The Department of Housing and Urban Development gradually increased the requirement that loans acquired by Fannie Mae and Freddie Mac be made to low- and moderate-income borrowers from 30% in 1992 to 56% in 2008.
As a result of these policies, by the middle of 2008 there were 31 million Nontraditional (low down payment and/or poor credit) Mortgages (NTMs) in the U.S. Financial system, more than half of all mortgages outstanding, with an aggregate value of more than $5 trillion. At least 76% of these were on the books of government agencies such as Fannie, Freddie and the FHA or banks and S&L institutions, holding loans which they were required to make by the Community Reinvestment Act.
The 24 million NTMs acquired or guaranteed by government agencies were major contributors to the growth of the housing bubble and its lengthy extension in time.
The growth of the bubble suppressed the losses that would ordinarily have brought NTM type Private Mortgage-Backed Securities (PMBS) to a halt but rather made these instruments look like good investments.
When the bubble finally burst, the unprecedented number of delinquencies and defaults among NTMs drove down housing prices.
Falling home prices produced losses on mortgages, whether they were government backed or PMBS.
Losses on mortgages caused investors to flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS.
Once the housing bubble burst, four major errors were made by our top government financial officials: The first and major error was the rescue of Bear Stearns. The moral hazard created by this action reduced the incentive for other firms to restore their capital positions. Once Bear had been rescued it was essential to rescue Lehman Brothers. Treasury Secretary Paulson and Fed Chairman Bernanke’s arguing that they did not have legal authority to rescue Lehman provided an excuse for Congress to pass the destructive Dodd-Frank Act. Finally, TARP accomplished little but caused much popular resentment against the banks which supposedly got bailed out.
Conclusion: as long as the American people don’t understand that government housing policies were the main cause of the financial crisis, we are likely to repeat the same mistakes over again.
It is now commonly agreed that the Financial Crisis of 2008 was caused by the collapse of the housing bubble beginning in 2007. There were three main aspects to the huge collapse of wealth caused by the Financial Crisis:
It Destroyed Mainly Middle Class Wealth. During the Great Recession housing values collapsed by $5.5 trillion, a large fraction of the total $14 trillion economy. As shown in the above chart, most of this loss of wealth came at the expense of middle- and lower-income families.
Foreclosures on Underwater Mortgages Lowered Housing Values across the Board. When foreclosed houses are sold at steeply discounted prices, the appraised value of all other houses in the area are lowered as well.
The Loss of Wealth of Indebted Households Forced Them to Cut Back on Their Overall Spending. The decline in aggregate demand due to wealth loss of the indebted then becomes a problem for everyone in the economy.
In a new book, the economists Atif Mian and Amir Sufi have proposed a new way to set up mortgages, called Shared Responsibility Mortgages (SRM), to protect holders of underwater mortgages during a housing crisis.
Consider a house bought for $100,000 with a 20% down payment and a 30 year mortgage of $80,000 at 5% interest. The annual mortgage payment is $5,204 per year. Suppose the value of the house drops 30% to $70,000. With an SRM the owner’s equity drops to 20% of $70,000 or $14,000. The annual mortgage payment would also drop 30% to $3,643. It would continue to be adjusted each year until the house returns to 100% of original value at which point the payment would revert to and remain at the original amount unless the value again drops below 100% of original value.
In return for sharing in the loss caused by a drop in value, the mortgage holder would receive 5% of any capital gain realized whenever the house was sold or refinanced in the future.
Suppose that all mortgages in 2007 had been SRMs. All three of the problems outlined above would have been avoided. The financial crisis would have been much less severe!
As I reported earlier, I am a volunteer for Fix the Debt, the outreach arm for the Washington DC think tank, Committee for a Responsible Federal Budget. I recently attended a workshop in D.C. put on by Fix the Debt and, in return, I have agreed to make presentations about our debt problem to local organizations during the coming year. Today I gave my first such talk to a local Kiwanis Club. The message is that a large debt means:
Lower Wages and Fewer Job Opportunities. The growing debt “crowds out” productive investments in people, machinery, technology and new ventures. For example, the Congressional Budget Office estimates that the average wage in 25 years will be $7000 lower if debt is on an upward path compared to a downward path (see above chart).
