Mortgage Crisis, the Dollar and its Future, Part 2

John Berlau, a scholar at the Competitive Enterprise Institute, says, “The collapse of whole segments of the housing market can be traced to FHA-subsidized mortgage products. Despite its decreasing market share, the FHA appears to have played a significant role in the current mortgage 'meltdown' attributed to subprime loans. For the past three years, [FHA] delinquency rates have consistently been higher than even those of the dreaded subprime mortgages...[and]...nearly twice as high as the rate for all mortgages.”

Berlau also notes: “FHA-insured loans have also 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.” These allegations have been documented by Congressional probes and investigative newspaper reporting. Senator Susan Collins of Maine, who headed a 2001 Senate investigation of mortgage fraud, said, “The federal government has essentially subsidized much of this fraud.” Over the years, FHA's down payment requirement of 20 % was gradually whittled down to 3 %. That was a result of the agency trying to compete for market share by making its own standards even more “subprime” than those of the private sector.

Fannie Mae and Freddie Mac own or guarantee 45 percent of all U.S. home-loan mortgages,. These giant agencies don't make loans. They are forbidden from doing so. Instead they buy mortgages from banks, bundle them into securities, and then resell these to investors. This “securitizing” of mortgages doesn't require Fannie or Freddie to hold a mortgage on its books any longer than it takes to package and resell it. Once a mortgage is off the books, the agency's capital is freed up to do the same thing all over again. Hence the potential for a credit bubble in the housing market. Fannie and Freddie have grown explosively since 1990. In 1990 their combined holdings of mortgages and related securities was $136 billion. In 2004 it was $1.6 trillion. Three years later it was $4.8 trillion.

In May 2006 the Office of Federal Housing Enterprise Oversight (OFHEO) announced a $400 million civil penalty against Fannie Mae for accounting manipulations. The agency discovered “a wide variety of unsafe and unsound practices.” Its report shows “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 was ordered to restate its earnings from prior years by an estimated $11 billion.

In 2003, Freddie Mac was fined $125 million by OFHEO for accounting irregularities and ordered to restate earnings 2000-2002 by $5 billion. In September 2007 Freddie was fined $50 million, this time by the SEC, for accounting fraud that deceived investors, and four former key officials including a CFO, COO and two senior vice presidents, who profited from the scheme, were required to repay ill-gotten gains.

In the housing boom following the tech-stock bubble in 2000, Wall Street investment firms started dominating the lucrative business pioneered by Fannie and Freddie of bundling mortgages into securities. But Wall Street was selling them world-wide, spreading the credit bubble far beyond our shores. By the end of 2006 the total U.S. residential mortgage debt was $10.3 trillion, almost double the level of just six years earlier.

Fannie Mae and Freddie Mac are not government agencies. They are private corporations established by federal charters, implicitly backed by the U.S. government. Government-backed financial institutions have been known to fail. In the savings-and-loan debacle in the 1980s, more than 1,000 S & Ls collapsed. The Federal Savings and Loan Insurance Corporation, which had been in existence since 1934 to guarantee depositors funds, became insolvent. Though recapitalized several times by Congress with multi-billion dollar infusions of taxpayer money, the FSLIC by 1989 was deemed too insolvent to save and was abolished. Overall, the S & L bailout cost taxpayers an estimated $124 billion. For a brief period in the 1980s, Fannie Mae was losing about $1 million a day and was technically insolvent.

The feeling that mortgages are backed by the federal government undoubtedly led investors to be less circumspect than they otherwise would have been. “Unsafe and unsound practices” and “excessive risk taking and poor risk management” escaped scrutiny behind the government guarantee. Inadequate recognition of risk coupled with the explosive growth of Fannie and Freddie produced the potential for a gigantic financial disaster. Even though the mortgages were sold to other investors, Fannie and Freddie for a fee still guaranteed that payments would be made on the loans. So when the banks divided the securitized mortgages and repackaged them in SIVs (structured investment vehicles) and CDOs (collateralized debt obligations), the mortgage payments were still federally guaranteed. And the banks would collect a fee for imaginatively repackaging and selling the SIVs and CDOs.

