Monthly Archives: July 2009

BIS Report Warns That Main Problems Have Not Been Solved

Posted on July 6, 2009 by | Comments Off on BIS Report Warns That Main Problems Have Not Been Solved

by Eric Tymoigne

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

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Coherently Confronting US Macro Challenges

Posted on July 3, 2009 by | 1 comment
Many investors, policy makers, and economists find themselves unnerved by current economic conditions, and reasonably so. Depression or recovery, deflation or run away inflation, private or public insolvency – debates rage on all fronts. The disarray reflects in part the uncharted waters the global economy has sailed into over the past year, but it also reflects the inadequacy of contemporary macro frameworks. The financial balance approach is a simple yet powerful lens that can help clarify relationships that otherwise remain elusive at the macroeconomic level. Without this lens, it is hard to think coherently about the options available and their possible consequences.

We first encountered the financial balance approach[1] in the work of Wynne Godley at the Levy Institute for Economics over a decade ago, but this framework also informed the contributions of Hy Minsky and Dr. Kurt Richebacher in anticipating the conditions that give rise to financial instability at the level of the economy as a whole. It is not a difficult approach to follow, but it has proven very useful in thinking through the implications of recent credit bubbles and episodes of financial instability.

We can enter this approach from the standard macro observation that in any accounting period, total income in an economy must equal total outlays, and total saving out of income flows must equal total investment expenditures on tangible assets. The financial balance of any sector in the economy is simply income minus outlays, or its equivalent, saving minus investment. A sector may net save or run a financial surplus by spending less than it earns, or it may net deficit spend as it runs a financing deficit by earning less than it spends.

Furthermore, a net saving sector can cover its own outlays and accumulate financial liabilities issued by other sectors, while a deficit spending sector requires external financing to complete its spending plans. At the end of any accounting period, the sum of the sectoral financial balances must net to zero. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. In macro, fortunately, it all has to add up. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.

We can next divide the economy into three major sectors: the domestic private sector (including households and businesses), the government sector, and the foreign sector and ask a simple question relevant to current developments. What happens if the domestic private sector tries to net save, with no attending change in the government or foreign sector financial balances?

If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output will be likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies – that is, unless creditors are generously willing to renegotiate existing debt contracts en masse.

In other words, such a configuration is an invitation to Irving Fisher’s cumulative debt deflation spiral which has been discussed on this website and in prior Richebacher letters. So unless some other sector is willing to reduce its net saving (as with the foreign sector recently, via a reduction in the US current account deficit as US imports have fallen faster than US exports) or increase its deficit spending (as with the federal budget balance of late) then the mere attempt by the domestic private sector to net save out of income flows, given the existing private debt overhang, can prove very disruptive.

In fact, the US economy has dipped into a mild version of Fisher’s debt deflation process as nominal GDP has fallen, wage and salary income flows have fallen, the CPI and other inflation measures have dropped into deflation, and private debt delinquencies and defaults are still spreading. Following the shocks to tangible and financial asset prices, credit availability, and the labor market, the US private sector, by our calculations, has swung from a 4.5% of GDP deficit spending position three and a half years ago to a 4% net saving position as of Q1 2009. This exceeds the 8% of GDP swing in the private sector financial balance witnessed as the tail end of the 1973-5 recession – it is an enormous adjustment, to put it mildly.

Had the current account deficit (which, remember, is the trade balance plus net income flows related to asset holdings, equals foreign net saving) not shrunk from 6% to 2% of GDP over the same period, while the combined government fiscal deficit increased from 1.5% to 6% of GDP, then the attempt by the private sector to complete such a dramatic swing in its financial balance position would have ended in a very sharp and severe debt deflation.

From an Austrian School perspective, nothing less than that is required to wipe the slate clean of excess private debt and to free up productive resources misallocated during the credit boom years. However, the political appetite for an Austrian solution appears to have all but disappeared following the global repercussions of the Lehman derailment. Investors and policy makers looked into the abyss, and they could not stomach what they saw. Even Germany Chancellor Merkel, who appears to have the most Austrian orientation among G7 policymakers, has chosen to introduce some degree of fiscal stimulus and financial sector intervention in the German economy.

