Advocating for the financial decoupling of government and business.

No more bailouts.  Let the free market function.  Educate, not regulate.

Education Not Regulation

2009-12-28 08:39:43

The purpose of government is to protect the population.  And while our government has served this purpose well over the last 200 years, it has now gone too far.  It’s time that we take back the responsibility to protect ourselves.  We no longer need the government to watch out for us.  In the past we were too busy or ignorant of banking systems and healthcare to make informed decisions for how to spend our money.  These days, with the level of education that most of us have, and the widespread use of the internet in which information flows freely, we are more than capable of protecting ourselves and our families without big government ‘help’.  In fact, the problems that our nation faces today in banking, healthcare, and other areas are a direct result of our desire for government to take care of us.

Our government (along with private enterprise) should be more focused on educating the population about making the right decisions, and not trying to make the decisions for them.  The best we can do is hope that people will make the ‘right’ decision based on the information supplied.  But people must be responsible for their own decisions.  If we leave the important decisions about healthcare and finances up to the government, we will have to suffer the consequences of their poor decision making.  It’s not rational to believe that suddenly the government will start making good policy decisions.  Furthermore, even if they do, they will be overturned by the next administration.

Mortgage Interest Tax Deduction

One example of this is the mortgage tax deduction.  There are many good reasons to encourage people to own homes instead of renting them.  It improves property values and reduces crime.  It strengthens the community.  On the other hand, there are good reasons to rent.  Not everyone is able to make a commitment to live somewhere for the rest of their lives, or even for a significant period of time.  Many people need to be mobile – to move to where the jobs are, for example.

Which is the better policy?  Should people be encouraged to buy homes or rent them?  The answer is that it all depends.  Unfortunately, the ‘smart’ people in government decided that it’s better to own a home.  And to encourage home ownership, they created a financial incentive: the mortgage interest tax deduction.  As a result, many people who might have rented a home now own one.  In fact, the US has one of the highest home ownership rates in the world.

Unfortunately this policy contributed to the real estate balloon.  Too many people bought homes that were too expensive.   When the market fell, they defaulted on their loans, resulting in the current financial crisis.  Nevertheless, the National Association of Realtors continues to support the deduction.  They claim that housing prices could fall 15% in some areas without it.  If this is true, it is evidence that the policy significantly contributed to the housing crisis.  (Was NAR behind the extensive home ownership tv commercial blitz of 2005-6?)

Without this incentive, many people simply would not have bought a home, or would have bought a cheaper home that they could better afford.  The market would not have inflated as much.  This would have reduced the foreclosure rate, mitigating the current crisis.  Also, the work force would be more mobile, and people could more easily move to where the jobs are, instead of being stuck in a ‘sinking ship’.

The deduction costs the government about $100 billion a year.   Far better it would be if the government created a consumer education campaign about the benefits of home ownership, and let the citizens decide for themselves.  An effective campaign would not even cost $100 million.

Yes, house values will fall.  But the deduction is too expensive and fundamentally unfair to renters who have to bear a greater burden of tax.  The policy also favors the rich who own more expensive homes, because their deduction is larger, and because lower income homeowners don’t itemize.  The rich are not paying their fair share of taxes.

The deduction should be discontinued for new home buyers in 5 years, and phased out over a period of 10 years for current mortgage holders.


Social security

Social Security was created in the 30’s with the best of intentions – helping the aging workforce avoid poverty after retirement.  It was a great program and very effective, and millions of seniors rely on it every month for their financial needs.  Unfortunately, seniors are taking out of social security far more than they put in.  Although the fund has money now, it will run out by 2020(?).  At that point, the government will have to start borrowing money to pay for social security.  Certainly there will be some increase in the workforce to supply additional funding, but ultimately it’s a true pyramid scheme.  It works great at the beginning, but fails catastrophically at some point.  We should not wait for this time to come.  Social security must be phased out over a period of 30 years.  Workers must start to make financial decisions on their own for investing their retirement savings.  They cannot rely on government.  Of course some people will make poor decisions.  And they should be helped.  But the vast majority will invest wisely, and will have a substantial nest egg to retire with.

Financial education is a critical component of this shift.  Children must be taught early on the basic concepts of financial planning, such as investment options and diversification.  Consumer advocacy groups must be vigilant in detecting potential problems with investment strategies and alerting the population.


The FDIC was created to protect bank customer’s deposits.  Now, people must take responsibility for their money.  We cannot rely on the government to protect us.  If we do, we will continue to face crisis after crisis.  It is simply unfair to ask other taxpayers to pay for our mistakes when choosing a reliable bank.  (Although taxpayer funds have not been used to bail out the FDIC, this is only because the Government bailed out AIG and other banks with over $1 trillion, thereby allowing many banks to avoid insolvency.)

If we want our money to be completely secure, we should invest in US Treasuries.  This is the most secure investment in the world.  Of course, the return is not high, but that is the price for stability.  If we want to invest in riskier markets, such as banks typically do, then we should expect that in some very rare cases the bank will lose a small amount of money.  In the current foreclosure crisis, foreclosure rates reached a peak of only 4%.  Assuming a bank was diversified in its holdings, the amount of loss of deposits would be only this amount.  For a small risk, we can expect a much more stable banking system.  Bank runs can be prevented by allowing banks to temporarily suspend withdrawals.  If the bank is going to fail, then its assets can be sold in an orderly manner, extracting the greatest return for the depositors.  We accept risk when investing in the stock market and real estate, we can certainly tolerate a small amount of risk with our bank accounts.

The current FDIC insurance mechanism is very unfair.  The limit of $250,000 protects the very rich, who can get around the limit simply by dividing their assets into multiple accounts at different banks.  Why should the average taxpayer be on the hook for the richest people’s money?




We no longer need the ‘Nanny State’.  We are grown up now and can take of ourselves.  We don’t need government regulators and policy makers to spend our money for us.  They will invariably make worse decisions, due to inevitable political pressure, than the great majority of American individuals.  Financial regulation does not work, and cannot work, because financial institutions will always figure out new ways around them.  Beware of anyone in finance who says their business should be more highly regulated.  They are only seeking cover for the next time they take our money.

The great irony of government protection is that it protects the richest among us the most, leaving everybody else on the hook.  The degree of government protection must be scaled back and phased out over time.  People must take responsibility for their financial decisions.  We must invest in high quality consumer education.  Of course there will be problems, but the level of crisis will be greatly reduced.  Don’t underestimate an American’s ability to make the right decision for his or her family.

None of this in any way reduces our moral duty to help out those who are in need.

How to prevent a bank run

2009-12-28 08:41:26

The history of the US banking system is in part the history of attempts to prevent bank runs. It’s almost inconceivable now: you hear a rumor that your bank might fail and you run to the bank to withdraw all your cash, hoping that they’ll even have it on hand to be able to give it to you. You find a long line of people waiting outside, or a scene of people demonstrating and even panicking. You might feel lucky even if you get back some of your deposits.


Bank runs occurred sporadically in the 1800’s, and reached a climax during the Great Depression, which experienced repeated waves of bank runs over 4 years and reduced the trust of Americans towards holding bank accounts. Many stuffed cash in their mattresses. Bank runs still occur today (e.g. Wamu and IndyMac) but they tend to be quieter and dissipate quickly. Consumers are not as fearful because they believe that their money is insured by the FDIC, which is backed by the American government and ultimately the taxpayer.


In the past, many runs were false alarms based on rumors, and ultimately the banks returned to business as usual. But in many cases the banks were failing, and customers might suffer a significant loss on their deposits. In the banking panic of 1907, for example, customers of failed banks lost up to 20% of their deposits. However, overall the number of failed banks was small, and the losses due to them was very small, approximately 0.2% of total commercial bank deposits on a yearly basis. Nevertheless, bank failure was always a significant concern, and consumers were generally well versed in the issue of solvency of banks. Today we don’t worry about this because we assume the government will protect us.


Unfortunately this protection comes at a great price. In the last 2 years, the Federal Government has spent over $2 trillion dollars to protect the banking system and prevent banking panics, as well as increasing insurance to bank accounts, up to $250,000 per account, as well as (temporarily) for money markets which were previously unprotected, and even accounts at investment banks. The taxpayer is now on the hook for any shortfalls if these banks fail, and certainly for propping up these banks, many of which are zombies. For example, Citigroup is by some accounts a zombie bank – surviving only through direct and indirect government support. (Citigroup received a grade of ‘F’ from Institutional Risk Analytics, the company hired by the FDIC to evaluate solvency of its member banks.)


The Federal Reserve and the Treasury justified their support of investment banks not because these organizations were fundamental in the economy. Indeed, as most people know, these institutions exist primarily for the purpose of making a profit, and unashamedly so. Instead, they justified their support of these institutions by the fear that if they fail, a banking panic would spread through the entire financial system, as it did in the Great Depression, and take down consumer banks as well. Federal Reserve Board Governor Ben Bernanke, a student of the Great Depression, knew very well that this must be avoided at all costs, because a severe impairment of a banking system deepens and lengthens a depression.


