Category Archives: Paulson/Geithner Plans

Mr. Obama’s Junk Economics: Democrats Relinquish the Populist Option to the Republicans

By Michael Hudson

In a dress rehearsal for this November’s mid-term election, Democrats and Republicans vied last week for who could denounce the banks and blame the other party the most for the giveaways to Wall Street that have swollen the public debt since September 2008, pushing the federal budget into deficit and the economy into a slump.
The Republicans are winning the populist war. On the weekend before his State of the Union address on Wednesday, Mr. Obama strong-armed Democratic senators to re-appoint Ben Bernanke as Federal Reserve Chairman. His Wednesday speech did not mention this act (happily applauded by Wall Street). The President sought to defuse voter opposition by acknowledging that nobody likes the banks. But he claimed that unemployment would be much higher if they hadn’t been bailed out. So the giveaway of public funds was all for the workers. The $13 trillion that has created a new power elite was just an incidental byproduct. Unpleasant, perhaps, as American democracy slips into oligarchy. But all for the people. The least bad option. It had to be done. People might not like it, but Main Street simply cannot prosper without creating hundreds of Wall Street billionaires – without enabling them to increase their bonuses and capital gains as bank stock prices quadruple. It’s all to get credit flowing again (at 30% for credit card users, to be sure).

So the rest of us must wait for wealth to trickle down. The cover story is that this is how the world works, like it or not. At least this is the argument of the lobbyists who are drafting and censoring laws and signing off on just who is acceptable to run the Federal Reserve, Treasury and other public-subsidy agencies. The working assumption is that the economy cannot recover without enriching Wall Street.

This is the Administration’s tragic flaw. What the economy needs is to recover from the Bush-Obama supposed cure, i.e., from the mushrooming debt overhead. It needs to recover from the enrichment of Wall Street. It doesn’t need more credit, but a write-down for the unpayably high debts that the banks have imposed on American families, businesses, states and localities, real estate, and the federal government itself.

Instead of helping debtors, Mr. Obama has moved to heal the creditors, making them whole at public expense. If debtors cannot pay, the Treasury and Fed will take their IOUs and bad casino gambles onto the public sector’s balance sheet. The financial winners must come first – and it seems second and third, too. The rationale is that unless the government gives the large financial institutions what they want and saves them from taking a loss, their “incentive” to protect the economy from devastation will be gone.

Knuckling under to this protection racket is not the change that most people voted for in November 2008. So on Thursday afternoon, most Republican senators opposed a second four-year term for Bernanke. By leading the effort to re-confirm him, the Corporate Democrats (but not most of their colleagues who had to face voters this autumn) removed this albatross from the Republican neck and put it around their own.

For starters, Chairman Bernanke has convinced the President that the Fed should be the single regulator of Wall Street – ideologically kindred, and drawn from its ranks, or with its assent. Mr. Obama’s address made no reference to the Consumer Financial Products Agency he promised a year ago to be the centerpiece of financial reform. Its main sponsor, Elizabeth Warren, has been warning that hopes for reform are being overwhelmed by financial lobbyists arguing that truth-in-lending laws and anti-usury regulations threaten to reduce bank profits, forcing lenders to raise costs to consumers. In Mr. Bernanke’s world, regulations to protect consumers simply will oblige the banks to pass on the cost increase caused by this “government interference.” The more regulation there is, the more consumers will have to pay.

This is the inside-out picture drawn by bank lobbyists and purveyed by Mr. Obama’s economic team. Could George Bush have gotten away with it? Democrats have a friendlier and more compassionate face, but the substance remains the same.

Most economists believe that Mr. Obama is whistling in the dark when he says the economy will recover this year under Chairman Bernanke’s guidance. The financial screws are being tightened, yet the Fed refuses to abide by its charter and regulate credit card rates going through the roof. Instead of countercyclical federal spending to rescue the economy from debt deflation, Mr. Obama says that since we have given so much to Wall Street in the past year and a half, little is left to spend on the “real” economy. Sounding like a Republican in Democratic clothing not unlike his Senate mentor Joe Lieberman, his State of the Union speech urged creation of a bipartisan (that is, Republican-friendly) working group to agree on how to lower the deficit. The President proposes that starting next year Congress should freeze spending not already committed under entitlement programs.