The situation was made worse by home-equity loans, which exploded during the housing boom. Home owners took advantage of rising home values and tapped their equity to fund spending or leverage other investments. Some took out “piggyback loans,” which allowed them to borrow as much as 100 percent of a home's value by combining a mortgage with a home-equity loan. The value of home-equity loans stood at $1.1 trillion in the third quarter of 2007.

It was a boom time for the home building industry. With easy credit terms available, many people bought homes who couldn't afford them and would eventually lose them to foreclosure. Others, who were better off, were buying second and third homes as investments, with little or no money down. Home buying was stimulated by people's experience of seeing homes appreciate over the years while the dollar lost purchasing power through inflation. Money is a medium of exchange, but it is also store of value; in fact, it must be a store of value before it can be a medium of exchange. It is often lamented that the U.S. has a low rate of saving, but why should people save dollars that will be worth less in future years? A significant threat of inflation is always an incentive for people to try to get out of the currency, to spend now before the money loses value, or to find an alternative asset which will serve as a store of value. Home ownership was regarded in this manner. Home buying was viewed as a “safe” investment and one likely to appreciate with inflation rather than be eroded by it. Certainly the real estate market, within the memory of most Americans, was much more stable than the stock market. For all these reasons, money poured into the home building industry until the supply of housing outstripped the demand. Then prices started coming down. And the mountain of debt started to crumble.

Banks have been blamed for creating the subprime mortgage crisis by making risky loans to borrowers who did not meet standards of creditworthiness, but the federal government forced them to do so. Boston Globe columnist Jeff Jacoby explains: "The crisis has its roots in the Community Reinvestment Act of 1977, a Carter-era law that purported to prevent 'redlining'—denying mortgages to black borrowers—by pressuring banks to make home loans in 'low- and moderate-income neighborhoods.' ...The CRA [was] made even more stringent during the Clinton administration....Banks nationwide thus ended up making more and more ‘sub-prime’ loans and agreeing to dangerously lax underwriting standards―no down payment, no verification of income, interest-only payment plans, weak credit history....Trapped in a no-win situation entirely of the government’s making, lenders could only hope that home prices would continue to rise, staving off the inevitable collapse. But once the housing bubble burst, there was no escape. Mortgage lenders have been bankrupted, thousands of sub-prime homeowners have been foreclosed on, and countless would-be borrowers can no longer get credit. The financial fallout has hurt investors around the world. And all of it thanks to the government, which was sure it understood the credit industry better than the free market did, and confidently created the conditions that made disaster unavoidable."

Homeowners with little equity found themselves “upside down” with their mortgages: they owed more than the homes were worth. So, many simply walked away, leaving the banks to swallow the losses. Those defaults reduced bank reserves, which further reduced capital to support credit of all types. The same thing was happening with Fannie and Freddie, which were called upon to make good on their mortgage guarantees. When borrowers fall behind on their loan payments, Fannie and Freddie must buy those loans and recognize a loss on any drop in market value below the amount they paid for them. At the end of the third quarter 2007, Freddie had marked down its assets by $3.6 billion to match current market levels. In addition, it took $1.2 billion in credit losses. These losses left the company with core capital of $34.6 billion, a mere $600 million above the minimum requirement of OHFEO. Freddie estimates its losses for 2008 and 2009 will be $1.5 billion and $2.1 billion respectively.

Banks have been trying to keep as much cash as possible as a cushion against further write-downs and credit losses. Banks are also wary of lending to each other because, knowing how bad their own assets are, they don't trust each other's balance sheets. Consequently, they have been charging each other higher interest rates. Those rates, in turn, affect monthly interest payments on millions of credit cards and mortgages in Europe and the U.S.

Research suggests consumer spending drops 9 cents for every dollar decline in home equity. A decline of $2.1 trillion in U.S. residential values has already occurred, implying a decline of $200 billion in consumer spending. Consumer spending accounts for two-thirds of U.S. economic activity.

Alan Greenspan recently stated, “After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own.”

James Grant, long-time editor of Grant's Interest Rate Observer, neatly summarized Greenspan's current view: “The enlightened central banker will let speculation take its course. Following the inevitable blow-up, he will clean up the mess with low interest rates and lots of freshly printed dollar bills—thereby gassing up a new bubble.”

