zero percent.



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LESSONS LEARNED #24: “You cannot lobby a politician unless he or she is for sale.” -Old Pithy

Posted by PITHOCRATES - July 29th, 2010

BUILDING A RAILROAD ain’t cheap.  It needs dump trucks of money.  Especially if it’s transcontinental.  And that’s what the Union Pacific and the Central Pacific were building.  Starting during the Civil War in 1863 (the year Vicksburg fell and Lee retreated from Gettysburg).  The Union Pacific was building west from Iowa.  And the Central pacific was building east from California. 

For the most part, Protestant, English-speaking Americans settled Texas.  Mexico had encouraged the American colonists to settle this region.  Because few Mexicans were moving north to do so.   The deal was that the colonists conduct official business in Spanish and convert to Catholicism.  They didn’t.  These and other issues soured relations between Mexico and the American Texans.  The Republic of Texas proclaimed their independence from Mexico.  America annexed Texas.  Mexico tried to get it back.  The Mexican-American War followed.  America won.  Texas became a state in 1845.  And that other Spanish/Mexican territory that America was especially interested in, California, became a state in 1850.  Hence the desire for a transcontinental railroad.

The U.S. government was very eager to connect the new state of California to the rest of America.  So they acted aggressively.  They would provide the dump trucks of money.  As America expanded, the U.S. government became the owner of more and more public land.  The sale of new lands provided a large amount of revenue for the federal government.  (Other forms of taxation (income taxes, excise taxes, etc.) grew as the amount of public lands to sell decreased.)  Land is valuable.  So they would grant the railroad companies some 44 million acres of land (i.e., land grants) for their use.  The railroad companies, then, would sell the land to raise the capital to build their railroads.  The government also provided some $60 million in federal loans.

But it didn’t end there.  The federal government came up with incentives to speed things up.  They based the amount of loans upon the miles of track laid.  The more difficult the ground, the more cash.  So, what you got from these incentives was the wrong incentive.  To lay as much track as possible on the most difficult ground they could find.  And then there were mineral rights.  The railroad would own the property they built on.  And any minerals located underneath.  So the tracks wandered and meandered to maximize these benefits.  And speed was key.  Not longevity.  Wherever possible they used wood instead of masonry.  The used the cheapest iron for track.  They even laid track on ice.   (They had to rebuild large chunks of the line before any trains would roll.)  And when the Union Pacific and Central Pacific met, they kept building, parallel to each other.  To lay more miles of track.  And get more cash from the government.

PAR FOR THE COURSE.  When government gets involved they can really mess things up.  But it gets worse.  Not only was government throwing dump trucks of American money down the toilet, they were also profiting from this hemorrhaging of public money.  As shareholders in Crédit Mobilier.

Thomas Durant of Union Pacific concocted the Crédit Mobilier Scandal.  As part of the government requirements to build the transcontinental railroad, Union Pacific had to sell stock at $100 per share.  Problem was, few believed the railroad could be built.  So there were few takers to buy the stock at $100 per share.  So he created Crédit Mobilier to buy that stock.  Once they did, they then resold the stock on the open market at prevailing market prices.  Which were well below $100 per share.  Union Pacific met the government requirements thanks to the willingness of Crédit Mobilier to buy their stock.  The only thing was, both companies had the same stockholders.  Crédit Mobilier was a sham company.  Union Pacific WAS Crédit Mobilier.  And it gets worse.

Union Pacific chose Crédit Mobilier to build their railroad.  Crédit Mobilier submitted highly inflated bills to Union Pacific who promptly paid them.  They then submitted the bills to the federal government (plus a small administration fee) for reimbursement.  Which the federal government promptly paid.  Crédit Mobilier proved to be highly profitable.  This pleased their shareholders.  Which included members of Congress who approved the overbillings as wells as additional funding for cost overruns.  No doubt Union Pacific/Crédit Mobilier had very good friends in Washington.  Including members of the Grant administration.  Until the party ended.  The press exposed the scandal during the 1872 presidential campaign.  Outraged, the federal government conducted an investigation.  But when you investigate yourself for wrongdoing you can guess the outcome.  Oh, there were some slaps on the wrists, but government came out relatively unscathed.  But the public money was gone.  As is usually the case with political graft.  Politicians get rich while the public pays the bill.

(Incidentally, the investigation did not implicate Ulysses Grant.  However, because members of his administration were implicated, this scandal tarnished his presidency.  Grant, though, was not corrupt.  He was a great general.  But not a shrewd politician.  Where there was a code of honor in the military, he found no such code in politics.  Friends used his political naivety for personal profit.  If you read Grant’s personal memoirs you can get a sense of Grant’s character.  Many consider his memoirs among the finest ever written.  He was honest and humble.  A man of integrity.  An expert horseman, he was reduced to riding in a horse and buggy in his later years.  Once, while president, he was stopped for speeding through the streets of Washington.  When the young policeman saw who he had pulled over, he apologized profusely to the president and let him go.  Grant told the young man to write him the ticket.  Because it was his job.  And the right thing to do.  For no man, even the president, was above the law.)

