Friday, October 15, 2010
Monetary Mess, the Dollar, Gold—and You, Part IV
(For previous parts in this series, scroll down and click on the links in the righthand column.)
Governments in the developed countries now inflate their money by expanding credit rather than by printing more paper currency. This is a far more powerful method, more complicated, and thus not so obvious to the general public. It enables politicians to disguise the cost of social and economic benefits they promise in return for the votes to keep themselves in office. And it makes it easy for them to blame others (e.g. banks, brokers, “speculators,” etc.) for the problems caused by government credit expansion and the regulatory bureaucracy. Then they pose as saviors by advocating more of the same and claiming that will “prevent this from ever happening again.”
The financial crisis began with Fannie Mae and Freddie Mac, the largest factors in housing and banking, which are among the most heavily regulated aspects of the economy. These agencies are where the credit expansion occurred that made them larger than the Federal Reserve—and even larger than the gross domestic product of Japan, the third-largest economy in the world. This credit bubble was not the product of free markets or capitalism but the antithesis. It was the product of federal laws, regulations, politics and malfeasance by regulatory agencies.
The banks are regulated by four separate agencies: the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency. Fannie and Freddie are federally chartered “government sponsored enterprises” (GSEs) that were regulated primarily by the Office of Federal Housing Enterprise Oversight (OFHEO) until 2008 when it was merged with various other agencies into a new Federal Housing Finance Agency. Congress and the President have control of the GSE budgets and programs in every sense. They exempted them from state and local taxes, authorized them to sell mortgage-backed securities, provided them with unlimited guarantees on their mortgages and the ability to borrow at preferential rates. There never was a shortage of regulatory agencies or powers to regulate. Or special advantages.
Fannie Mae was founded in 1938 in response to many homeowners losing their homes to foreclosure during the Great Depression. In 1968 the federal government converted Fannie Mae into a private shareholder corporation to remove its accounts from the balance sheet of the federal budget. This was a time of increased spending for Lyndon Johnson's Great Society and the Viet Nam war. So, like the Greek government in more recent times, the LBJ administration chose to hide the extent of its spending by simply removing a large expenditure from government accounting. In 1970 the government created Freddie Mac to supplement Fannie Mae.
In 2003 Freddie Mac was fined $125 million by OFHEO for accounting irregularities, and in 2007 it was fined $50 million by the SEC for accounting fraud. In 2006, OFHEO discovered “a wide variety of unsafe and unsound practices” at Fannie Mae. Its report stated: “Fannie Mae's faults were not limited to violating accounting and corporate governance standards, but included excessive risk-taking and poor risk management as well.” Fannie Mae was fined $400 million and ordered to restate its earning from prior years by an estimated $11 billion.
The Federal Housing Administration (FHA) is actually older than Fannie Mae, having been founded in 1934. It, too, was part of Franklin Roosevelt's New Deal effort to expand credit to home buyers in the depression and enhance his popularity with voters. While much smaller than Fannie and Freddie before the recent collapse of the mortgage bubble, it has since grown enormously. Yet John Berlau, a scholar at the Competitive Enterprise Institute, says it had significant involvement in the bubble: “The collapse of whole segments of the housing market can be traced to FHA-subsidized mortgage products.” FHA loans, he says, “have been at the center of some of the worst excesses of the housing boom, including mortgage fraud, loans made without income verification, and property 'flipping' with inflated appraisals.” Senator Susan Collins, who headed a 2001 Senate investigation, said, “The federal government has essentially subsidized much of this fraud.” FHA mortgages originally required down payment of 20 percent, but that was whittled down over the years to 3 percent.
During the Carter administration, the Community Reinvestment Act of 1977 (CRA) purported to remedy “redlining”—racial discrimination by banks denying mortgages in black neighborhoods. The evidence for such discrimination was feeble and misleading. Most applicants were approved regardless of race, and the slightly higher rejection for minorities reflected their poorer credit history. But the banks were now required to open new branches in low-income areas and to have a certain percentage of their small-business loans and home mortgages located there. They were also prevented from opening new branches in other—untroubled—areas if they failed to maintain this ratio.