Testifying Wednesday morning as a run-up to Pres. Obama’s evening speech, Messrs. Geithner and Paulson at least avoided the Washington ploy of emulating Alzheimer’s patients and saying that they couldn’t recall anything about their giveaways. Sophisticated enough to outplay their questioners in verbal tennis, the past and present Treasury Secretaries brazened it out. Using the Plausible Deniability defense, they claimed that they weren’t even in the loop when it came to paying AIG enough to turn around and pay Goldman Sachs and other arbitrageurs 100 cents on the dollar for securities worth about a fifth as much. It was all done by their subordinates. Their underlings did it. “This was a Federal Reserve loan,” Mr. Paulson explained. “They had the authority. They had the technical expertise … and I was working on many other things which were in my bailiwick.” And in any case an AIG bankruptcy “would have buckled our financial system and wrought economic havoc.” Unemployment, he warned, “could have risen to 25%.” The Fed had to protect people.

When there was no way to dodge, they frankly admitted what had happened, providing helpful pieties to the effect that it is the job of Congress to change the law to make sure nothing like this happens again. Yes, there was a big giveaway, but we saved the economy. Wall Street’s loss would have been the peoples’ loss. Certainly we need new rules to protect the taxpayer, blah, blah, blah. We’re all in the same boat. If the banks took a loss, they would have to raise the price of financial services and we would all have had to pay more. Thank heavens that everything is getting back to normal now.

“A lot of people think the president of the New York Fed works for the government,” Democrat Marcy Kaptur of Ohio concluded, “but in fact he works for the banks on the board that elected you.” Not so, testified New York Federal Reserve general counsel Thomas Baxter. “A.I.G. wanted to keep the information confidential, for fear that it would lose business if customers were named.” And if it lost business, “This would have had the effect of harming the taxpayers’ investment in A.I.G.” So it was all to save the taxpayers money that the Fed spent $185 billion of their money.

But was it really necessary not to let A.I.G. go bankrupt in September of 2008? The Wall Street Journal’s editorial page blew the whistle on how the government’s wheeler-dealer insiders have been changing their story again and again – not usually a sign of truthfulness. “Secretary of the Treasury Timothy Geithner and predecessor Hank Paulson said they didn’t bail out AIG to save its derivatives counterparties” from bad credit default swap contracts because if it would have asked these counterparties to “take a haircut,” credit-ratings agencies would have downgraded AIG. A lower rating would have obliged it to post even more collateral on its other swap contracts, presumably because of the higher risk.

There are a number of problems with this story, the editorial explained. First of all, Goldman Sachs and other counterparties unilaterally said the prices had declined for securities that had no market price at all, only subjective valuations. A.I.G. would have been reasonable in disputing this. In any event, as the firm’s new 80% stockholder, the U.S. Government said it would stand behind AIG. This should have removed fears of non-payment. But most important of all was the claim by Messrs. Paulson and Geithner that failure to “honor” AIG’s swaps would have threatened its far-flung insurance businesses on which so many American consumers depended. New York Insurance Superintendent Eric Dinallo, who was AIG’s principal insurance regulator at the time, testified before the Senate last year that these operations were not threatened at all! “‘The main reason why the federal government decided to rescue AIG was not because of its insurance companies.’ He was so confident in the health of the AIG subsidiaries that, before the federal bailout, he was working on a plan to transfer $20 billion of their excess reserves to the parent company.”

This directly contradicts Mr. Geithner’s claim “that the ‘people responsible’ for overseeing the insurance subsidiaries ‘had no idea’ about the risks facing AIG policyholders. He’s talking about Mr. Dinallo here. Instead of being safely segregated, Mr. Geithner said the insurance businesses were ‘tightly connected’ to the parent company. Mr. Paulson added that the healthy parts of AIG had been ‘infected’ by the ‘toxic assets.’ He added, ‘One part of the company would have contaminated the other.’” Does this mean that New York’s “heavy state insurance regulation was a sham,” the newspaper asked? It would seem that “When push came to shove, policyholders were not protected from a default by the parent company.” It urges that Mr. Dinallo be brought back to straighten the matter out.

Mr. Geithner closed his own comments by saying, “if you are outraged by what happened with A.I.G., then you should be deeply committed to financial reform.” This is rhetorical judo. The financial system in question is not the economy at large. It was A.I.G.’s carefully segregated bookies’ account for wealthy hedge fund gambles and Wall Street speculations that should have had little to do with the “real” economy at all.

Wall Street – and most business schools – promote the myth that the “real” economy of production and consumption cannot function without making Wall Street’s insiders immensely rich. Emulating Louis XIV, Wall Street’s spokesmen explain, “L’economie, c’est nous.” There seems nothing to be done about banks impoverishing people by extortionate credit card rates, junk securities and a debt burden so heavy that it will require one bailout after another over the next few years. Present policy is based on the assumption that the U.S. economy will crash if we don’t keep the debt overhead growing at past exponential rates. It is credit – that is, debt – that is supposed to pull real estate out of its present negative equity. Credit – that is, debt leveraging – that is supposed to raise stock market prices to enable pension funds to meet their scheduled payments. And it is credit – that is, debt –is supposed to be the key to employment growth.