Increased Costs of Home, Auto, Student and Credit Card Loans. Although interest rates are currently low, they will almost certainly rise as the economy recovers, and they will rise much higher if debt continues to grow.
Less Room for Investment in Infrastructure, Research, and the Next Generation. The CBO projects that interest costs will nearly quadruple from $220 billion in 2013 to $800 billion in 2025. By 2030, 100% of all revenue will go towards interest payments and mandatory spending.
A Threatened Social Security Net. Both Social Security and Medicare are on a road to insolvency. By 2033 both Medicare’s hospital insurance trust fund and the Social Security trust fund will run out of money.
An Increased Likelihood of a New Fiscal Crisis. If investors lose confidence in our ability to service debt, there will be tanking markets, sharply rising interest rates, mass unemployment and rapid inflation.
A Missed Opportunity to Grow the Economy. Debt reduction, tax reform and modest entitlement reforms have the potential to increase economic growth by 9.5% by 2035. Think of all the new jobs this would create!
Do you belong to a club or other civic organization in metro Omaha which brings in outside speakers? If so I’d be happy to bring Fix the Debt’s message to your group. Shoot me an email at email@example.com!
“If stupidity got us into this mess, why can’t stupidity get us out?”
Will Rogers, 1879 – 1935
The Financial Crisis of 2008 and the subsequent Great Recession, from which we are still slowly emerging, is the greatest shock to our fiscal and economic health since the Great Depression of the 1930s. There are many explanations available for what happened, the most believable ones being written by the major participants themselves. My favorite reference for these events is the book, “Bull by the Horns,” written by the former Chair of the Federal Deposit Insurance Corporation, Sheila Bair, who held this post from 2006 – 2011. Ms. Bair could see the crisis coming. She interacted with all of the prime players but was too late on the scene, and with too little clout, to have a major effect on the outcome. Another persuasive account is provided by Richard Kovacevich, Chairman Emeritus of Wells Fargo, in a recent speech, “The Financial Crisis: Why the Conventional Wisdom Has It All Wrong.” According to Mr. Kovacevich:
Forcing all large banks to take TARP funds, in October 2008, even if they didn’t want or need the funds, was one of the worst economic decisions in the history of the U.S.
If Bear Stearns had been allowed to go bankrupt in March 2008, Lehman Brothers would have been sold and the subsequent financial crisis greatly reduced. A total of just 20 financial institutions caused the crisis, half investment banks and half savings and loans, yet 6000 commercial banks are being punished by Dodd-Frank.
Dodd-Frank does not address the major causes of the recent crisis and offers few approaches to prevent the next one.
Since regulatory agencies are not capable of using the authority they already have to prevent failures, we need a regulatory system which limits the damage of failures. In case of failure, all creditors, other than insured depositors, should take a “haircut”.
Requiring excessive levels of capital will only cause financial institutions to take on greater risks. If equity and long term debt, at both the bank and bank holding company levels, is required to be maintained at 30% of assets, it is unlikely that the FDIC will ever incur losses.
The quasi-private/public agencies Fannie Mae and Freddie Mac need to be abolished.
The Glass-Steagall Act, passed in 1933 and repealed in 1999, should not be reinstated because investment banking is far less risky than commercial banking, and therefore the two forms of banking need not be separated.
There are three warning signs when a financial institution is approaching the danger zone: concentration of risk, inadequate liquidity and significant exposure to capital markets. Competent regulators, not Dodd-Frank, are needed to address these risks.
Recoveries from past recessions have been much more vigorous than our anemic 2.2% rate of GDP growth for the past five years. Mr. Kovacevich believes that because of the Dodd-Frank legislation, and the current monetary policies of the Federal Reserve, the bottom 25% of Americans on the economic ladder have restricted access to mortgages and personal loans. This is inhibiting economic growth and contributing significantly to the inequality gap.