Whether the taxpayer receives back his $2 trillion investment to prop up the banking system remains to be seen. I suspect that much money will be lost because the government is still artificially inflating the housing market through the nationalization of Freddie and Fannie, and purchases by the Federal Reserve. Furthermore, banks are probably still not valuing their housing-market based assets fairly. It’s likely that the housing bubble will pop again, and banks will need even more government support, which may or may not be given depending on the public’s appetite for more bailouts. A new wave of bank runs may occur on a scale never before seen.



Anatomy of a Bank Run


There are two basic types of bank runs: runs on ‘good’ banks and runs on ‘bad’ banks. A good bank is one that is solvent and can meet customers demand for withdrawals, even if it does not have the cash immediately on hand. It can sell assets to raise cash, hopefully in a good market, restore confidence, and then resume normal operations. Runs may spread to other banks, but will soon dissipate.


However, a run on a ‘bad’ bank, by contrast, does not end so well. In this case, the bank runs out of available cash and does not liquidate more assets. The governing body, state or federal bank regulator, will examine the bank’s holdings and declare if the bank is solvent (if its assets are greater than its liabilities). If it’s not solvent, the bank will be suspended and customers will have to wait to retrieve their deposits. Depending on if the bank is insured (essentially all banks are insured these days) the customer will receive back some or all of their deposit. This type of bank run is more likely to spread to other banks, as others question the solvency of their own banks. Thus there is the potential domino effect of banks failing.


This is actually a simplistic view, because banks are not so clearly ‘good’ or ‘bad’. In fact, probably many good banks failed during the Great Depression. The reasons for this are complex, but one important component was that, because the overall economy was very poor, banks had to sell assets, particularly bonds, into a depressed market to raise cash in the event of a run.  This lowered the overall asset base and forced them into insolvency, which would then spread to the next bank. If they could have waited, then they would have survived. An influential view at the time was that the economic contraction was necessary to purge the economy of the weak institutions, so such bank failures were actually considered ‘healthy’. Economists at the time did not appreciate the importance of a robust banking system in overcoming an economic downturn, and the damaging effects of an impaired banking system.


Banking Panic of 1907


The banking panic of 1907 started with the failure of several speculative copper industry banks, which spread to the Knickerbocker Trust in New York City a week later. This was before the FDIC and the Federal Reserve, and so depositors panicked in their attempt to withdraw money, which they feared could be lost forever, and the panic spread to other trusts as well as the stock market. To ease fears, New York State stepped in with $25 million to loan to the bank network, but that did not stop the panic. JP Morgan raised another $25 million, and this seemed to calm the nervous public.


However, the fear by this time had spread throughout the country. Banks responded by imposing a restriction on cash withdrawals, as they had done several times previously when threatened with runs. This was a painful limitation on a population so dependent on cash for every day needs as well as industrial requirements. However, the banks permitted other types of transactions, such as cashier’s checks and bank transfers. The restriction lasted up to 3 months in some parts of the country. This prevented failure of many banks because they had the ‘breathing room’ to restore customer confidence. Although a painful experience, a severe bank run and a wave of bank failures was avoided and the economy recovered.


However, the population had enough of restrictions on withdrawals. The government responded with the Aldrich-Vreeland Banking Act of 1908, which provided for loans to be made to banks quickly in the event of a run. This act was used only once, in 1914 related to the start of WW I, and seemed to work well.


This financial mechanism was superseded by the Federal Reserve System in 1914. Although we think of the Federal Reserve today as governing monetary policy to optimize economic conditions (by setting important interest rates), back then the purpose was primarily to prevent bank runs to avoid restrictions on payments. This was done by offering secured loans through its ‘discount window’. Adherence to the gold standard, as well as the governors’ poor understanding of monetary policy coupled with a very cautionary approach, prevented the System from having much influence on the economy.



Unfortunately the cure was worse than the disease. In the attempt to prevent bank runs and restrictions on payments, the end result was a series of waves of the worst bank runs in history (from 1930 to 1933), along with the most severe restrictions on payments ever, the banking holiday of March 1933, which lasted for a week, during which banks were shut down completely, resulting in economic chaos and suspension of half of of them.


Thus the panics of 1907 and 1933 were greatly different in character. According to Milton Friedman’s A Monetary History of the United States:


If the 1907 banking system had been in operation in 1929, restriction of payments might have come in October 1929 when the stock market crashed. If not, it would surely have come at the latest at the end of 1930 — probably on the occasion of the failure of the Bank of United States on December 11, 1930. Had the restriction come then, it seems likely in retrospect that it would have produced an immediate shock and reaction much more severe than the unspectacular worsening of conditions that occurred in the fall of 1930, but would also have prevented the collapse of the banking system and the drastic fall in the stock of money that were destined to take place, and that certainly intensified the severity of the contraction, if they were not indeed the major factors converting it from a reasonably severe into a catastrophic contraction. (p. 168)


The reform measure finally enacted — the Federal Reserve System — with the aim of preventing and such panics or any such restriction of convertibility in the future did not in fact stem the worse panic in American economic history and the severest restrictions of convertibility, the collapse of the banking system from 1930 to 1933 terminating in the banking holiday of March 1933. (p. 698)


To be sure, Friedman is not advocating for the return of restrictions on payment. He believes that Fed policy was far too tight, and was in fact the main cause of the Great Depression. Relaxing the policy (i.e. ‘easy money’) would have been a far better solution, in his opinion. Bank runs and resulting suspensions would be reduced through greater liquidity, and perhaps more importantly, there would be a better financial environment in which banks could operate with greater stability.


How to prevent a bank run, Part II: FDIC


After the panics of March 1933, the public became even more distrustful of banks and continued hoarding cash. The economy continued to contract. The Banking Act of 1933 established the FDIC, which created government backed insurance for all bank accounts in member banks, up to a limit of $2,500. This policy has been greatly successful in restoring confidence in the banking system, and has prevented severe bank runs up to the present day. (However, the ultimate cost of the policy I believe will be very high — far greater than the loss of assets it was intended to protect.)


Before the FDIC, deposits were not guaranteed, and everyone knew that they could lose their money in a failed bank (although as stated before this was rare). Now, bank accounts were protected by the Federal government. This was part of FDR’s New Deal (though not actually requested by FDR), which included other social safety nets such as unemployment insurance and Social Security. People no longer had to worry nearly as much. Security of deposit became a right.


Most economists agree that government insurance of deposits was a great idea, including Milton Friedman and JK Galbraith. According to Galbraith, on the establishment of FDIC: “As a result one grievous defect of the old system, by which failure begot failure, was cured. Rarely has so much been accomplished by a single law.” It seemed to be the panacea that everyone was searching for.

Moral hazard

As with all insurance, however, came the problem of ‘moral hazard’. Because bank accounts were guaranteed, bankers and depositors didn’t need to worry about the health of their banks as much, and so banks were subject to decreased market discipline. This presented a risk to the taxpayer, who was on the hook in the event of failure. Therefore, it was necessary for the government to regulate banks to make sure they acted responsibly. A regulatory framework was therefore developed, and the public put its trust in that framework.

The Savings and Loan crisis of the 1980’s resulted from the breakdown of the regulatory framework of the FDIC. The purpose of Savings and Loans, when they were created, was to provide funding for mortgages, and S&L’s were limited to home mortgages only. In the early 80’s the banks were brought in under the FDIC umbrella. However, in the mid 80’s, as interest rates rose, the banks became insolvent because the value of their fixed-rate mortgage assets decreased, while the interest they were required to pay on deposit accounts (in order to remain competitive) increased. They were allowed to continue, and were permitted to branch into higher yielding, riskier loans in commercial real estate, in the hopes that they would regain solvency. This strategy was a tremendous failure. They were finally shut down in the late 80’s, and resulted in a cost to the taxpayer of $140 billion. The FDIC insurance fund was depleted and covered only a fraction of total losses.

Because these banks were insured and regulated, the consumer had little reason to question the solvency of their bank or the soundness of its investments, which were in some cases complex real estate transactions (e.g. Whitewater). Instead it was left up to regulators, who for various reasons did not take action until it was too late. This was a prime example of the ‘moral hazard’ of insurance.

The cost to the taxpayer of the S&L crisis was far greater even than the total losses during the Great Depression, which amounted to about $7 billion total, which is about $50 billion in 1987 comparable dollars. This provides strong evidence that the real cost of insuring accounts is far greater than the potential loss of assets. When the depositor is monitoring his bank, problems with the bank are likely to be detected much earlier on.