Credit means giving Wall Street what it wants. Regulating it is supposed to interfere with prosperity. Truth-in-lending, for example, will increase the “cost of production” by “making” banks charge consumers even more for creating credit on their computer keyboards.

This Stockholm syndrome when it comes to Wall Street’s power-grab is junk economics. Wall Street is not “the economy.” It is a superstructure of credit and money management privileges positioned to extract as much as it can, while threatening to close down the economy if it does not get its way. High finance holds the economy hostage not only economically but also intellectually at least to the extent of having captured Mr. Obama’s brain – and also the federal budget, as money paid to Wall Street has crowded out spending on economic recovery. It has re-defined “reform” to mean putting Wall Street even more in power by making the Fed the sole regulator of Wall Street. Under these conditions, saving “the system” means saving a mess. It means saving a debt dynamic that must grow exponentially at the economy’s expense, absorbing more and more federal bailout funds and hence crowding out the spending needed to revive the economy.

Mr. Paulson’s testimony echoed the idea that the rescue of A.I.G. was necessary to keep the economy from collapsing. “We would have seen a complete collapse of our financial system,” Mr. Paulson said, “and unemployment easily could have risen to the 25 percent level reached in the Great Depression.” So it was all for the working class, for employees and consumers. It was done to save the government – a.k.a. “taxpayers” – from losing money on its investment. It was to save the economy from breaking down – or perhaps to pay off protection-racket money to Wall Street not to wreck the economy. And as we all know, taxpayers today are mainly the lower-income individuals unable to take their revenue in the form of low-taxed “capital gains” like Wall Street traders, in today’s fiscal war between finance and labor.

It seems to be merely an incidental by-product of saving taxpayers and labor that Wall Street ended up with the hundreds of billions of dollars of gains (and losses avoided) – at a $13 trillion expense of government and of about four million jobs in the overall economy whose employment is shrinking, and about four million home foreclosures in 2009-10. The cover story is that matters would have been worse otherwise. This was the price for “saving the system.” But “the system” turns out to be the Bubble Economy, in which the Obama administration has put as much faith as Bush did. This is why the same managers have been kept in place. This policy has enabled Republicans to strike a posture of denouncing the banks in preparation for this November’s mid-term election.

“Saving the economy” has become a euphemism for the policy of keeping bad debts on the books and saving high finance from writing them down to reflect the realistic ability to pay. Wall Street has used its bailout money to lobby Washington, back its political nominees to hold Congress hostage, and blame the downturn on any regulator or president who does not yield to its demands.

The resulting program is not saving the economy; it is sacrificing it. What has been saved is the debt overhead – the wrong side of the balance sheet.

The reactionary political outlook

A bipartisan compact between Corporate Democrats and Republicans is not the change voters expected in November 2008. Confronted with the “Obama surprise” – an absence of change – the only option that many voters believe they have is to change the existing party. Republicans are setting their eyes on Pres. Obama’s former Senate seat in Illinois, Vice Pres. Biden’s seat in Baltimore, and Majority Leader Reid’s seat in Nevada. Losing these and other seats would create a political standoff giving Mr. Obama further excuse for not changing course.

This kind of standoff normally would enable a popular president to ask voters to elect a majority large enough to legislate the program he outlines. But instead of a program, Mr. Obama has simply appointed the leading Bush-era administrators and brought back the Clinton “Rubinomics” team from Wall Street. His spending freeze in a shrinking economy is a Republican program, his modest “stimulus package” is over, and he has dropped the Consumer Financial Products Agency under Wall Street pressure. So if we are to look at what the administration actually is doing, its program is simply a blank check to the Fed and Treasury (under Bush-era management) to revive Wall Street fortunes – in a nutshell, more Rubinomics.

Convergence between the two parties reflects the privatization of politics by political lobbying and campaign contributions. Getting paid back with fiscal favors, sell-offs and bailouts promises to increase in the wake of the recent Supreme Court “Frankenstein” decision that corporations are virtual people when it comes to freedom of speech and the purchase of media time.