That was the lesson from the savings and loan crisis. Under Greenspan, the Fed became a kind of first responder to financial distress following the 1987 stock market crash, the Mexican peso crisis in 1994-95, and the Long-Term Capital Management crisis of 1998. Following the tech-stock bubble in 2000, Greenspan steadily brought interest rates down to 1 percent in June 2003 and kept them there until mid-2004. Many economists now blame those low interest rates for contributing to the housing bubble that burst in 2007.

To be continued.

Mortgage Crisis, the Dollar and its Future, Part 1

The popular definition of “inflation” is a general increase in the level of prices. But what causes the price level to rise? It is an increase in the money supply without a corresponding increase in goods and services; there is more money with which to bid up the prices of available goods and services. Inflation used to mean an increase in the money supply without an increase in physical assets, namely gold or silver. Higher prices are the result. Replacing the traditional meaning of inflation with the popular one, which refers to the effect rather than the cause, has obscured the fact that government is the cause since it controls the money supply. “Inflation,” writes economist Kelley L. Ross, Ph.D., “does not occur because of a 'wage-price spiral,' an 'overheated' economy, excessive economic growth, or through any other natural mechanism of the market. A government debasing the currency would not have fooled anyone a century ago. Now, through deception, a government can try to blame inflation on anything but its own irresponsible actions.”

The money supply can be increased by simply printing more paper currency—unbacked by gold or silver—or by increasing bank credit, which is the method used in the U.S. and other developed countries today.

Every period of “easy money”—loose credit—is inevitably followed by a correction that wrings the excess credit out of the system. The result is the familiar “boom-and-bust” cycle in the economy. It is commonly called the “business cycle,” but it is basically a monetary cycle. The initial economic stimulus of excess monetary credit is followed by an offsetting loss of value in the currency and an economic slowdown as markets readjust from the credit distortions. While some people may gain from inflated prices, everyone else—particularly the common people—lose because of the depreciating value of the currency. It is reminiscent of an old Russian proverb: “The shortage will be divided among the peasants.”

The central bank, in our case the Federal Reserve, attempts to fine tune the economy by tightening or loosening credit in order to control inflation and prevent the economy from sliding into recession or depression. This is a tricky task because of external factors over which the Fed has no control and an unpredictable time lag between Fed actions and their consequences. Nobel Prize-winning economist Milton Friedman says this time lag may range from 3 to 18 months, a range so large that Fed timing is difficult. As a result, the Fed is always subject to criticism that it acted too soon or not soon enough, or that its measures were too strong or not strong enough at a particular time. The difficulty of timing Fed actions led Friedman to declare that the Fed shouldn't try to fine tune the economy at all. He said this was more disruptive of economic growth than a fixed policy. He proposed that a steady but moderate growth of the money supply would be a major contribution to the avoidance of either inflation or deflation. “I’ve always been in favor,” Friedman said, “of replacing the Fed with a laptop computer, to calculate the monetary base and expand it annually, through war, peace, feast and famine, by a predictable 2%.”

Now, interestingly, the world's gold supply has typically increased 1.5 to 3 percent annually, which is right in line with Friedman's recommended figure. So, why do we need a gold standard? Why not just increase the money supply steadily by the same fixed amount without tying it to gold? Because gold never becomes worthless; paper currencies can and do. The supply of gold never decreases. And only on very rare occasions, such as the major discoveries of gold in California in the 1850s and in South Africa and Australia in the 1890s, has it increased annually by over 4 percent. Those increases were very modest compared to the price increases caused by governments inflating the money supply. Moreover, while increased gold production did push up prices, this was because of the increase in material value, not arbitrary paper value. The world really was richer. On the other hand, there has never been a paper money unredeemable in a material asset that did not eventually become worthless. Obviously, therefore, no government can be trusted to increase the supply of an unredeemable money at a fixed rate. Sooner or later, political expediency combined with monetary ignorance and shortsightedness—not to mention “good intentions”—will result in the first small steps down the inflationary road. The first few steps will seem harmless enough, and so the process will be repeated. And broadened. More and more “good intentions” will be found. And they will be more and more expensive.