Too Big to Fail

The “Too Big to Fail” doctrine is not new. In fact it was first enunciated in 1984 in response to problems at Continental Illinois Bank, which was the seventh largest bank at the time. Large losses on various assets resulted in a bank run by its uninsured depositors. The FDIC, in an attempt to prevent the panic from spreading to other banks, decided to offer full coverage for all accounts. While this worked, and allowed for an orderly wind down of the bank’s assets (over several years), it had two unanticipated results. First of all, the FDIC had to extend coverage nearly universally, as small banks demanded equal treatment. Secondly, it introduced the doctrine of “Too Big to Fail”. As Comptroller of the Currency Todd Conover testified, if the bank was allowed to fail:

We could very well have seen a national, if not an international, financial crisis the dimensions of which were difficult to imagine. None of us wanted to find out.

Thus a bank run was prevented, but at great cost. First of all, the taxpayer was now on the hook for the entire commercial banking sector. Secondly, the government had established a precedent for saving a ‘Too Big to Fail’ institution. If Continental was allowed to fail, certainly it would have been a shock to the banking system and might have taken down other banks. But the economy would have recovered. The government learned an important lesson, which was that this could be done, and in fact the Treasury under Hank Paulson used a similar strategy in 2008 to effect the $1 trillion dollar financial bailout of financial firms, Fannie and Freddie, and AIG. Certainly the failure of these institutions would have created a great shock to the system. However, as the failure of Lehman proves, the market is capable of withstanding such a shock.


The problem today


And as time went on, Federal insurance of bank accounts greatly expanded. Now, most bank accounts are insured up to $250,000, but individuals can divide their funds into multiple accounts, making the protection effectively unlimited. This increase of deposit insurance was not intended or anticipated, but was a necessary result of the system: as long as there was unprotected money in the banking system, a run was possible.


The total liability of the FDIC now is huge. There is no way that the FDIC could cover losses in a significant banking crisis, which means that the taxpayer must cover the shortfall as they did in the S&L crisis. Unfortunately the banking system now is not in a healthy state, with at least one huge zombie bank – Citigroup. If other large commercial banks aren’t zombies, it is only because of the taxpayer support they’ve received, and further downturns may force them into insolvency again.


This is the inevitable result of FDIC policy. In order to prevent bank runs, it must eventually insure the entire market. Otherwise there will be a run on uninsured deposits. But this creates a huge and untenable liability for the taxpayer. Furthermore, the government gets sucked into supporting zombie banks to avoid FDIC insurance fund losses, further increasing the taxpayer liability. Once a zombie, the bank will have great difficulty returning to solvency, and will be subsidized by the taxpayer indefinitely. This increases the Federal debt, which in turn reduces the solvency of the country as a whole.


Big investment banks like Goldman Sachs can now borrow directly from the Fed discount window (they were given access as a result of the financial crisis).  They can borrow at low interest rates and use the money to invest in risky assets, repay their TARP, and even pay themselves.  All this was done in order to maintain stability of the financial system, since the FDIC alone couldn’t do the job.


And lest one think that at least the problem of ‘restriction of cash withdrawals’ has been solved by the FDIC — it certainly has not.  The Credit Crunch of 2008 was simply a back door restriction.  The problem is back.  It simply something that we need to learn to live with.



Return to basics


The Federal Reserve and FDIC were both attempts to prevent bank runs and suspension of withdrawals. While it succeeded for 80 years in that regard, the limits of the policy have been reached. In its attempt to save the ‘good’ banks, the policy has resulted in zombie banks, and if history is any guide, the cost to resolve these banks will ultimately be far greater than the potential losses of assets of a bank failure that was caught early on.


As shown above, bank runs can be prevented by temporary restriction of cash withdrawals. While this was a big problem in a cash-based economy in the 1800’s, today the results would not be nearly as severe, since people can use other forms of payment, such as checks and credit and debit cards. Perhaps there would be limits on those methods of payments as well, but they would be temporary and the crisis would pass once confidence has been restored, or the bank is suspended. (This is a form of what happened in the Credit Crunch of 2008.)  Of course there would be a significant loss to the depositor if the bank is suspended (perhaps 20% – 50%), but this is a very rare occurrence and so the overall loss would not be great.


The consumer would have to learn to protect themselves against a bank failure, as they did in the 1800’s. If one wants to ensure complete liquidity and safety, one can invest in short term US Government Treasury bills, and in fact banks can create such accounts, as well as other types of high-reserve/low-yield accounts. Beyond this safe harbor, customers can deposit into more standard types of bank accounts with higher yield, accepting the risk of a fall in value just as they do when investing in the stock market. Currently US Treasury bills are the safest investment of all, although even they are threatened by the continuing government support of failed institutions.


It is an ironic but unavoidable fact that the attempt to make everything safe puts everything at risk.


Regulation doesn’t work; Education does

2009-12-28 08:42:29

Rethinking Bank Regulation: Till Angels Govern (Book review)


Contrary to the common view that banking regulations improve the security of bank deposits and reduce risky and careless behavior by bankers, the actual evidence is to the contrary: regulation and government supervision actually reduces the stability of the banking system. We can make conjectures as to the reasons for this: government supervision lulls the public into a false sense of security and allows bankers to behave recklessly. Or the regulatory agencies eventually become overly influenced by self-interested political powers. Or even the proponents of regulation actually have sinister motivations (certainly true in some countries). Regardless of the reason, the fact remains: regulations don’t work.


In their pioneering and comprehensive study of 150 banking systems around the world, internationally known banking experts James Barth, Gerard Caprio and Ross Levine contradict the conventional wisdom and show that regulations actually have adverse consequences on the banking industry, and probably always will, at least “till angels govern” (quoting from the political philosophy of James Madison).



Across the different statistical approaches, we find that empowering direct official supervision of banks and strengthening capital standards do not boost bank development, improve bank efficiency, reduce corruption in lending, or lower banking system fragility. Indeed, the evidence suggests that fortifying official supervisory oversight and disciplinary powers actually impedes the efficient operation of banks, increases corruption in lending, and therefore hurts the effectiveness of capital allocation without any corresponding improvement in bank stability.


What they are saying is the primary tools of banking regulation in the US (such as capital requirements and ability to shut down a bank), are not effective in other countries, and are in fact harmful.  Deposit insurance in particular, doesn’t work:


Also, although a state objective of government sponsored deposit insurance is to stabilize the banking systems, we find the opposite: the generosity of the deposit insurance regime is associated with greater banking system fragility, not enhanced stability.


This conclusion is quite scary, because in the 2008 financial crisis the Treasury and Fed greatly increased the level of government insurance: up to $250,000 per account.  Although their conclusions regard foreign banks, the lessons are still relevant for us.


However, there is something that actually improves banking performance: Education and market scrutiny.


One mechanism for fostering private monitoring of banks is by requiring the disclosure of reliable, comprehensive, and timely information. Countries that enact and implement these pro-private monitoring regulations enjoy more efficient banks and suffer from less corruption in lending. Furthermore, laws that strengthen the rights of private investors enhance the corporate governance of banks.


The authors only state the correlation. However, we can speculate on various reasons.  The ‘moral hazard’ argument is that insurance induces recklessness and carelessness on both the consumer and the banker: since the consumer doesn’t have to worry about the safety of their deposit, they don’t enforce any discipline on their bank, and the bankers take greater risks because they have reduced downside liability (government safety net). This is true of the S&L debacle of the 80’s, when investors continued to put money in insolvent banks for years, because they knew they were insured.  Furthermore, bank managers may mistake regulation for good practice, and believe that any action they take, as long as it conforms to regulation, is appropriate.


Clearly we, the public, must take responsibility ourselves for monitoring the banks. Government’s role primarily is to ensure a strong legal system.  Beyond that, it can require transparency and disclosure of information from banks, as it does with stocks and bonds. But it should not regulate them. If we take responsible for the safety of our money, we will do a much better job than the government in protecting it and avoiding financial catastrophe. If we allow government to do the job, we are almost guaranteeing another calamity.


Krugman’s folly

2009-12-28 08:43:28

In his recent New York Times Op Ed, Disaster and Denial, Paul Krugman argues that deregulation was the cause of the recent financial crisis, and that Republicans are simply in denial when they oppose increasing regulation. Krugman is wrong on both counts. The cause of the financial crisis was the housing bubble which was created by US government policy. And while there was deregulation, it had little effect on the financial crisis.



The cause of the financial crisis was the huge housing bubble, as can be seen in the graphs of historical home prices: Prices increased 50% – 80% and more in the most populous areas of the country between 1998 and 2006. When the bubble popped, the financial crisis resulted. What was the cause of the housing bubble? The US government policy of pumping money into it. Currently there is a $12 trillion mortgage market. Three quarters of this market is government supported. First of all, Freddie and Fannie own or support about half of this total market: Standards at Freddie and Fannie were low, and got lowered further as a result of government pressure (Barney Frank, George Bush, CRA) as well as the competition between the two companies (Freddie Mac was originally created to compete with Fannie Mae). Secondly, the Federal Home Loan Morgage Bank (FHLB) pumped in another $1 trillion. Other government entities contributed as well, in the form of mortgage insurance for below-par home buyers. Ginnie Mae (HUD) currently guarantees mortgages for $1 trillion, and FHA (also HUD) insures $560 billion. (According to the Wall Street Journal: Contrary to Krugman’s assertion that the government was not in the subprime business, these agencies are in fact packaging subprime mortgages. Even worse, they have the explicit backing of the Federal government. They are the next Fannie and Freddie, and the US taxpayer is on the hook if foreclosures continue. Nearly 9 of every 10 new mortgages now carry a Federal guarantee.