The only countervailing power is that within the Republican Party a fringe of tea partiers threatens to run against more established candidates safely sold to special interests. The Democratic Party always has been a looser coalition, which may not hold together if the Rubinomics team continues to lock out non-Corporate Democrats. So a political realignment may be in the making. Financial and fiscal restructuring issues span left and right, progressive Democrats and populist Republicans. So far, their sentiments are reactive rather than being spelled out in a policy program. But there is a widening realization that the economy has painted itself into a financial corner.

What is needed is to explain to voters how financial and tax policies are symbiotic. The tax shift off finance, insurance and real estate (FIRE) onto labor and industry since 1980 has polarized the economy between a creditor class at the top of and an indebted “real” economy below. Unless this tax favoritism is reversed, more and more revenue will be diverted away from spending on consumption and investment to pay debt service and “financialize” the economy even more.

It is natural that the world’s most debt-ridden economies – Latvia and its Baltic and post-Soviet neighbors, and Iceland – are the first to perceive the problem. They may be viewed as an object lesson for a dystopian future of debt peonage. New Europe’s debt strains are threatening to break up the core euro-currency area (aggravated from within by the Greek, Spanish and Irish public debt problems). The British economy is likewise financialized, weakening sterling. And Europe lacks the U.S. financial safeguard that enables mortgage debtors here to walk away from properties that have fallen into negative equity. Insolvent homeowners in Europe face a lifetime of literal debt peonage to make the banks (even foreign banks, which dominate Central Europe’s post-Soviet economies) whole on their bad debts as the continent’s real estate prices are plunging even more steeply than those in the United States – some 70 percent in Iceland and Latvia.

The only silver lining I can see is that perception will spread that the financial sector is an intrusive dynamic subjecting the economy to debt deflation. But at present, lawmakers are acting as if the economy is an albatross around Wall Street’s neck. (“How are we wealthy people to bear the cost of healing the sick and employing the masses?” the financial sector complains. “The cost is eating into our ability to create wealth.”) Libertarians have warned that our economy is going down the Road to Serfdom. What they do not realize is that by fighting against government power to check financial hubris, they are paving the road for centralized financial planning by Wall Street. They have been tricked into leading the parade on behalf of the financial, insurance and real estate sector – down the road to debt peonage in a monopolized and polarized economy.

Fed Profits From The Bailout? Don’t Count Those Chickens Before They Hatch

A flurry of reports appears to indicate simultaneously that the government’s bailout of Wall Street is working to bring banks back to life, and that the Fed is making profits on the deal: See for instance here, here and here. According to these reports, the Fed received $19 billion in interest on its emergency loans to troubled institutions, which was about $14 billion more than it would have received if it had instead bought Treasuries. In addition, it was reported that the Fed made $4 billion of profits from the eight largest banks that have repaid TARP funds. This is seen as good news in Congress: “The taxpayers want their money back and they want the government out of our banking system,” said Representative Jeb Hensarling.

There are three fundamental problems with these stories. The first is that it raises a question about the function of the Fed: should a branch of government seek profits at the expense of the private sector? As we all know, the Fed is normally profitable and returns earnings above 6% on equity back to the Treasury. When the Fed profits on its holdings of government debt, that is essentially the government paying itself and thus of no consequence. Profiting at the expense of private institutions—even if they are the hated “banksters” of Wall Street—doesn’t seem to be something to celebrate. Especially when we are in a deep recession or depression, with a long way to go before the financial system recovers. All else equal, I’d rather see the private sector accumulate some profits so that it can recover.

Don’t get me wrong. I want retribution, too. We need a “bank holiday”, to begin next Friday: close suspect banks including all of the biggest that were subjected to the wimpy “stress test”. Spend the weekend going through the books and then on Monday begin to resolve the insolvent, to prosecute the banksters for fraud, and to retrieve from them their outsized bonuses financed by the public purse. It is payback time. My only objection is to the notion that we should be celebrating because the Fed appears to have made a profit on (a small part of) the bailout.

Second, there is every reason to suspect that the banks that have repaid TARP money and those making payments on loans from the Fed are still massively insolvent at any true valuation of the toxic waste still on their balance sheets. Recent reported profit in the financial sector is window-dressing, designed to fuel the irrationally exuberant stock market bubble. This will allow traders and other employees to cash in their stock options to recover some of the losses they incurred last year, even as bonuses are boosted for this year. Indeed, the main reason for returning the borrowed funds is to escape controls on executive salaries and bonuses. And, finally, it provides some important PR to counteract the growing anger over the financial bailouts. Only the foolish or those with some dog in the hunt will believe that the banksters have really managed to restore health to the financial sector as they continue to do what they did to cause the crisis.