To further illustrate the current situation, we can use the 1973-5 recession as a rough guide – after all, as mentioned above, that is when domestic private net saving jumped to its highest share of GDP in the post WWII period. Currently, we appear to have an even deeper recession, and we know the drop in the ratio of household net worth to disposable income is over four times that experienced in the 1973-5 episode. What happens if private net saving preferences run all the way up to 10% of GDP, with say an additional 4% of GDP increase from the household side, and another 2% from the business side?

If the swing evident from 2006 is any indication, the hypothetical 4% increase in the household financial balance as a share of GDP will take the current account back to balance (for the first time in nearly two decades) from its recent 2% of GDP deficit position. To further contain debt deflation dynamics, given a domestic private sector attempting to save 10% of GDP, the combined fiscal balance will need to expand out to 10% of GDP, or else private income will fall further. The reduction in foreign net saving and the increase in fiscal deficit spending will then match the increase in private net saving from Q1 2009 values assumed above.

If the combined government deficit aims for 12-13% of GDP while the domestic private sector is shooting for 10% and net foreign saving is zero, then the odds improve that an economic recovery can take root alongside a larger private sector deleveraging than we witnessed in Q1 2009. Household and business incomes will be buttressed by tax cuts and government spending, which will allow higher private spending for any given private saving target. In other words, in a worst case scenario, it does appear debt deflation dynamics can be contained and reversed, but at the price of a rather large fiscal deficit that in essence validates higher domestic private sector net saving. The linkages between rising private sector net saving and deflation, and between fiscal deficits and private net saving, are currently poorly understood, but the financial balance approach helps bring some clarity to these questions.

Normally, the business sector tends toward a deficit spending position as profitable investment opportunities exceed retained earnings. This makes a certain amount of sense: debt imposes future cash flow commitments on borrowers, and using debt to expand productive capacity allows the borrower to have a decent shot at generating sufficient cash flow to service debt. Notice this is not usually the case with consumer debt, except perhaps with the case of mortgages used to purchase rental properties, or credit cards used to finance new small businesses. Households do not directly increase their income earning capacity, and hence their debt servicing capacity, by purchasing a flat screen TV or a larger house on credit. Of course, businesses that use credit to buy back shares or complete a merger or acquisition similarly are not directly enhancing their ability to service debt with new productive capacity, so the intended use of new debt is relevant in either sector.

Richard Koo makes the related point in his book, “The Holy Grail of Macroeconomics”, that following the bursting of an asset bubble, businesses often move into a debt reduction mode that takes over their usual search for profitable opportunities. For the current post bubble period, reeling fiscal deficit spending back in before the business sector is headed back toward its more “natural” deficit spending position, or before the rest of the world has found its way to a faster pace of recovery than the US (thereby aiding US export growth), could prove disruptive.

Ideally then, fiscal deficit spending would be designed to encourage businesses to reinvest in more efficient technology or in new product innovation, both of which could help improve US export competitiveness. Alternatively, public/private cooperation in R&D projects like Sematech could be explored with various emerging energy technologies, for example, in order to reduce US energy dependence. Such moves would speed the transition away from deep fiscal deficit spending which began riling investors in longer dated Treasury debt back in March. Nevertheless, such a shift in the fiscal deficit was required for the domestic private sector to return to a net saving position and begin reducing its debt load without setting off a full blown debt deflation.