Of course governments do not want a fixed monetary policy. The Fed board of governors does not want to be replaced by a laptop computer. Nor do politicians want to give up the power to be expedient and irresponsible with other people's money—all in the name of good intentions, of course. They have a vested interest in inflation. They do not want a system that would restrain the lavish spending that buys voter support for their reelections. They do not want to give up playing god with the economy and the populace. Their good intentions for both can be financed in only two ways: 1) by taking money away from the people (taxation), or 2) by taking value away from the money (inflation). Taxation is not sufficient; there is no way the voters would accept taxes high enough to equal what they lose through inflation that finances the politicians' schemes.

The gold standard produced remarkable price stability. The Bank of England, founded in 1694 as a private company (nationalized in 1946), acted responsibly in issuing paper money. Its banknotes were “as good as gold” and led to Great Britain adopting the gold standard in 1816. Historical research by David Ranson and Penney Russell shows the stabilizing effect of this monetary policy. Ranson holds four degrees, including an M.B.A. in finance and a Ph.D. in business economics, and taught at the University of Chicago Graduate School of Business; Russell, a mathematician, is executive vice-president of H.C. Wainwright & Co. Economics, of which Ranson is president and director of research. Their research shows prices were lower in Great Britain at the beginning of World War II than in 1800. In the U.S., cumulative consumer-price inflation from 1820 to 1913, when the Federal Reserve Act was passed, was zero. According to the inflation calculator on the U.S. Bureau of Labor Statistics website, the dollar has lost more than 95% of its purchasing power since 1913.

In the 1920s (and even prior to 1920), the Fed rapidly expanded credit. This produced an enormous boom in the economy and a growing wave of optimism about continued prosperity. The result was a bubble in prices, most notoriously in the stock market. In the 1920s, stocks could be bought on margin for only 10 percent, the remainder being on credit from the brokerage houses. By 1926, they could be bought on 5 % margin. In September 1922, brokers' loans totaled $1.7 billion; by December 1926, they were $4.4 billion. And by September 1929, they were $8.5 billion.

The credit bubble of the 1920s was also evident in real estate. Henry Hoagland, a Federal Home Loan Bank board member, later wrote: “After a prolonged period of insufficient home construction during the World War, a tremendous surge of residential building in the decade of the twenties turned villages into cities and added tremendous acreage to our urban centers...[There was] a demand for modern homes greater than had ever been experienced before. This demand was matched by an ever-increasing supply of homes on easy terms.

“The easy-terms plan has a catch in it. It usually accompanies high prices and small ownership equities, giving superficial covering to a mountain of debt. When the crash came in 1929, a large proportion of home owners had but a thin equity in their homes. Only a small decline in prices was necessary to wipe out this equity. Unfortunately, deflationary processes are never satisfied with small declines in values. They feed upon themselves and produce results all out of proportion to their causes.” Sound familiar?

After the crash of 1929, stock market margins were never that low again. Since 1974, the margin rate has been 50 %. But we should not be surprised by the recent price bubble in residential real estate. For several years it was possible to buy a home for as little as 5 percent down, then 3 percent, and finally in many instances with no money down at all. According to a survey of first-time buyers by the National Association of Realtors in late 2004 and early 2005, a stunning 43% had put no money down.

The Great Depression led to greater involvement by the government in the economy as it tried to alleviate problems its monetary policies had caused. As a remedy for the disaster in the housing market, the government created the Home Loan Bank system in 1932 patterned after the Federal Reserve system, with 12 regional banks. That proved insufficient. Banks were still failing, and people were still losing their homes through foreclosures. So the government decided another agency was needed to make more credit available on easier terms. The result, in 1934, was the Federal Housing Administration (FHA), which originally required 20% down payment. Then more agencies were added to make even more mortgage credit available. In 1938 the Federal National Mortgage Association (Fannie Mae) was created. Freddie Mac (Federal Home Loan Mortgage Corp.) was created in 1970 to supplement Fannie Mae's role.

FHA, Fannie Mae, and Freddie Mac met with public approval but planted the seeds of future problems. Vernon L. Smith, a Nobel Prize-winning economist and professor of law and economics at George Mason University, says the government “set the stage for housing bubbles by creating those implicitly taxpayer-backed agencies, Fannie Mae and Freddie Mac, as lenders of last resort.”