The financial crisis of 2008 was the biggest shock to our financial system since the Great Depression of the 1930s. It caused a deep recession from which we are still recovering. To aid the recovery the Federal Reserve launched an unprecedented expansion of the money supply, referred to as quantitative easing, as well as keeping short term interest rates near zero. As explained by James Rickards, a portfolio manager at West Shore Group, in his new book, “The Death of Money, the coming collapse of the international monetary system,” such a severe recession would normally have caused a corrective period of deflation. Quantitative easing has warded off deflation and, so far, without igniting inflation. We are now in a catch-22 situation. Congress could and should adopt several policy changes to speed up the recovery as I described several days ago in “The Federal Reserve Cannot Revive the Economy by Itself.” But, if and when the economy does start growing faster, it will require great skill by the Fed to exit from its current policies without harm. If it contracts the money supply too quickly, it risks a sharp rise in interest rates. If it contracts the money supply too slowly, it risks a sharp rise in inflation. Mr. Rickards doubts that the Fed will be able to accomplish this fine tuning without another major crisis. Here are his Seven Signs of what to look for:
The price of gold ($1300 per ounce today). A rapid rise to $2500 will anticipate inflation. A rapid decrease to $800 signals severe deflation.
Gold’s continued acquisition by Central Banks. Large purchases by China, for example, will announce inflation.
IMF governance reforms, e.g. towards more voting power for China, will be an inflation warning.
The failure of regulatory reform, i.e. reinstatement of Glass-Steagall in addition to the Volcker Rule, will increase the chances of systemic failure.
System crashes, resulting from high-speed, highly automated, high volume trading. An increasing tempo of such events will cause disequilibrium which could close markets.
The end of QE, could give deflation a second wind and lead to a new round of QE.
A Chinese collapse (predicted by Rickards), will lead first to deflation and then inflation.
We all hope that the Federal Reserve can steer clear of a new, and much deeper, financial crisis. But it doesn’t hurt to have guideposts and Mr. Rickards knows what he’s talking about.
“Life’s tragedy is that we get old too soon and wise too late”
Benjamin Franklin, 1706 – 1790
The above chart from the Congressional Budget Office’s latest budget forecast “Updated Budget Projections: 2014 to 2024” shows very clearly how the public debt (on which we pay interest) has climbed dramatically in the last six years, as a percentage of GDP, and is projected to keep on growing indefinitely. As the economy improves and interest rates return to normal levels, interest payments on the debt will skyrocket and become a permanent drag on future growth.
In a recent post “How to Control Federal Spending: The Highway Trust Fund” I pointed out that thanks to the Budget Sequester Act from 2011, it is unlikely that the $35 billion Highway Trust Fund, supported by an 18.2 cent per gallon federal gasoline tax, will be supplemented by general government revenue, paid for by increasing the deficit. In other words, discretionary spending is under control at the present time due to the ten year sequester limits.
But this makes up less than 1/3 of the federal budget, the rest being “mandatory” entitlement spending, for such programs as Social Security, Medicare and Medicaid. This is where the huge projected future growth in overall federal spending comes from and therefore where we need to focus on budget control. The huge challenge is that the number of Americans who are retired, now about 50 million, is growing rapidly. Furthermore, older citizens vote in greater proportion than any other age group and don’t want their benefits to be cut. Elected representatives need help to resist the pressure from senior citizens for greater benefits. Here are two possible ways to provide this help:
A Balanced Budget Amendment to the U.S. Constitution. It would have to be flexible enough to allow overrides for emergencies by a supermajority vote, but otherwise it would force Congress to either cut spending or else raise taxes to bring in more revenue. The tradeoff between these two alternatives would create the discipline to make the hard choices required.