At best, favorable effects on business investment will arise be secondary or peripheral results of some of the infrastructure and green tech investments in the current fiscal stimulus package, generally due to ramp up in 2010 and 2011. Unfortunately, since few economists work with the financial balance approach we shared with you above, policy makers are not yet emphasizing this type of policy design. Nevertheless, the financial balance approach does offer a more coherent way of thinking about the macroeconomic dynamics currently underway, and the plausible paths ahead. From this framework, we can see the situation is indeed difficult, but not insurmountable, as some of the necessary adjustments in US sector financial imbalances are already in motion. Deflation in the US does look like it can be contained and reversed, but the quest for a new growth model – one that does not rely on serial asset bubbles, household deficit spending and debt accumulation, and imported consumer goods leading to a perpetually rising current account deficit – remains ahead. No doubt it will test the ingenuity and adaptability of an entire generation – a generation that through the abundance of credit, may have forgotten that in order to consume, one must first produce.

[1] Very simply, if income (Y) equals expenditures (E) at the level of the whole economy, and we split the economy into three sectors, domestic private (dp), government (g), and foreign (f) then the following holds true:

Y = E
Ydp + Yg + Yf = Edp + Eg + Ef
(Ydp-Edp) + (Yg-Eg) + (Yf – Ef) = 0

The first term in parentheses is the domestic private financial balance, the second is the combined government financial balance, and the third term is the inverse of the current account balance, since US imports are income to foreign producers, and US exports are expenditures of foreign economic agents. The sum of the domestic private financial balance and the combined government financial balance minus the current account balance must net to zero.

This is an ex post accounting identity that must hold true. It could equally be derived using the saving equals investment identity for the economy as a whole. Values for these concepts can be derived from the Fed’s Flow of Funds quarterly report. In general, nominal income adjusts to reconcile divergences in planned investment relative to intended saving.

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Bring the Stubborn Unemployment Numbers Down Now

Posted on July 2, 2009 by | 18 comments

by Pavlina R. Tcherneva

Every month this year (perhaps with the exception of May) economic forecasters were stunned by the unexpectedly high unemployment numbers. Today the Bureau of Labor Statistics reported that in June employers shed 467,000 jobs, pushing the unemployment rate to 9.5%, a 25-year high. With an ever gloomier jobs picture, President Obama’s economic team has started to change its tune with respect to the promised job creation. The first economic report on the job impact of his recovery plan carefully phrased the objectives to include “creating or saving” at least 3 million jobs by the end of 2010. Those early projections called for peak unemployment of 8% in the third quarter of this year, far less than today’s actual unemployment rate of 9.5%

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‘Easy Money’ Didn’t Sink the Economy

Posted on July 2, 2009 by | 2 comments

By Stephanie Kelton

Brad DeLong, Mark Thoma and David Beckworth have spent the last few days debating the extent to which Alan Greenspan’s easy money stance (2001-2004) qualifies as a “significant policy mistake.” DeLong asks:

“Should Alan Greenspan have kept interest rates higher and triggered a much bigger recession with much higher unemployment back then in order to head off the growth of a housing bubble?”

As I see it, these are really two separate questions: (1) Did Greenspan’s easy money policy cause the bubble? (2) Should Greenspan have attempted to diffuse the bubble – with higher interest rates — once he identified it?

I wrestled with these precise questions in a presentation I have given many times since last fall. I started with Greenspan’s own argument.

In an interview with a reporter from the Wall Street Journal, Greenspan characterized himself as “an old 19th-century liberal who is uncomfortable with low interest rates.” Yet he lowered the federal funds rate thirteen times from 2001-2003, pushing it to just 1% at the end of the easing cycle. Looking back on that period, Greenspan admits that his “inner soul didn’t feel comfortable” with those sustained rate cuts, but he maintains that it was the right policy in the aftermath of the dot.com bubble. Moreover, he insists that the run-up in housing prices was not the result of his monetary easing and that “no sensible policy . . . could have prevented the housing bubble.” Indeed, Greenspan maintains that the housing bubble emerged because risk premiums – not interest rates – were kept too low for too long.