With government involved in over $8.5 trillion of the $12 trillion housing market, it is clear that it created the housing bubble. And there’s no way to pop a bubble without an economic crisis. Standards were no higher in the government regulated entities than in the public market. And the taxpayer liability is far greater for government backed mortgages than on private mortgages. This will cost taxpayers hundreds of billions if not trillions of dollars if we do not stop backing overpriced and risky mortgages. (The housing market is still greatly inflated due not only to the aforementioned policies, but the fact that the Federal Reserve has been buying up MBS over the past year – over $1 trillion, plus the Fed is loaning money to investment banks which the banks are still using to pay back their TARP funds and purchase more MBS. The market will crash again once this artificial support ends.)


The mortgage interest tax deduction contributed as well to the housing bubble.


It’s ridiculous to blame the crisis on deregulation when the cause was the popping of the housing bubble. Did deregulation contribute? Perhaps Krugman is referring to the repeal of the Glass-Steagall Act in 1998, which prohibited commercial banks from participating in investment banking practices. However, the hardest hit entities were standalone banks (WaMu, Countrywide) and standalone investment banks (Bear Stearns, Lehman). Citigroup seemed to do just fine. WaMu failed because home prices fell, threatening its solvency. Its largest creditor? FHLB, which is funded by tax-exempt bonds.


Regulations are relaxed over time, and in fact Gramm-Leach-Bliley, which repealed Glass-Steagall, simply made the current regulatory environment official. For example, Citigroup was created a year before the repeal. Furthermore, deregulation often has bipartisan support (Clinton supported the repeal, for example, and rejects any role of the repeal in the financial crisis). There’s no way to cast blame on political parties, and while certain people might be right in certain situations, they might not be right in all situations, and even if they were, they don’t live forever. There’s no way to pick a perfect regulator.


Krugman argues that bankers loosened lending standards as a result of deregulation. That’s ridiculous: they loosened lending standards because there was someone stupid enough to buy the stuff.  The biggest customers were Freddie and Fannie, who bought 33% of all subprime MBS in 2005, according to FHFA’s report here.  Troubled assets (subprime and low documentation loans) comprise about 15% of their portfolio.  Furthermore, the FBI knew of the wide spread mortgage fraud in 2004 and did almost nothing.  And we’re to believe that mild-mannered regulators would be more effective?


The other main contributors to the crisis were the ratings agencies: S&P, Moody’s, Fitch.  They rated the junk AAA, and the reason stems from government regulation that gave them the power to control access to the credit markets.  (This is explained in The Cause of the Financial Crisis.)


Krugman’s thesis undermines his whole argument: political pressure over time relaxes regulation. It’s a fact of life.  There’s no way to prevent that, and he offers no solution to the problem. Are we to be taught as children that the ‘invisible hand’ of capitalism is just a fairy tale? And what do we do with people who dare to look up the idea on the internet?


A recent study of international banking practices shows that regulations in fact reduce the safety of banking systems. While it’s hard to determine the exact reason for this, it is probably due to the fact that they lull the public into a false sense of security.


Regulations can’t work for so many reasons, including: business changes faster than regulators can oversee it, businesses are usually smarter than well-intentioned regulators, and regulators themselves come from the banking industry and often have conflicts of interest (personal, social, and financial), such as incentives to allow certain companies to survive.


And finally, his conclusion that anti-regulators are condemning us to repeat history is most disturbing, because in fact it’s the government’s continuing policy to inflate the housing market and bail out failed banks that will likely result in another financial crisis of even greater magnitude.


We must accept that regulations can’t work, and we must take responsibility ourselves for the safety of our money.  If we allow the government to perform this task, we can expect the same outcome as before: financial crisis.  We must also decouple government and industry so that the taxpayer is not on the hook when a bank fails.


If we didn’t have institutions that were too big to fail before, we certainly do now. Most financial institutions are now backed by so many government guarantees that failure will result in huge taxpayer losses. For example, now money market accounts are guaranteed and investment banks get FDIC insurance and can borrow directly from the Fed! And under the Democratic administration, banks are still able to hide hundreds of billions in asset losses. In the attempt by government regulations and policies to make everything safe, everything is put at risk.


Too Big to Fail by Andrew Ross Sorkin

2009-12-28 08:44:18

Too Big To Fail by Andrew Ross Sorkin is a fascinating and intricate play-by-play account of the events leading up to the Economic Crisis of 2008, culminating in the Credit Crisis in September, from the perspective of the leaders of all the big banks and government officials. The book is so richly detailed that it reads almost like fiction. One gets to know the personalities of all the main players, with their strengths and quirks, and experiences the roller coaster emotional atmosphere as this group of people creates history in the face of crisis.


The book also includes historical background on the personalities and the companies, and the origins of the subprime mortgage mess, stretching back over 10 years or so. Sorkin is thorough, to say the least.  At 550 pages, reading the book would take a week of full-time devotion. No doubt, however, this book is destined to be a classic, if not for public consumption like JK Galbraith’s The Great Crash 1929, it will provide endless analytic fodder for academics, politicians, business leaders, and history buffs alike. There is probably nothing like it in terms of the number of people involved, the scope of the issue, and the level of access to the top leaders in both industry and government during such a critical time in history.


Perhaps what’s most extraordinary about the story is the access to the mental states of many of the top players, laid out side-by-side with their public behavior and actions. The plot of the story is driven primarily by government officials: then New York Reserve Governor Timothy Geithner, his boss Federal Bank Reserve Chairman Ben Bernanke, and Treasury Secretary Hank Paulson. The three men fear a coming Great Depression and are desperate to prevent it. As the mess envelops them, they assume the role of “Saviors of the World Economy”, and take it upon themselves to prevent the failures of banks and other companies to prevent Armageddon.



Our heros


Sorkin portrays the men reverentially, which is particularly obvious in comparison to his treatment of other government officials, such as Sheila Bair of the FDIC, who comes across as a show-horse, and Christopher Cox of the SEC, a political hack in over his depth, and like a deer in the headlights.  Dick Fund, CEO of Lehman, is portrayed as desperate, paranoid, and incompetent.


However, I would argue that a disinterested observation of their behavior reveals the men acting out of panic and desperation, without a strategy and without thinking through the consequences of their decisions.  The result is a financial system that is even more dependent on the government and taxpayers than before, just as sick, and now the economy is burdened by the addition to the national debt of about a trillion dollars.  The stakes of failure are now even higher.  If these companies that they were trying to save were not too big to fail before, they certainly are now.


In their attempt to avert the Second Great Depression, and their belief that the failure of any company will trigger Armageddon, they run around like chickens with their heads cut off.  They fabricate trillion dollar rescue plans out of whole cloth, and attempt shot-gun marriages between all combinations of financial companies in the hopes of keeping them afloat and maintaining confidence in the market. It is surprising to see their incompetence and short sightededness, and how manipulative they are, despite their stature in the field, and their brilliance in academics and management. Though they are overwhelmed, they nevertheless maintain an air of confidence and certainty, because no doubt that is part of their job description. They order corporate presidents and CEOs around like chess pieces. Paulson’s propensity to vomit, such as during a crumbling of his best-laid plans at a critical point, reveals the stress. One can’t help but feel a little bit sorry for them.


By October 2008, the Treasury and Federal Reserve had given out over $1 trillion in financial support to big banks, Freddie Mac and Fannie Mae, and other companies deemed to have ‘systemic risk’. The book carefully lays out the sequence of meetings throughout the crisis, including what was said by each person, and revealing their true feelings through the emotion in their voice, facial expressions, and body language.


The book explains the “Scare the s**t out of them” strategy that Paulson, Geithner, and Bernanke employ to obtain funding for TARP. For example, in a meeting with the banking committee on September 18, 2008:


Paulson: “If it doesn’t pass, then heaven help us all.”


Bernanke: “I can tell you from history that if we don’t act in a big way, you can expect another great depression, and this time it is going to be far, far worse.”


In fact, despite their Chicken Little pleading, TARP was initially voted down on September 29, because it simply gave the Treasury too much power to spend $700 billion for toxic assets of unknown value. (TARP was passed on October 3, in part due to modifications for greater accountability, and in part due to increasing panic.)