Term Limits for national office. I would choose 12 year limits for both the Senate and the House of Representatives but other choices are possible. Knowing that one’s time in office is limited will help provide the strength to make the difficult decisions to either cut spending or raise tax revenue. New members of Congress are more independent thinking than the careerists whose main goal is to get reelected.
Either of these two possible changes in the rules would help turn things around. We need to do something before we have another financial crisis much worse than the last one!
The publication of two new books is causing a reevaluation of the financial rescue and its aftermath, e.g. “The Case Against the Bernanke-Obama Financial Rescue”. The two books are “Stress Test” by Timothy Geithner, former Treasury Secretary, and “House of Debt” by the economists Atif Mian and Amir Sufi. Mr. Mian and Mr. Sufi maintain that the government’s response to the financial crisis should have focused less on saving the banking system and more on the problem of excessive household debt. They discovered in their research that, during the housing bubble, less affluent people were spending as much as 25 – 30 cents for every dollar of increase in housing equity. When the bubble burst, and housing prices started to fall, these borrowers cut way back on spending which caused many businesses to lay off employees. The authors propose setting up a government program to help borrowers decrease what they owe in underwater mortgages.
Five years after the end of the Great Recession it would still be very helpful to speed up our lagging economy. Here are three different possible ways to do this:
The Keynesians say the best way to stimulate the economy is with more government (deficit) spending. For example, spending several hundred billion dollars a year on infra-structure would create hundreds of thousands, if not millions, of new construction jobs. I think this is a good idea, but only if it’s paid for with a new tax (e.g. a carbon tax or a wealth tax).
The Mian/Sufi plan, as described above, would alleviate mortgage debt problems for millions of middle class homeowners who are still under water, encouraging them to spend more money which would in turn boost the economy. The problem is that the M/S plan creates a moral hazard for mortgage holders unless it’s paid for by mortgage insurance which would raise costs for borrowers.
Broad-based tax reform, with lower tax rates for everyone, paid for by closing loopholes and limiting tax deductions for the wealthy, would automatically put more income in the hands of the two-thirds of tax payers who do not itemize deductions. These middle class wage earners would tend to spend this extra money thereby boosting the economy.
The point is that there very definitely are ways to boost the economy, some better than others, and it should be a top priority of Congress and the President to get this done.
The occasion of the publication of Timothy Geithner’s book “Stress Test,” giving his version of the financial crisis, has led to a number of newspaper articles looking back at the Great Recession and its aftermath. The New York Times’ economics reporter David Leonhardt has such an analysis “A Rescue That Worked, But Left a Troubled Economy” in today’s NYT. “The Great Depression created much of modern American government and reversed decades of rising inequality. Today, by contrast, incomes are rising at the top again, while still stagnant for most Americans. Wall Street is flourishing again.”
“The financial crisis offered an opportunity to change this dynamic. But the (Dodd-Frank) law seems unlikely to transform Wall Street, and the debate over finance’s huge role in today’s economy will now fall to others. Should the banks be broken up? Should the government tax wealth? Should the banks face higher taxes?”
In my opinion, the real problem is not our financial system but the strong headwinds which are slowing down the economy.
Globalization of markets which creates huge pressure for low operating costs.
Labor saving technology which also puts downward pressure on wages.
Women and immigrants having entered the labor market in huge numbers, and therefore greatly increasing the labor supply.
The loss of wealth in the Great Recession also means that even people with good jobs have less money to spend. What we sorely need is faster economic growth to create more jobs and higher paying jobs. How do we accomplish this?
The best way to boost the economy is with broad-based tax reform to achieve the lowest possible tax rates to put more money in the hands of the working people who are the most likely to spend it. Such lower rates can be offset by closing the myriad tax loopholes and at least shrinking, if not completely eliminating, tax deductions which primarily benefit the wealthy.
Lowering corporate tax rates, again offset by eliminating deductions, providing a huge incentive for American multinational companies to bring their profits back home for reinvestment or redistribution.