Last but not least, the Fed’s “profits” are based on an infinitesimally small fraction of its ramped-up operations—its liquidity facilities (that also include discount window loans and currency swaps with other central banks, purchases of commercial paper and financing for investors in asset-backed securities). It has also spent $1.75 trillion buying bad assets, with any losses on those excluded from the profits numbers. The government’s profits also exclude current and expected spending on the rest of its reported $23.7 trillion dollar commitment to the financial bailout and fiscal stimulus package. The failure of just one medium-sized bank could easily wipe out the entire $14 billion of profits that has attracted so much notice. (See also Dean Baker on the government’s “profits”)

It is ironic that Euroland’s regulators are calling for much more radical steps than Washington is willing to take. German Chancellor Angela Merkel and French President Nicolas Sarkozy are calling for more regulation and for limits on executive compensation even as the Obama administration continues to argue that such limits would constrain the financial sector’s ability to retain the “best and the brightest”. If the bozos that created this crisis are the best that Wall Street can find, it would be better to shut down the US financial system than to keep them in charge. It is doubly ironic that Nigeria (a country that normally would not come immediately to mind as a role model) has actually charged the leadership of five of its major banks with crimes. Each of these banks had received government money in a bailout, and the CEOs stand accused of “fraud, giving loans to fake companies, lending to businesses they had a personal interest in and conspiring with stockbrokers to drive up share prices.”

Isn’t that normal business practice for Wall Street banks favored by Ben Bernanke and Timothy Geithner? It is time to get the NY Fed out of Goldman’s back pocket, and to permanently downsize the role played by Wall Street and the Fed in our economic system.

The Carnage Continues: Time To Ramp Up the Stimulus

By L. Randall Wray

Some like to see green shoots everywhere, but that is becoming an increasingly audacious hope. Here are four related stories from the July 5th edition of the New York Times:

Tax Bill Appeals Take Rising Toll on Governments By JACK HEALY

Homeowners across the country are challenging their property tax bills in droves as the value of their homes drop, threatening local governments with another big drain on their budgets…. The tax appeals and reassessments present a new budget nightmare for governments. In a survey conducted by the National Association of Counties, 76 percent of large counties said that falling property tax revenue was significantly affecting their budgets…. Officials in some states say their property tax revenue is falling for the first time since World War II.

Safety Net Is Fraying for the Very Poor By ERIK ECKHOLM

Government “safety net” programs like Social Security and food stamps have pulled growing numbers of Americans out of poverty since the mid-1990s. But even before the current recession, these programs were providing less help to the most desperately poor, mainly nonworking families with children… The recession is expected to raise poverty rates, economists agree, although the impact is being softened by the federal stimulus package adopted this year…. “It’s a good thing we have the stimulus package,” Mr. {Arloc} Sherman said. “But what happens to the most vulnerable families in two years, when most of the provisions expire?”

Employment Report Sours the Market By JEFF SOMMER

A grim report on unemployment on Thursday let the air out of the stock market…. In a monthly report, the Labor Department said that 467,000 jobs were lost in June. In surveys, most economists expected 100,000 fewer jobs lost. The unemployment rate edged up to 9.5 percent from 9.4 percent the previous month, to its highest level in 26 years, and virtually all analysts expect joblessness to mount in the coming months.

So Many Foreclosures, So Little Logic By GRETCHEN MORGENSON

LAST week, the stock market tumbled on news that housing foreclosures and delinquencies rose again in the first quarter. The Office of the Comptroller of the Currency said that among the 34 million loans it tracks, foreclosures in progress rose 22 percent, to 844,389. That figure was 73 percent higher than in the same period last year…. But the most fascinating, and frightening, figures in the data detail how much money is lost when foreclosed homes are sold. In June, the data show almost 32,000 liquidation sales; the average loss on those was 64.7 percent of the original loan balance.

What do these reports have in common? They provide powerful evidence that the federal government is not doing enough to help the “real” economy. As Sam Gompers famously responded when asked what workers wanted–“More!”—our nation’s state and local governments, households, workers, and poor need more help, now. We have tried the Reagan/Paulson/Rubin/Geithner “trickle down” approach of targeting relief to Wall Street, but the only thing trickling down is misery. The only way to stop the downward spiral is to substitute trickle-up policy—and even if nothing trickles-up, at least we will have helped those most in need.

I have already outlined a comprehensive recovery package so will here simply summarize four policies that would bring immediate relief.

1. Payroll tax holiday: This provides nearly $2500 of tax relief per year for each worker, with the same amount of relief going to that worker’s employer. The total stimulus to the economy would be somewhere around $650 billion per year. The relief is well-targeted (to workers and employers), immediate (take home pay rises as soon as the holiday takes effect), simple to administrate, and can be phased out (if desired) after the economy recovers.