Behind the scenes, however, Paulson didn’t even know what TARP should be. Originally it was intended to purchase toxic assets to clean up a bank’s balance sheet, to reduce doubt as to whether a bank was still solvent. The previous year, two of Paulson’s top aids, Neel Kashkari and Phillip Swagel, developed their “Break the Glass” plan for emergency rescue of financial companies by having government purchase their toxic assets. Unfortunately there was no mention in the plan about how to value the assets for purchase. Toxic assets are so complicated that they would take months to value – even Alan Greenspan considered them to be incomprehensible, and the banks themselves were woefully overvaluing them. Nevertheless this was the plan that Paulson had in mind when he went to Congress.


But then he received a call from Steven Schwartzman of the BlackRock group, who told him that banks would not want to sell their toxic assets because that would force a write down. They’d rather hold the securities for as long as they can, believing or pretending that they’re still valuable. So after some waffling, Paulson decides the best bet is to invest directly in banks (buy bank stocks).


Couldn’t Paulson have floated the plan with banks before going to Congress? After all he had months to work on it (it had been presented to Bernanke in April, 2008). You’d think he’d want to discuss a plan to save banks with the banks. And you’d think the banks if they wanted to be saved would have spoken to Paulson about the best ways to do it. Well, regulators know best.


Anyway, Paulson calls the top banking CEOs to Washington for an extraordinary meeting (instead of going to Wall Street) and gets them all to accept the TARP investment, effectively partially nationalizing all the major banks (including the banks that didn’t need it because Paulson didn’t want to make the others look weak). As of a year later, the bank TARP money has been repaid (with borrowed Fed money). But the banks still maintain toxic securities, setting us up for another crisis.


Running around in a panic, they made many other blunders. They played matchmaker with the banks, and in the midst of the crisis, Paulson encouraged a merger between Goldman Sachs and Wachovia, implying the government would backstop Wachovia’s bad assets. The companies, under that assumption, pursued merger talks, only to be told 24 hours later that it couldn’t be done due to Paulson’s previous position as CEO of Goldman. It was a clear conflict of interest and was politically untenable. Oops.


They also tried to get JP Morgan and Morgan Stanley to merge. The only problem was that neither side wanted to do it. There was a huge overlap between the companies, and Morgan Stanley had about $50 billion in poor quality securities. Jamie Dimon of JP Morgan was adamant, but Paulson replied, “I might need you to do it.” Is this capitalism?


In desperation, Paulson called CIC (China Investment Corporation) and pleaded with the Chinese government to support an investment in Morgan Stanley. He even offered the financial assistance of the American government. So CIC flies over to take a look. However, Morgan Stanley was in the middle of a deal to receive a $9 billion investment from Mitsubishi Bank. Needless to say, CIC and the Chinese government were not happy.


The regulators seem more interested in saving the investment banks than the banks themselves. These are companies whose main job is to make money, mostly by making risky bets. And we need to save them?  Despite all of the detailed history in the book and explanations of financial concepts, Sorkin never addresses this issue.  It’s quite an omission, considering the title of the book.


Lehman failed on September 14.  In the weeks leading up to the bankruptcy, they were struggling to pull Lehman back from the brink (it was saddled with about $70 billion in toxic assets and huge CDS liabilities). Of course, our heros – Paulson and Geithner – fearing Armageddon, tried valiantly to save it. They had recently organized the Bear Stearns – JP Morgan merger with a $30 billion government guarantee, but now they were under pressure by Congress (particularly Nancy Pelosi) not to offer another bailout. So they turned to Wall Street to work something out. Geithner: “If you don’t find a solution, it’s only going to make the situation worse for everybody here.” Christopher Cox of the SEC remarked on “The patriotic duty they were undertaking.” After a weekend of strenuous negotiations, the Wall Street bankers came up with funds to support a complicated arrangement in which Barclay’s would buy Lehman. But then to everyone’s surprise (supposedly), the British government nixed Barclay’s role. Despite Paulson’s pleas to the Brititsh government, they would not budge. There was no choice. Lehman went down.


This was by most accounts the right outcome, in retrospect. Although Paulson was quite upset by it, most of the country, including President Bush, didn’t seem to mind. There was an orderly wind-down of Lehman assets. (Barclay’s got a great deal on Lehman’s trading arm – the only piece it wanted anyway.) Barney Frank anointed this day “Free Market Day,” as it was the only time the government allowed the markets to function.


AIG was another debacle. AIG is a large and well established insurance company, providing many types of conventional insurance products such as life insurance. This part of the business was healthy and organized into financially protected subsidiaries in each state. However, starting around 2000, AIG’s Financial Products division (AIGFP) started selling insurance on subprime securities owned by other banks (known as Credit Default Swaps). As the subprime loans dropped in value, AIG’s potential liabilities ballooned. They had insurance on at least $1 trillion in toxic assets owned by many of the major banks around the world, and might eventually have to make payouts if those assets defaulted. They were being asked to post more collateral by the banks to protect against defaults, but they simply had run out of available assets. They were facing bankruptcy.


Geithner believed that he could not let AIG fail, because without the insurance on their toxic assets, European banks would have to come clean on the true value of those assets, and that could force them into bankruptcy. (US banks could continue to conceal their toxic asset values, as they have.) Also he was concerned that people who had life insurance at AIG would panic and take down the insurance industry (even though their money is safe). Regardless, he feels he must avert an Armageddon. So as AIG was preparing for bankruptcy on September 16, Geithner calls them and offers to rescue them with a $85 billion bailout. AIG is shocked and in disbelief, but they follow Geithner’s instructions to post stock as collateral, and they’re back in business. Suddenly realizing, however, that this would not look good without a new CEO, Paulson taps Ed Liddy, the retired ex-CEO of Allstate, and puts him in the spot (a 24 hour executive search). The board is a bit dumbfounded. “He wouldn’t be my first choice,” many of them seem to be thinking. Liddy resigns less than a year later.


President Bush was perplexed and dubious about the AIG bailout. But Paulson and Bernanke impressed upon him the gravity of the situation: AIG provides life insurance and annuities to lots and lots of people. Bush acceded.


The US taxpayer has by now pumped $180 billion into the company. Much of this money has gone to foreign banks, and much of it has gone straight to the big investment banks to cancel their CDS contracts with AIG, including $14 billion to Goldman Sachs, which actually claimed to be well hedged against an AIG bankruptcy. Geithner failed even to negotiate a deal beneficial to the taxpayer, paying 100% of the liability, when he could have bargained it down. But hey what’s a few billion dollars?


The erratic behavior of the government – will they bail out or not? – resulted in great uncertainty in the markets. In their desperation to save the markets they only aggravated the situation. The markets continued to fall for a few weeks, but eventually stabilized.


Why Sorkin treats the men so respectfully despite their reckless blundering is a bit mysterious, especially considering how harsh he is on others.  Perhaps that’s the price he paid for the level of access – an implicit agreement to make them look good on the surface.  However, he nevertheless reported the entire story with great objectivity, so the facts speak for themselves.  The critical reader will  have more than enough information to draw the right conclusions.



The aftermath – A slow descent into Armageddon


I believe that Paulson, Geithner and Bernanke essentially gave away the store. In their frenzy, they created several “Too Big to Fail” behemoths, and made mistakes that will burden the taxpayers for generations. It’s hard to know the true motive for their actions. Some might say that they were just protecting their industry and their friends. No doubt that was part of it. But I would provide a more charitable explanation: they knew personally the hardships that a failure of a big company would be on so many thousands of people, the kind of people they worked with their whole lives, and so they would go to great lengths to prevent it. And perhaps they overestimated the importance of their own industry in the world economy.
But I suspect that the main reason was that they didn’t want to be seen as sitting back and doing nothing while the country sunk into the Great Depression II. Bernanke was a scholar of the Great Depression, and knew exactly what should have been done differently – in particular, it required taking a very aggressive approach. However, I believe that it would have been much better if the government had allowed the companies to fail. Of course it would have been painful, but it was necessary. Companies would behave more responsibly, and the taxpayer would not be on the hook for a trillion dollars of bailouts. And even if the stock market went down further, or unemployment increased, the government could focus on building the economy back up on a firmer foundation.


If companies weren’t too big to fail in 2008, they certainly are now. As a result of mergers and government guarantees, they are now bigger and more dependent than ever. Bear Stearns and JP Morgan are now merged with a government guarantee. Bear Stearns has billions in toxic assets that ultimately must be revealed, and then the $30 billion guarantee may have to be spent. Merrill Lynch and Bank Of America are now merged, and Merrill is still full of toxic assets (Merrill subsequently requested more money from the government, and when BofA threatened to withdraw from the deal, Paulson and Bernanke threatened to fire him). After making huge investments in AIG, the government will probably keep supporting it, pouring in good money after bad. This company (at least the AIGFP division) does not need to exist.