THE FINANCIAL WORLD fell apart in 2007.  And this happened because someone changed the definition of the American Dream from individual liberty to owning a house.  Even if you couldn’t afford to buy one.  Even if you couldn’t qualify for a mortgage.  Even, if you should get a mortgage, you had no chance in hell of making your payments.

Home ownership would be the key to American prosperity.  Per the American government.  Build homes and grow the economy.   That was the official mantra.  So Washington designed American policy accordingly.  Lenders came up with clever financing schemes to put ever more people into new homes.  And they were clever.  But left out were the poorest of the poor.  Even a small down payment on the most modest of homes was out of their range.  Proponents of these poor said this was discriminatory.  Many of the inner city poor in the biggest of cities were minority.  People cried racism in mortgage lending.  Government heard.  They pressured lenders to lend to these poor people.  Or else.  Lenders were reluctant.  With no money for down payments and questionable employment to service these mortgages, they saw great financial risk.  So the government said not to worry.  We’ll take that risk.  Fannie Mae and Freddie Mac would guarantee certain ‘risky’ loans as long as they met minimum criteria.  And they would also buy risky mortgages and get them off their books.  Well, with no risk, the lenders would lend to anyone.  They made NINJA loans (loans to people with No Income, No Job, and no Assets).  And why not?  If any loan was likely to default it was a NINJA loan.  But if Freddie or Fannie bought before the default, what did a lender care?  And even they defaulted before, Fannie and Freddie guaranteed the loan.  How could a lender lose?

Once upon a time, there was no safer loan than a home mortgage.  Why?  Because it would take someone’s lifesavings to pay for the down payment (20% of the home price in the common conventional mortgage).  And people lived in these houses.  In other words, these new home owners had a vested interested to service those mortgages.  Someone who doesn’t put up that 20% down payment with their own money, though, has less incentive to service that mortgage.  They can walk away with little financial loss.

ARE YOU GETTING the picture?  With this easy lending there was a housing boom.  Then a bubble.  With such easy money, housing demand went up.  As did prices.  So housing values soared.  Some poor people were buying these homes with creative financing (used to make the unqualified qualify for a mortgage).  We call these subprime mortgages.  They include Adjustable Rate Mortgages (ARMs).  These have adjustable interest rates.  This removes the risk of inflation.  So they have lower interest rates than fixed-rate mortgages.  If there is inflation (and interest rates go up), they adjust the interest rate on the mortgage up.  Other clever financing included interest only mortgages.  These include a balloon payment at the end of a set term of the full principal.  These and other clever instruments put people into houses who could only afford the smallest of monthly payments.  The idea was that they would refinance after an ‘introductory’ period.  And it would work as long as interest rates did not go up.  But they went up.  And house prices fell.  The bubble burst.  Mortgages went underwater (people owed more than the houses were worth).  Some people struggled to make their payments and simply couldn’t.  Others with little of their own money invested simply walked away.  The subprime industry imploded.  So what happened, then, to all those subprime mortgages?

Fannie and Freddie bought these risky mortgages.  And securitized them.  They chopped and diced them and created investment devices called Collateralized Debt Obligations (CDOs).  These are fancy bonds backed by those ‘safe’ home mortgages.  Especially safe with those Fannie and Freddie guarantees.  They were as safe as government bonds but more profitable.  As long as people kept making their mortgage payments.

But risk is a funny thing.  You can manage it.  But you can’t get rid of it.  Interest rates went up.  The ARMs reset their interest rates.  People defaulted.  The value of the subprime mortgages that backed those CDOs collapsed, making the value of the CDOs collapse.  And everyone who bought those CDOs took a hit.  Investors around the globe shared those losses. 

Those subprime loans were very risky.  Lenders would not make the loans unless someone else took that risk.  The government took that risk in the guise of Fannie and Freddie.  Who passed on that risk to the investors buying what they thought were safe investments.  Who saw large chunks of their investment portfolios go ‘puff’ into thin air.

SO WHAT ARE Freddie and Fannie exactly?  They are government-sponsored enterprises (GSEs).  They key word here is government.  Once again, you put huge piles of money and government together and the results are predictable.  In an effort to extend the ‘American Dream’ to as many Americans as possible, the federal oversight body for Freddie and Fannie lowered the minimum criteria for making those risky loans.  Even excluding an applicant’s credit worthiness from the application process (so called ‘no-doc’ loans were loans made without any documentation to prove the credit worthiness of the applicant.)  To encourage further reckless lending.  Ultimately causing the worst financial crisis since the Great Depression. 

And, of course, members of Congress did well during the good times of the subprime boom.  They got large campaign contributions.  Some sweetheart mortgagee deals.  A grateful voting bloc.  And other largess from the profitable subprime industry.  Government did well.  Just as they did during the Crédit Mobilier Scandal.  And the American taxpayer gets to pay the bill.  Some things never change.  Government created both of these scandals.  As government is wont to do whenever around huge piles of money.  For when it comes to stealing from the government, someone in the government has to let it happen.  For it takes a nod and a wink from someone in power to let such massive fraud to take place. 



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