2. State and local government assistance: The current stimulus package provided some relief to state and local governments, but was so little that it is forcing them to make Hobson’s choices: cut poor children from Medicaid roles or decimate universities? Furloughs for firefighters or postpone bridge repairs? Increase real estate taxes or raise fees for services? Only the federal government can resolve revenue shortfalls by providing funding to keep state and local governments running. Perhaps $400 billion, allocated by population (a bit over $1200 per capita) across state and local governments would be sufficient. If President Obama really could reform healthcare, that would generate tremendous savings for state governments that are saddled with exploding Medicaid costs to cover low income and elderly patients. Until then, direct grants are required. As I have argued, for the long-term we need a permanent program of federal transfers to states, with some of that attached to a requirement that they reduce reliance on regressive taxes.

3. Jobs to reduce poverty: Last week Pavlina Tcherneva provided an excellent argument for direct job creation by the federal government. We have already lost 6 million jobs, and Tcherneva notes that unemployed plus discouraged workers total about twice that number. However, a plausible case can be made that we are short more than 20 million jobs—as Marc Andre Pigeon and I demonstrated a decade ago. Further, as Stephanie Kelton and I showed, a substantial amount of America’s poverty problem is really a jobless problem. We found that in 2002 the poverty rate of families with no member working reached nearly 26%; on the other hand, if the family had at least one member working full-time, the poverty rate fell to just 3.5%. Our conclusions were similar to those offered by Hyman Minsky: “The achievement and sustaining of tight full employment could do almost all of the job of eliminating poverty” (1968, p. 329); “a large portion of those living in poverty and an even larger portion of those living close to poverty do so because of the meager income they receive from work” (p. 328). Minsky believed that “a suggestion of real merit is that the government become an employer of last resort” (1968, p. 338). Thus, not only will direct job creation reverse the trend toward ever-higher unemployment rates, but it will also go a long way toward filling the growing holes in the social safety net.

4. Homeowner relief: The plan offered by Warren Mosler provides an alternative to the current painful foreclosure process. When banks begin to foreclose, the government would step in to purchase the property at the lower of market price or outstanding mortgage balance. Of course, establishing market price in a glut is not simple and I will leave it to real estate market experts to compose a plan. What is more important is to keep people in their homes. Mosler proposes that the federal government would rent homes back to the dispossessed owners (Dean Baker has a similar plan) for a specified period (perhaps two years) at fair market rent. At the end of that period, the government would sell the home, with the occupant having the right of first refusal to buy it. By itself, this proposal would do little to stop spiraling delinquencies and foreclosures, and home prices will probably continue to decline for many months (or even years). However, as the other parts of this stimulus package begin to spur recovery, the real estate sector freefall will (eventually) be halted. I am somewhat ambivalent about continued falling house prices—on one hand, this will make housing more affordable; on the other it is devastating for families. Still, reducing evictions by offering a rental alternative will help reduce the pain of foreclosure. It might also allow the process to speed up (with smaller losses for banks) since many families would choose to stay-on as renters, with the possibility that they could later buy their homes at more reasonable prices.

I will not address here the preposterous argument that failure of the economy to swiftly recover is evidence against the Keynesian belief that government spending is the answer. Leaving to the side the Wall Street bail-outs (that do little to stimulate production and jobs), only a small portion of the stimulus package has been spent to date. There is evidence, however, that the automatic stabilizers (falling federal tax revenue and rising federal spending) are doing some good already—and would eventually pull the economy out of this depression. However, there is no reason to wait for our ship to hit bottom before it slowly resurfaces. Active, discretionary, targeted policy can reduce suffering and generate the forces that will be required to overcome substantial headwinds created by the private sector as well as by our state and local governments. Only the federal government has the fiscal wherewithal to lead us out.

The Two Documents Everyone Should Read to Better Understand the Crisis

By William K. Black (Via Huffington Post)

As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an “epidemic” of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.* When the person that controls a seemingly legitimate business or government agency uses it as a “weapon” to defraud we categorize it as a “control fraud” (“The Organization as ‘Weapon’ in White Collar Crime.” Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds’ “weapon of choice” is accounting. Control frauds cause greater financial losses than all other forms of property crime — combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a “criminogenic environment” (Big Money Crime. Calavita, Pontell & Tillman 1997.)

The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.

Don’t ask; don’t tell: book profits, “earn” bonuses and closet your losses
The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages “underlying” the derivative. A senior manager sends a blistering reply with this forceful punctuation:

“Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.”

Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, “most investors” (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The “AAA” rating is supposed to indicate that there is virtually no credit risk — the risk is equivalent to U.S. government bonds, which finance refers to as “risk-free.” We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven [PDF]. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.

Worse, the S&P document demonstrates that the investment and commercial banks that purchased nonprime loans, pooled them to create financial derivatives, and sold them to others engaged in the same willful blindness. They did not review samples of loan files because doing so would have exposed the toxic nature of the assets they were buying and selling. The entire business was premised on a massive lie — that fraudulent, toxic nonprime mortgage loans were virtually risk-free. The lie was so blatant that the banks even pooled loans that were known in the trade as “liar’s loans” and obtained AAA ratings despite FBI warnings that mortgage fraud was “epidemic.” The supposedly most financially sophisticated entities in the world — in the core of their expertise, evaluating credit risk — did not undertake the most basic and essential step to evaluate the most dangerous credit risk. They did not review the loan files. In the short and intermediate-term this optimized their accounting fraud but it was also certain to destroy the corporation if it purchased or retained significant nonprime paper.

Stress this: stress tests are useless against the nonprime problems

What commentators have missed is that the big banks often do not have the vital nonprime loan files now. That means that neither they nor the Treasury know their asset quality. It also means that Geithner’s “stress tests” can’t “test” assets when they don’t have the essential information to “stress.” No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses.

The results were disconcerting

A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch’s report on what they found.

Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.
[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.

Fitch also explained [PDF] why these forms of mortgage fraud cause severe losses.
For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.”
The widespread claim that nonprime loan originators that sold their loans caused the crisis because they “had no skin in the game” ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game. Neoclassical economics and finance predicts that because they know that the nonprime originators have perverse incentives to sell them toxic loans they will take particular care in their due diligence to detect and block any such sales. They assuredly would never buy assets that the trade openly labeled as fraudulent, after receiving FBI warnings of a fraud epidemic, without the taking exceptional due diligence precautions. The rating agencies’ concerns for their reputations would make them even more cautious. Real markets, however, became perverse — “due diligence” and “private market discipline” became oxymoronic. These two documents are enough to begin to understand:
  • the FBI accurately described mortgage fraud as “epidemic”
  • nonprime lenders are overwhelmingly responsible for the epidemic
  • the fraud was so endemic that it would have been easy to spot if anyone looked
  • the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a “don’t ask; don’t tell” policy
  • willful blindness was essential to originate, sell, pool and resell the loans
  • willful blindness was the pretext for not posting loss reserves
  • both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed
  • the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses
  • the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation
  • many of the big banks are deeply insolvent due to severe credit losses
  • those big banks and Treasury don’t know how insolvent they are because they didn’t even have the loan files
  • a “stress test” can’t remedy the banks’ problem — they do not have the loan files

* “Mortgage Fraud: Strengthening Federal and State Mortgage Fraud Prevention Efforts” (2007). Tenth Periodic Case Report to the Mortgage Bankers Association, produced by MARI.

Government Deficits Generate Household Savings

by L. Randall Wray

A Bloomberg report by Rich Miller and Alison Sider recently noted that “Americans are shutting their wallets and building their nest eggs at the fastest pace in 15 years.” It went on: [T]he household savings rate rose to 6.9 percent in May, the highest since December 1993, as personal spending increased less than incomes. The rate in April 2008 was zero. Most of the rise in income in May was due to one-time government stimulus payments to seniors, said Nigel Gault, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts.
These should not be surprising events, as we have explained in previous posts (here, here and here). Government sector spending creates private sector income; government sector deficits create private sector savings. These are identities that virtually no one recognizes. I can recall that during the Clinton administration’s budget surpluses, the Wall Street Journal ran two front-page stories side-by-side, one congratulating the government for finally getting its budget in order—supposedly adding to national savings–and the other chastising consumers for spending more than their incomes—reducing national savings. The rising Obama budget deficit will help our private sector to accumulate savings and retire debt, part of the necessary remedy to the run-up of debt that occurred over the past dozen years. Unfortunately, fiscal policy remains too tight, as evidenced by continued (and, I think, growing) stress in the retail sector.