As Greenspan argued in his memoir, geopolitical forces outside the control of the Fed caused risk premiums to decline, and this, ultimately, led to the housing bubble. In his view, there was nothing the Fed could have done to prevent the decline in risk premiums, which had its roots “in the aftermath of the Cold War.” His argument runs as follows: Over the past quarter century, the fall of the Berlin Wall, the collapse of the Soviet Union, China’s protection of foreigner’s property rights, the adoption of export-led growth models by the Asian Tigers, and the reinstatement of free trade produced significant productivity growth in much of the developing world. And because developing nations save more than developed nations – in part due to weaker social safety nets – there has been a shift in the share of world GDP from low-saving developed nations to higher-saving developing countries. Greenspan believes that this resulted in excessive savings worldwide (as saving growth greatly exceeded planned investment) and placed significant downward pressure on global interest rates. Thus, as he sees it, the demise of central planning ushered in an era of competitive pressures that reduced labor compensation and lowered inflation expectations. As a result, the global economy experienced years of unprecedented growth, markets became euphoric, and risk became underpriced.

This takes me back to Mark Thoma’s argument. Thoma believes that Greenspan’s easy money policy was a significant policy mistake. He said:

“It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria.”

But Greenspan seems to be arguing that the natural rate was also declining, so it isn’t clear that market rates were pushed too low. And while I don’t buy Greenspan’s argument, I also don’t believe easy money sunk the economy.

I think there is an alternative explanation that is based on factors that had little (if anything) to do with Greenspan’s monetary easing from 2001-2003 or with geopolitical factors. To be sure, this sustained period of low interest rates made home ownership more affordable and increased the demand for home loans. But the increase in home prices could not have expanded at such a frenzied pace in the absence of rating agencies, mortgage insurance companies and appraisers who validated the process at each step.

As my colleague Jan Kregel put it, “the current crisis has little to do with the mortgage market (or subprime mortgages per se), but rather with the basic structure of a financial system that overestimates creditworthiness and underprices risk.” Like Greenspan, Kregel views the housing bubble and ensuing credit crisis as the inevitable consequence of sustaining risk premiums at too low a level. Unlike Greenspan, however, he maintains that bubbles and crises are an inherent feature of the “originate and distribute” model. Under the current model, risks become discounted because “those who bear the risk are no longer responsible for evaluating the creditworthiness of borrowers.”

Thus, with respect to the debate over the role of low interest rates, I would argue that it was not loose monetary policy but loose lending standards (abetted by a hefty dose of control fraud) that brought us to where we are today.

Now to the second question: Should Greenspan have raised rates sooner, in order to “head off the bubble”?

DeLong has admitted to being “genuinely not sure which side I come down on in this debate.” Unlike Thoma, DeLong appears sympathetic, even empathetic, trying to imagine what it must have been like to be in Alan Greenspan’s shoes:

“If we push interest rates up, Alan Greenspan thought, millions of extra Americans will be unemployed and without incomes to no benefit . . . . If we allow interest rates to fall, Alan Greenspan thought, these extra workers will be employed building houses and making things to sell to all the people whose incomes come from the construction sector . . . . If a bubble does develop, Greenspan thought, then will be the time to deal with that.”

But Alan Greenspan was never so clear-headed in his thinking. Indeed, like DeLong, Greenspan appears to have been genuinely conflicted. He has argued that it is virtually impossible to spot an emerging bubble:

“The stock market as best I can judge is high; it’s not that there is a bubble in there; I am not sure we would know a bubble if we saw it, at least in advance.” (FOMC transcripts, May 1996)

Then, just four months later, Greenspan indicated that he could not only spot an emerging bubble but that it would be dangerous to ignore it:

“Everyone enjoys an economic party, but the long term costs of a bubble to the economy and society are potentially great. As in the U.S. in the late 1920s and Japan in the late 1980s, the case for a central bank to ultimately to burst that bubble becomes overwhelming. I think that it is far better that we do so while the bubble still resembles surface froth, and before the bubble caries to the economy to stratospheric heights. Whenever we do it, it is going to be painful, however.” (FOMC transcripts, September 1996)

In 2004, Greenspan spoke before the American Economics Association and took the position that it is dangerous to address a bubble, insisting that it is preferable to let the bubble burst on its own and then lower interest rates to help the economy recover:

“Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion”.