With millions of unemployed and underemployed workers, reviving our economy with a faster rate of growth should be one of the very top priorities of Congress and the President. Survey after survey show that this is what voters want. Why isn’t it happening?
The economist and public lecturer, Richard Wolff, gave an address in Omaha NE last night, entitled “Capitalism in Crisis: How Lopsided Wealth Distribution Threatens Our Democracy”. His thesis is that after 150 years, from 1820 – 1970, of steadily increasing worker productivity and matching wage gains, a structural change has taken place in our economy. Since 1970 worker productivity has continued to increase at the same historical rate while the median wage level has been flat with no appreciable increase. This wage stagnation has been caused by an imbalance of supply and demand as follows:
Technology has eliminated lots of low skill and medium skill jobs in the U.S.
Globalization has made it less expensive for low skill jobs to be performed in the developing world at lower cost than in the U.S.
At the same time as jobs were being replaced by technology and disappearing overseas, millions of women entered the labor force.
A new wave of Hispanic immigration has caused even more competition for low skilled jobs.
In addition, stagnant wages for the low skilled and medium skilled worker have been accompanied by an increase in private debt through the advent of credit cards and subprime mortgage borrowing. This enormous increase of consumer debt led to the housing bubble, its bursting in 2007-2008, and the resulting Great Recession.
Five years after the end of the recession in June 2009, we still have an enormous mess on our hands: a stagnant economy, high unemployment, massive and increasing debt and a fractious political process. How in the world are we going to come together to address our perilous situation in a rational and timely manner?
Mr. Wolff believes that capitalism’s faults are too severe to be fixed with regulatory tweaks. He also agrees that socialism has proven to be unsuccessful where it has been tried. He proposes a new economic system of “Workers’ Self-Directed Enterprises” as an alternative.
I agree with Mr. Wolff that capitalism is in a crisis but I think that it can be repaired from within. The challenge is to simultaneously give our economy a sufficient boost to put millions of people back to work and to do this while dramatically shrinking our annual deficits in order to get our massive debt on a downward trajectory as a percent of GDP. How to do this is the main focus of my blog, day in and day out!
“Consider the following scenario. You are an airline pilot charged with flying a planeload of passengers across the Atlantic. You are offered the choice of two different aircraft. The first aircraft has been prepared by chief engineer Keynes and the second by chief engineer Hayek.
You have to choose which plane to use, so naturally you ask the advice of the two engineers. Keynes urges you to use his aircraft, offering a convincing explanation of why Hayek’s plane will crash on take-off. Hayek urges you to use his aircraft, offering an equally convincing explanation of why Keynes’s plane will crash on landing. At loss as to which plane to choose, you seek the advice of two leading independent experts – Karl Marx and Adam Smith. Marx assures you that it does not matter which aircraft you choose as both will inevitably suffer catastrophic failure. Similarly, Smith also reassures you that it does not matter which aircraft you choose, as long as you allow your chosen craft to fly itself.”
Thus begins a fascinating new book, “Money, Blood and Revolution: How Darwin and the doctor of King Charles I could turn economics into a true science,” by the fund manager and economist, George Cooper. Mr. Cooper sets up a circulatory model of democratic capitalism whereby rent, interest payments and profits flow from low income people at the bottom of the pyramid to the wealthy at the top. And then tax revenue (collected mostly from the wealthy) is redistributed downward in the form of government programs.
According to Mr. Cooper, the financial crisis was caused by a combination of lax regulation and excessive credit and monetary stimulus. The question is what to do about it. Mr. Cooper says:
Stop adding to the problem. High student debt and high mortgage debt are still being supported by government programs.
Change the course of the monetary river. Quantitative easing does not work because it just puts money into the hands of the wealthy and they have no incentive to spend it.
Change the course of the fiscal river. Instead put money into the hands of the people at the bottom of the pyramid with expanded government spending on infrastructure (paid for by taxing the wealthy).
Without endorsing all of Mr. Cooper’s suggestions, he nevertheless has many good ones and expresses them in a highly entertaining style!