The report goes on: “the trend will put the country’s finances in better balance and reduce its dependence on Chinese investment”. Now this is utterly confused. Yes, our household sector’s finances will improve and might eventually recover—if the fiscal stance loosens and job losses are turned around to employment growth. However, the US did not, indeed in a significant sense cannot, rely on the Chinese. Our spending is in dollars, and we are the source of those dollars. Needless to say, every dollar spent by the Chinese was generated by us. In fact, we “financed” their accumulation of dollars, mostly through our current account deficit (we bought more stuff from them than they bought from us). This allowed them to “net save” in dollar assets. As our trade deficit with China shrinks (by the way, not necessarily a good thing for us!), China’s net saving in dollars will also shrink. It is quite unlikely that the trade balance will reverse any time soon (China is not going to become a net importer in the near future), so China will continue to accumulate dollar assets although (probably) at a reduced pace. But that does not “finance” US domestic spending.

Why The Stimulus Isn’t Working

by Stephanie Kelton

President Obama’s economic advisors are predicting that the recession will come to an end sometime this year, as fiscal stimulus spending kicks into high gear. But the conditions for an economic recovery have not been laid.

What the left hand giveth (see table), the right is quickly taking away.

And I’m not talking about the “right-wing.” I’m talking about state and local governments across the nation, who are unwittingly pulling the rug out from under the federal government and thwarting any chance for a sustainable recovery by 2010.

But it isn’t their fault. Tax revenues have fallen off a cliff, leaving states with a cumulative budget gap of more than $100 billion for fiscal ’09.

To deal with these shortfalls, states have laid off or furloughed thousands of employees, raised taxes and fees, and slashed spending on education and other social programs – some, many times over. It was supposed to balance their ’09 budgets. But it wasn’t nearly enough.

As it turns out, state officials were far too optimistic about the ’09 revenue picture, and they are scrambling to deal with widening shortfalls before the end of the fiscal year (which, by the way, is tomorrow for all but a few states). At this stage in the game, there are only a couple of ways for states to balance their ’09 budgets (it’s too late for more tax hikes and spending cuts). Most are expected to do one of two things: (1) tap rainy day funds or (2) use federal stimulus money.

For example, Ohio is expected to dip into its $948 million rainy day fund in order to deal with its worst-ever decline in tax revenue. Meanwhile, Massachusetts Gov. Deval Patrick has indicated that his state will be forced to use some of its federal stimulus money to plug a budget gap of nearly $1 billion by June 30.

The problem, of course, is that the macroeconomic effects of these micro-level policies are working at odds against the federal stimulus effort. Jobs that are being created (or saved) through the left hand of the Obama stimulus package are disappearing at least as rapidly as the right hand slashes billions from state budgets.

And, while Obama’s advisors are focused on the silver lining in the recent job data (losses are slowing), the employment picture remains bleak. The following table shows the change in unemployment rates – by state – since the start of the recession and from April ’09 to May ’09.

All but two states saw an increase in unemployment last month, and fourteen states are now in double-digit territory. President Obama’s economic team has admited that the national average will probably reach double-digits, but they anticipate a turnaround as a flood of stimulus money makes its way into the economy later this year.

But Obama’s advisors may be overlooking the fact that much of the stimulus money isn’t going to be there to fund new projects and drive economic growth. This is because states like Massachusetts are diverting stimulus money away from future projects in order to cover past (2009) budget shortfalls.

And the worst may be yet to come. States are bracing for even bigger revenue shortages next year, and governors across the nation are warning of deeper cuts in fiscal 2010. And right now, no single state poses a bigger threat to the nation’s economic recovery than California.

With an estimated $24 billion budget shortfall and a July 1 deadline to close its deficit, California’s top officials asked the federal government for emergency funding to help alleviate further drastic cuts in state spending. But the president’s top economic advisors – including Treasury Secretary Timothy Geithner, and White House economists Lawrence Summers and Christina Romer – rejected Gov. Schwarzenegger’s request for aid, choosing, instead, to admonish the governor for failing to put California’s fiscal house in order.

The Washington Post reported that Gov. Schwarzenegger was denied federal assistance because White House officials feared that it would lead to “a cascade of demands from other states.” This kind of head-in-the-sand thinking will have tragic consequences.

States need more aid, and they need it now. The White House should be faced with a cascade of demands, and these demands should come from a broad coalition of governors, who storm the White House – cameras rolling – to explain the dire consequences of denying them emergency aid. Randy Wray suggested, in a previous post, that states need another $400 billion or so, and that seems like a reasonable figure. I would urge our nation’s governors to immediately request an additional $1,000 per resident.

As I have argued in a previous post, the Obama administration’s initial forecasts were far too rosy, and the Economic Recovery & Reinvestment Act didn’t provide enough aid for states. More needs to be done, and it needs to be done now. Every dollar slashed from a state budget undermines a dollar of federal stimulus spending.

Stress tests Total Sham

“Stress tests Total Sham” William K. Black on Fox Business.