Since then, Greenspan has argued that the Fed actually was trying to address the emerging housing bubble when it began to raise rates in the mid-2000s, but he says the policy was unsuccessful because long-term rates remained stubbornly low. Of course, he also said:

“I don’t remember a case when the process by which the decision making at the Federal Reserve failed.”

And I think we can all agree to disagree on that point.

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A Message to President Obama: Stop Priming the Pump, Hire the Unemployed

Posted on July 2, 2009 by | 2 comments
by Pavlina R. TchernevaMany have called President Obama’s stimulus plan a return to Keynesian policy. Some of us who like reading Keynes professionally or for leisure have already been scratching our heads. I have wondered in particular whether the plan isn’t set up to work in a manner completely backwards from what Keynes himself had in mind when he advocated economic stabilization by government.

There are two things to remember about Keynes’s fiscal policy proposals: 1) government spending was always linked to the goal of full employment (the absence of both cyclical and structural unemployment) and 2) to achieve macro-stability and full employment, the government had to employ the unemployed directly into public works.

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The Two Documents Everyone Should Read to Better Understand the Crisis

Posted on July 1, 2009 by | 2 comments

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.

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The Sovereign State of California?

Posted on July 1, 2009 by | 4 comments
by L. Randall Wray

As everyone knows, California’s state budget is in dire straits. Unlike the federal government, US state governments really do finance their spending through a combination of tax revenues and borrowing. They are users of the nation’s currency (the dollar), not issuers. The current recession (or depression) has caused their tax revenues to collapse. Their projected budget deficits cause ratings agencies to downgrade their debt—making it too expensive to borrow as this sets off a vicious cycle of further downgrades and ever rising interest rates.

However, California might have discovered a solution. Why not become sovereign? (As a native Californian, I can recall the 1960s pipedream of secession of northern California along with Oregon and Washington to create a utopian, green, peaceful nation—but that is another matter.) As reported this morning by Jim Christie:

“California prepared on Tuesday to resort to issuing IOUs as the giant but cash-strapped U.S. state struggled to approve a new budget in time for the new fiscal year that begins on Wednesday. The IOUs, which are notes promising payment to vendors and local agencies, or shutting down some public services, are among measures that California and other states may have to rely on as they contend with staggering budget gaps caused by the U.S. recession.”

That could be a step in the right direction, but it is still borrowing. Here is a suggested improvement. The state should announce a new currency, the California Dollar. Henceforth, the California Dollar will be accepted in all payments made to the Great State of California (fees, fines, and taxes, including payments made by students to the state’s public universities). The state, in turn, will begin to make a portion of its payments in the form of California Dollars. Of course, no one can actually make payments in the form of California Dollars until the state has actually spent some into existence. State payments using California Dollars will be made, as described above, to “vendors and local agencies”. Over time the state can negotiate with others, including employees, to pay out California Dollars. Note that the state will run deficits in California Dollars only to the extent that the population wants to accumulate those Dollars (in excess of the fees, fines, and taxes paid).

Some readers might worry about anti-counterfeiting laws. So far as I understand it, the California Dollar would be treated like the “local currency” systems already in operation around the nation. In the beginning, California will probably value the California Dollar at par against the US dollar. However, it should not promise to convert the California Dollar on demand since that could lead to insolvency (after all, California’s current problem is that it cannot get enough US dollars to cover its spending). The California Dollar would be freely convertible in private exchanges, however—at a floating rate. Exchange rates are very complexly determined and I would not want to predict how the California Dollar will do over the next few years. However, since this proposal would allow California to halt the “Little Hoover” downward spiral occurring in states all across the country, I expect its new Dollar would do pretty well.

Who knows, maybe Arnold—not Obama–is the next FDR?

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