Even worse, now the big investment banks – Goldman Sachs and Morgan Stanley – have been converted to bank holding companies so they are now eligible for Fed financing through the discount window, meaning they can borrow at low rates and do as they please – pay back their TARP investment and engage in the same risky behavior that got them into trouble in the first place.  Furthermore, their deposits are now protected by the FDIC (through the Temporary Liquidity Guarantee Program). This was another move by Paulson to calm the markets, and while Sheila Bair of the FDIC initially recoiled at the idea, eventually she was pressured to relent. This represents “The biggest policy shift in history” according to experts at the Treasury, but hardly anyone even noticed. Nothing could be more dangerous, because now we’ve provided government money to the very people who nearly destroyed their own companies by taking great risks. Of course now the companies are under greater government supervision. Do you feel safer?


As well, money market funds were guaranteed by the Treasury. These are liquid funds that typically invest in safe assets, and allow for easy deposits and withdrawals of large amounts. Paulson thought that they should be insured to prevent a panic if people started to pull out of them (one of the biggest funds dropped about 3%, sparking some panic). Although the guarantee has since been repealed and they didn’t take any Federal dollars, they certainly could in the future if the program is re-implemented.


So now we are in a much more precarious state than before, because not only are toxic assets still on the books, but the government has explicitly guaranteed them, along with many other components of the market. Things may seem better because banks have returned the TARP funds, but underneath nothing has changed. Soon enough it will be time to pay the piper.



Lessons to be learned?


The only thing that most big banks have learned is that the government will bail them out no matter what. They can now operate with recklessness and impunity. Although for now they will behave due to high levels of scrutiny, soon enough they will be back to their old tricks.


The only solution is to cut off the government guarantees, and create a policy to allow banks to fail. To prevent runs on a bank, the bank needs the ability to temporarily limit withdrawals, at least until it can either calm fears or wind down assets. People might lose some money in this case, but it’s far cheaper than the cost of the policy of bailing out banks for their past and future mistakes.


The Epilogue has a tacked-on feel, but it’s important because Sorkin provides his perspective from one year later, tying up loose ends and finally revealing his policy recommendations.  He draws the opposite conclusions from what I would say. He believes that the free market failed, and the illusion of the ‘invisible hand’ was finally shattered. And although he provides no supporting evidence in the book, he blames the failure on deregulation (for example, the Glass-Steagall act, which has now been overturned de-facto with the mergers of the commercial and investment banks) and the structure of short-term compensation packages. He supports stricter regulation of banks – limits on leverage and pay structures – a great irony considering the incompetence of the regulators and their inaction until the crisis.  He also recommends a ‘crackdown on rumormongors’, which is particularly surprising in light of his portrayal of Lehman’s CEO Dick Fuld’s absurdly paranoid crusade against them.  He also blames the push for homeownership and low interest rates, and on that we’d be at least partially in agreement.


It’s also interesting that Sorkin never directly criticizes the frenzied, half-baked, and inconsistent policy making of the top economic officials. While acknowledging the great nationalization of the banking sector, he fails to acknowledge that the situation is now even worse.


This is a book about history more than policy, and perhaps that’s why Sorkin withholds his policy opinions until the very end.  It’s a fascinating and worthwhile read, and a treasure trove of important historical information.  It is amazing to realize that everything in the book was weaved together from hundreds of hours of interviews, written notes, email, video tape, news reports (newspapers, magazines, and tv), and public records.

End the FDIC

2009-12-28 08:45:12

Most people think of the FDIC as a the friendly Federal agency that insures your money if your bank goes belly up.  You can stash your money away safely, up to $250,000, and not worry about it because if anything happens, the FDIC will be there if things go bad.

That’s how the fairy tale begins.



The FDIC was created to protect savings accounts and prevent bank runs.  This was a big problem in the Great Depression from 1929 to 1933, as depositors besieged their banks all at once, forcing some banks into failure because they could not satisfy immediately all their customers’ demands.  As one bank went bust, the fear spread through the population, causing more runs, and knocking banks down like dominos.  During this period, about half of all banks were closed.  By insuring accounts, however, depositors could wait for the problem to be resolved, or if not resolved, at least they would get repaid by the government.  For the most part this is what the FDIC did for 80 years.  “Rarely has so much been accomplished a single law,” according to JK Galbraith, referring to the establishment of the FDIC.


The end of the line for FDIC


However, the FDIC failed completely in 2008.  The scope of the economic crisis was simply too great.  Banks had hundreds of billions of ‘toxic waste’ (mortgage-based assets) on their balance sheets, and the FDIC insurance fund (around $50 billion) was far too small to cover the potential losses.  The failure of IndyMac alone (a midsize bank) resulted in a 20% drop of its entire fund.  The FDIC could not handle the failure of many large banks.  (In this sense, the banks were ‘too big to fail’.)  As a result, banks received bailouts from the Federal government, including TARP, the Federal Reserve, and indirectly through AIG.  As of today, most of the big banks are ‘zombie’ banks:  they are technically insolvent, but kept alive by Federal money, Federal support of mortgage-backed securities (which temporarily inflate asset prices on the balance sheets), and the implicit guarantee of a Federal rescue.  Citigroup is the largest of the zombies, and Bank of America is not far behind.


The Credit Crunch of September 2008 was caused by of the FDIC.  First, this was because banks were hoarding cash for fear that they could be taken over by the FDIC if they fell below their capital requirements (about 6% cash to assets).  Since they did not know the value of some of the ‘toxic waste’ assets, this was a legitimate fear.  As a result, they did not lend it out as they were supposed to.  Without FDIC regulations, they could have continued lending, albeit at a lower level, to unfreeze the credit markets.  Secondly, investors took huge amounts of cash out of uninsured money markets and the stock market to put into insured FDIC accounts (depositing a record $185 billion in one month).  However, businesses depend on the money markets for short term loans for daily operations, so many businesses were brought to the brink.  Investors used taxpayer-funded insurance to protect their wealth, at the expense of the overall health of the economy.  Perhaps a shrewd move, but it’s an abuse of the system.  And yet it is the inevitable result.  Why not insure all your money if you can?


Although it is technically still the banks’s regulator, the FDIC is no longer relevant.  Now the Federal government – and the taxpayer – will have to pay when banks finally state their true losses.  Then the banks can be closed or bought buy their smaller, healthier competitors.  Although this will be a painful process, it is necessary medicine.  Only then can a new, sound economic foundation be established.  But as has been shown repeatedly, allowing zombie banks to live only prolongs a recession and increases the final cost (e.g. the S&L Crisis and Japan’s ‘Lost Decade’).


Do we even need deposit insurance?


Deposit insurance was created in 1933 to protect deposits (up to $2500) and prevent bank runs.  However, it is possible to protect deposits in other ways, such as with special bank accounts that invest only in short term government securities.  Bank runs can be prevented by temporarily limiting cash withdrawals.


While it’s nice to know that your money is ‘safe’, it’s not fair to expect other taxpayers to insure it.  Furthermore, the insurance is subject to abuse well beyond the original purpose.  Each account is insured up to $250,000, but a person can have as many accounts as they like as long as they are in different banks.  Thus, there is no limit to FDIC insurance.  If a millionaire’s bank fails and depletes the FDIC insurance fund, it’s the average taxpayer who has to pay them back.


Furthermore, recent research on banking systems across the world has shown that deposit insurance actually makes banking riskier (Rethinking Bank Regulations, Barth, Caprio, & Levine).  Though paradoxical, this actually makes sense.  If we are not monitoring the banks ourselves, knowing that our accounts are insured, they will start to take risks and otherwise behave irresponsibly in the hope of making more money.  Of course government is supposed to regulate and control this.  But banks can generally learn to game the system or ‘capture’ regulators over time.  Secondly, leaving the government in charge is like putting the fox in charge of the hen house (there are huge conflicts of interest).  Countries where consumers must take some responsibility for monitoring banks have more stable banking systems.


In a further paradox, stricter and more powerful regulation (such as capital and supervisory regulations) also makes the banking system more fragile.  This is partly because the banks cannot operate freely to do what is best for a given situation, and partly because highly regulated banking becomes a political game at the expense of the taxpayer.


The FDIC program must be ended


It is impossible to insure part of the financial system without insuring all of it.  A run on uninsured funds threatens the safety of insured funds.  This has been shown repeatedly in history, as government backed insurance has steadily increased in scope in order to prevent runs.  Even money market funds were federally insured in October 2008, for about a year, to stabilize the markets.  Although this insurance is no longer available, it could be offered again in a future crisis, putting more taxpayer money on the line.  If we continue down this path, the taxpayer will be liable for the entire financial system.


Insurance is not only unnecessary, it is harmful to the banking system.  Individuals must take responsibility for their money. This will force banks to be much more transparent and accountable to their customers, because customers will be monitoring them very closely.  Market discipline is the most important factor in improved bank performance, according toRethinking Bank Regulations.