From 1977 to 1991, $9 billion were announced for CRA lending commitments. Then came the 1992 Federal Housing Enterprises Financial Safety Act, also known as the GSE Act. This contained 'affordable housing' requirements which resulted in Fannie and Freddie acquiring $6 trillion in single-family loans over the next 16 years. According to Edward Pinto, former chief credit officer at Fannie Mae:
Acorn and other community groups were informally deputized by then House Banking Chairman Henry Gonzalez to draft statutory language setting the law's affordable-housing mandates....The goal of the community groups was to force Fannie and Freddie to loosen their underwriting standards, in order to facilitate the purchase of loans made under CRA....Thus a provision was inserted into the law whereby Congress signaled to the GSEs that they should accept down payments of 5% or less, ignore impaired credit if the blot was over one year old, and otherwise loosen their lending guidelines.
Initially, the affordable-housing mandate was set at 30 percent of single-family mortgages purchased by Fannie and Freddie. In 1995, Henry Cisneros, President Clinton's secretary of housing and urban development, directed Fannie and Freddie to buy the mortgages of low- and moderate-income borrowers amounting to 42 percent of their annual business volume. His successor Andrew Cuomo upped that to 50 percent and directed the GSEs to buy mortgages from borrowers with “very low income.” Banks ended up having to make more and more “subprime” loans and agreeing to dangerously lax underwriting standards—no down payment, no verification of income, interest-only payment plans, and weak credit history. By 2007, HUD's affordable housing regulations required 55 percent of all the GSE loans to be made to borrowers at or below the median income, with almost half of these required to be low-income borrowers.
The credit bubble was now inflated to the bursting point. But when it burst, it was not government but the banks that took the blame. The virulently anti-business and anti-capitalist Obama was quick to decry the “fat-cat bankers on Wall Street,” the “greedy” and “irresponsible” lenders who pushed subprime mortgages on the poor and vulnerable who couldn't afford them and now were losing their homes. The Obama-adoring news media, still in love with him since the early days of the presidential campaign, flooded the public with stories about how the economic misery was due to businesses run amuck in the reckless pursuit of profit and the lack of regulation. What was needed, according to the politicians, commentators and opinion makers who dominated the media coverage was greater regulation “to prevent this from ever happening again.” The question of whether the problems had been caused by regulation in the first place never seemed to come up.
Nor did the issue of whether the federal government should even be involved in the housing market. Republicans as well as Democrats overwhelmingly supported the idea that government should help the poor, the down-trodden to achieve the “American Dream” of owning a home. And they certainly did not want to incur the wrath of voters by being perceived as unsympathetic to the poor and against programs for their betterment. Rather, they wanted voters to see them as caring and compassionate—and be willing to vote for them. In 2002 President George W. Bush, having Republican control of both houses of Congress, signed the Single-Family Affordable Housing Tax Credit Act. This Renewing the American Dream program provided almost $2.4 billion in tax credits to investors and builders developing single-family housing in poor and distressed areas. In 2003 he signed the American Dream Downpayment Act, which provided $200 million per year 2004-2007 toward down payment and closing costs for home buyers.
The idea that home ownership was a socially desirable goal that should be promoted by the government led to a vast, incredibly expensive, decades-long effort, but how effective was it? Home ownership in the U.S. peaked at 69 % at the top of the housing bubble and is now 67%. But there are at least 14 countries that have higher ownership rates than the U.S., including Hungary, Iceland, and Poland. In the European Union, where most countries don't offer tax breaks and subsidies like the U.S., home ownership was just shy of 75% in 2006, according to Eurostat. Homeownership in the U.S. increased by only 3.4 percentage points over the last 20 years, the period of the the U.S. government's greatest efforts to promote it. In the Netherlands and Italy, it increased by 12 percentage points between 1991 and 2008.
Canadian banks weathered the international financial crisis much better than U.S. banks. Canada has nothing comparable to Fannie or Freddie or our Community Reinvestment Act. It does not have 30-year fixed-rate mortgages, and interest on mortgages is not tax deductible. Down payments of less than 20 percent require the mortgage holder to buy mortgage insurance. Canada's regulatory agency concerns itself with risk management and abstains from social and political objectives, such as affordable housing and diversity. Yet it has a home ownership rate of 68%, and the percentage of mortgage loans delinquent for more than 90 days is approximately one-tenth of the U.S. level. A comparison to the U.S. shows two very different housing finance systems, one much more political and riskier than the other, with no advantage to the U.S. system.
For Part V of this series, click on this link.