There are several things that can be done to protect depositors.  Depositors should be the first in line when a bank fails, in front of bond holders and stock holders.  This will make bond holders think twice before adding leverage to a bank.  Government can take a role in educating consumers on the importance of monitoring their bank and provide references for how to do so.  It can also help insure that banks report their status fully and honestly.   For investors who want 100% safety, they can invest in a US Treasury fund.


We have no guarantees in the stock market.  We have few guarantees when purchasing a home.  We must also assume some risk when putting money in the bank.  We can no longer expect our government to protect us.  The cost to do this is simply too high and it’s unfair to pass this cost on to our children in the form of huge deficits.


The Cause of the Financial Crisis

2009-12-28 08:45:58

How government regulations, guarantees, and special-interest tax policy systematically undermined the free-market economy and created the current financial crisis.


Government regulations and special-interest tax policies enacted over the past 80 years, although created with the best of intentions, have systematically weakened the US economy to the point of near collapse by paralyzing the ‘invisible hand’ that normally would keep abuses in check and prevent corporate greed from taking down the financial system. Many people would say that in fact the current crisis was caused by the lack of proper government oversight, and would recommend increased government regulation. As Obama said on Letterman (9/22/09): “Because of the lack of regulation, for example, we ended up having to pony up hundreds of billions of dollars to banks. And that if we had some good regulations in place, we wouldn’t have had to do that.”



[This article is rife with errors.  Sorry.  I have to get back to this and fix it.  But I’ll leave it up for now.]


I will show that this view is false, and really what is needed is to greatly reduce regulation, government guarantees, and special-interest tax policy. If the free market is allowed to function freely, then the country can enjoy a robust, competitive, and safe banking system. If the over-regulation is allowed to continue, then we are setting ourselves up for another, even greater, financial crisis down the road. And the worst part is that the taxpayer will again have to bail out the ‘Too big to fail’ greedy corporations that created the mess.



The Stages of the Crisis


The events leading up to the financial crisis can be divided into four stages. First was the housing bubble, which occurred over the last 10 years or so, inflating the value of real estate around the country to unsustainable levels. The second stage began when the bubble burst, resulting in fast dropping home values and many foreclosures. The third part was the ensuing ‘credit crisis’, in which banks, saddled with uncertain mortgages and mortgage-backed assets, stopped lending to businesses and individuals. The entire economy was under grave threat, and so the Treasury had to step in (the fourth and final stage) and loan $1 trillion to commercial banks, investment banks, AIG, and other companies to clean up the toxic assets to keep the economy afloat.


The first stage, the housing bubble, was caused by government policies, including the long-standing mortgage interest tax deduction, institutions such as Fannie Mae and Freddie Mac, and other factors which I will review. The foreclosure crisis was the inevitable result, but was made worse by FDIC bank regulations. The ‘credit crisis’ as well occurred only because of inappropriate FDIC solvency regulations that strongly discouraged banks from lending. Finally, the huge government bailout of investment banks and AIG was necessary to allow banks to resume function without requiring a nationwide FDIC takeover, which would have been huge and unprecedented, and perhaps impossible. Just as important, it was done to protect state and federal pension funds, which also presented a tremendous liability to government if they dropped in value. The thread that connects all the stages are the AAA rated mortgage bonds, the government insured ‘toxic waste’ that flowed through the system, and as I will show, also a consequence of government policy.



The Housing Bubble


The housing bubble was caused by government policies that funneled too much money into the housing market, increasing prices, speculation, and risk, and creating a huge and unsustainable market in real estate. The worst part was that much of the money was government insured, meaning that any fall in value would be borne by the taxpayer.


The first culprit is the long-standing mortgage interest tax deduction, which encourages people to buy instead of rent. So many people who perhaps should have rented a property were encouraged to buy a new one. Without the deduction, certainly fewer bad mortgages would have been sold. National Association of Realtors lobbies for the deduction, claiming that home values could fall as much as 15% in some areas. Clearly it was a significant contributor to the bubble.


Just as importantly, Freddie Mac and Fannie May (and the Community Reinvestment Act) created huge markets for bad loans. Under pressure from Congress (Barney Frank in particular), they gladly bought up poor quality mortgages in the name of the public good – getting more people to own homes. Currently they own or guarantee about half of the total national $14 trillion mortgage market. By purchasing the mortgages they added fuel to the fire – putting more money back in the hands of the banks to make more loans. Freddie and Fannie funded their operations by selling AAA loans to the public, which carried an implicit government guarantee that was part of the basis for their high rating.


The big investment houses – JP Morgan, Lehman Brothers, and Bear Stearns – also got in on the game. For the ‘non-conforming’ mortgages that the public sector would not take (either because they were too big or the buyer had insufficient equity), the big boys bought them up, diced and sliced them, insured them internally or though AIG(FP), put on a ‘AAA’ sticker, and sold them to pension funds and foreign banks, and often right back to the banks that originated them. Although taking on a huge liability, they made lots of money from fees, perhaps believing that government would bail them out in the event of failure. And it did – at least for Lehman Brothers. (Bear Stearns was allowed to fail.)


Another big contributor to the housing bubble and subsequent mortgage crisis was the Federal Home Loan Bank (FHLB), a little-known but huge mortgage lender, funneling money through its network of member banks. Its assets of $1.3 trillion make it the largest borrower in the country, second only to the Federal Government. (It borrows money by selling tax exempt bonds to the general public.) This represents almost 10% of the total $14 trillion national mortgage market.


Why would FHLB (which is considered at-risk in many parts of the country) continue to make such bad loans? And why would investors buy their bonds to fund the loans? The reason is that the bonds are tax exempt, both federally and locally. Also they sport an implicit government guarantee. Even though the FHLB denies this, it’s the basis of their AAA rating (according to Moody’s), and furthermore the Treasury has opened a line of credit for them (though they have not yet used it). The average investor buys FHLB bonds not because of an interest in the mortgage market, but because they are considered safe and tax exempt. However this money can be used only for buying homes. Thus they unwittingly provided the leverage the banks needed to put themselves out of business. When WaMu failed, by far its largest creditor was FHLB, with $83 billion in loans.


While there is nothing wrong with leverage in principle, it should be done with private funds, not government-guaranteed funds. Regulation that fails to take this into account cannot work.


With so much extra money in the housing market, banks had to put it somewhere. As opportunities for prime mortgages ran out, they had no choice but to consider qualified subprime borrowers, and after those ran out, there was no choice but to fudge the applications. Banks also turned to independent mortgage companies, more often than not unscrupulous and aggressive ‘predatory lenders’. These lenders sold high interest mortgages to people who couldn’t afford them (so-called “Liar’s Loans”, because the buyers were encouraged to lie about their income, job, and assets). They also offered risky low-down-payment loans, among other types of dubious practices. But the banks didn’t care because they could easily sell the mortgages to others.  However, the supply of even poor quality borrowers was not limitless.


By selling off their mortgages to Freddie, Fannie, and the big investment banks, mortgage lenders had no ‘skin in the game’. They had nothing to worry about. If the investment failed, no problem – the taxpayer would be on the hook for repayment. And that’s exactly what happened. The lenders’ only mistake was not getting rid of the mortgages fast enough. When the mortgage crisis hit, some banks still had sufficient toxic assets on their books to take them down. For example, WaMu had sold off hundreds of billions in mortgages, but still had about $20 billion in bad assets when it failed.


Of course lenders were not forced to lend, but the environment created such a great opportunity. Should they have given the money back? Of course they should. But they didn’t. Certainly this behavior was illegal, but the incentive was irresistible.


The additional funding also fueled speculation, as investors got cheap money for second properties (both for rental and for flipping). This inflated the market still further, making mortgages even more unaffordable and risky.


In this way, government’s pro-homeownership policies contributed greatly to the real estate market bubble. Furthermore, if the government didn’t guarantee the mortgages, then at least the taxpayer would not have had to pay for the damage from the collapse.



The Bubble Bursts


In this fragile market in 2007, defaults became more commonplace. The loss of a job or an unexpected expense, and a payment was missed. The foreclosures started. The supply of even unqualified borrowers to support the market had run low.  Housing prices starting falling, and many homeowners dropped underwater (i.e. the mortgage was greater than the value of the home). They chose just to walk away. The wave of foreclosures grew.


If instead these people had rented a property, and either the rent increased or they lost their job, the situation would be much more fluid. They could move to another cheaper property, or move to where the jobs are. Rental prices would also go down as they do in a poor economy, making rentals more affordable. Instead, many homeowners were trapped in a sinking ship. The unintended consequences of well-intentioned government policy.


As real estate prices fell, banks could sell foreclosed homes only at a loss, causing a significant drop in mortgage bond values. If not for the artificially induced bubble, many of these homes could be re-sold, thereby retaining the value of the bond, and thus not presenting such a risk to the banks and funds that owned them.


To make matters worse, many foreclosed homes sat empty while waiting for a new buyer. In additional to the loss of potential income on the asset, this increased neighborhood blight and inflated local rental prices – making the situation even worse. The reason? FDIC regulations discourage banks from renting out their property, as it is outside their customary line of business.



Grade Inflation: AAA Junk Bonds


The ensuing credit crisis resulted from the fact that the AAA rated bonds were now of dubious value, threatening the solvency of banks and pension funds across the country and around the world (due to FDIC and other regulations). How did these bonds get AAA rating in the first place? Fannie Mae and Freddie Mac bonds get AAA rating because as Government Regulated Entities (GREs), they get an implicit government guarantee. The rating agencies believe that the mission of these agencies (increasing homeownership) is so important, that the federal government will step in and bail them out if they fail. Of course that’s exactly what happened. It’s the same for FHLB. Although the FHLB web site denies that the bonds are backed by the government, the agency still receives AAA from Moody’s, despite the fact that 6 of its 12 banks are considered to be at-risk, because as a GRE there is an implicit government guarantee. In fact, the Treasury in 2008 opened a $1 trillion line of credit to FHLB, although this credit has not yet been tapped.


The story behind the AAA ratings for investment bank Mortgage Backed Obligations (MBOs) is a bit more complicated. The reason is that the ratings agencies make lots of money from the companies and instruments that they rate. It’s a fundamental conflict of interest. (This is not the case with stocks, where the investor buys the ratings recommendations from an independent rater such as Morningstar. In the case of bonds, investors get ratings for free. There is no recourse if the ratings are bad.) How did this conflict of interest occur? Surprisingly it is also due to government regulation. In the 60’s, after investors got burned by poor quality ungraded bonds, the government chartered a monopoly for the 3 agencies – Moody’s, S&P, and Fitch, requiring that all bonds must get rated. So now the agencies could charge companies for the right to get their bonds on the market. These agencies all started in the early 1900’s as investor-subscription services, and were originally accountable only to investors. But after this new regulation, their business model changed, and they started charging fees to bond issuers. Abuses started to occur, such as shopping around for the best rating, and paying for a higher rating. One can imagine the huge incentive to make the huge market of poor quality mortgage-backed investments appear to sparkle with a triple-A rating. This is what happened with CDOs and MBSs. This is also what happened with AIG. In fact the ratings agencies never even investigated the loan files. When they finally did, according to Fitch, “There was the appearance of fraud or misrepresentation in almost every file.”


Any other company that committed such a mistake would be out of business by now.  Although it’s likely that the malefactors will be prosecuted, the business are too important for the government to be dismantled.  As a result, it is unlikely that any lessons will be learned, except that they can survive after committing fraud.


Credit Default Swaps were an integral part of the process. A new and little known financial instrument in 2000, by 2005 they had become the ‘special sauce’ for subprime loans, making them palatable to banks and pension funds. Basically they are insurance on bonds, purchased for a fee, and in this case turned low-rated securities into AAA (the insured bonds inherit the rating of their AAA insurer – in this case AIG). They became a huge part of the bond market. Common sense would suggest that such a product is a bad idea. You can’t insure an entire market, because if the market goes down all at once, then there’s a huge hit. For example, most insurance companies don’t cover flooding, because floods tend to affect a large number of customers all at once. This presents a huge liability, potentially crippling the company. On the other hand, car accidents are much more predictable and easy to insure. You don’t know where an accident will happen, but you have a pretty good sense of frequency based on historical data. So CDS should not exist on a large scale, but they did, because they turned junk into gold. AIG remained a AAA rated company despite their huge liability.


As CDS became more popular, AIG realized that the entire financial system was in fact dependent on them. They could sell more and more, secure in the knowledge that even if the market turned, the government would have to bail out the company to avoid financial catastrophe. As Obama said on Letterman (9/22), “People were taking wild risks, expecting that maybe taxpayers would come back and bail them out after the fact because we couldn’t afford to let the whole financial system to go under.”


Thus bonds were cleaned by this financial laundry service. The fundamental market principle of ‘risk/reward’ was decoupled. These were seemingly very low risk investments with high interest rates. They basically sold themselves.


Banks and pension funds bought them up like candy.



The Credit Crisis


In the face of obvious trouble, the rating agencies finally started to downgrade bonds. People began to realize that the “Emperor has no clothes.” The bond market froze up because no one knew how much the troubled assets were worth.


As a bank’s assets falls below AAA, its capital reserve requirements increase. If it cannot meet these requirements the bank is deemed insolvent by the FDIC. The agency would have to step in and resolve the situation, either by orchestrating a merger, or selling off the bank’s assets (into a troubled market) and restoring it’s depositors. As a result the credit markets froze up, since banks didn’t know if their assets would fall below AAA, and if they did, whether they would be able to sell them into a troubled market to raise capital.


The credit markets are essential to the daily function of industry big and small, as well as consumer spending. Having frozen up, the economy was brought to the brink. There was a level of crisis and fear not experienced since the Great Depression.


Ironically it was the FDIC reserve requirements that caused the problem — ironic because the FDIC was created to prevent public panic. Without the regulations, banks could continue to lend, and the problem would not have been nearly so bad. Furthermore, the crisis created panic in Washington. Something had to be done, and fast.



The Bailout


The federal government, fearing economic collapse and bank runs on a wide scale, decided it had no choice but to maintain the AAA ratings of bonds at all costs. If it didn’t, then the banks would fail, and the FDIC would have to resolve bank failures on a scale never before seen. They would have to sell their assets in a depressed market AND make their depositors whole. It would have been an impossible task. FDIC insurance fund is far to small to take on such a huge problem.


The additional irony is the utter powerlessness of the FDIC. The very organization that is supposed to rescue banks in times of crisis itself had to be rescued.


Pension funds were in a similar situation. Lower bond ratings would require costly state intervention.


So in addition to bailing out Freddie Mac and Fannie Mae, the government also had to bail out AIG and other Wall Street investment banks to maintain their high credit ratings and the ratings of the bonds they insured.


Without the FDIC regulations, AIG could have been allowed to fail, and banks could continue to service their customers. Perhaps it would be necessary to limit withdrawals temporarily until the bond market resumed functioning. Worst case if bankrupt, the bank could slowly wind down and distribute the proceeds to its customers. Losses from troubled assets were generally only a fraction of total deposits, so depositors would receive most of their funds.


(The FDIC is often justified as necessary to prevent bank runs. But bank runs can be prevented in other ways, such as by allowing banks to limit withdrawals in crisis situations. This may not prevent a bank failure, but it would prevent a panic and allow an orderly wind-down.)


It was not only the FDIC, but other government regulations which contributed to the crisis. The insurance companies in New York State are themselves self-insured. By state regulation, if any insurance company fails, then all other companies have to bail it out and restore their customers. Thus, AIG could not be allowed to fail. If it did, all the other insurance companies would have to bear the cost. With a company as big as AIG, this could destroy them. So for their own survival, business in NYS supported the bailout of AIG.


(Similarly, FDIC is funded by insurance payments from member banks. Recently the FDIC raised their insurance premiums, which hit small community banks harder, even though they were among the healthiest. This further helps the big banks at the expense of the small ones.)


Despite the bailout, the problem is far from resolved. Banks are still holding onto assets of dubious value and could still face a future crisis.


As well, now that subprime lenders are gone, the FHA (Federal Housing Agency) has stepped in to insure the riskiest mortgages.   Because the FHA has very low standards with regard to approval, it is now supporting about 30% of loan applications.  The worst part, of course, is that if the borrower defaults, the American taxpayer must pay the bill.  It is estimated that the cost could be half a trillion dollars.  Thus the housing market remains artificially inflated, and when it falls again, another crisis will ensue.




Thus we see that a combination of government regulations, institutions, guarantees, and policies were the cause of the financial crisis. The free market was not allowed to function normally because the ‘invisible hand’ of the market was slowly being paralyzed, to the point in 2008 where it could no longer function at all.


Only by retracting these policies can we avoid a future crisis. Obama draws the opposite conclusion from the same facts: “We had too little government, too little regulation.” Most people share Obama’s belief. The reason, I suspect, is simply that most people don’t realize the depth of the corrupt state of affairs leading up to the crisis. In part this is because we are so used to certain policies that we don’t even question them, such as FDIC, the conflict of interest with ratings agencies, and the mortgage tax deduction. Furthermore, some of these policies are favored by many for their own self interest. However, people need to be advised of the dangers posed by these policies, and they must be retracted or phased out. Only in this way can we avoid future crises and catastrophes.


We must also recognize that to a great extent these problems are our own fault. We Americans demand insurance for our bank deposits, tax deductions for our mortgages, and security with our pension funds. But this requires a government guarantee, which ultimately leaves the taxpayer on the hook. We need to take responsibility for where we put our money, just like we do with real estate and the stock market. We don’t expect the government to bail us out for a bad stock pick. We should not expect the government to bail us out 100% if our bank fails. Or if our pension fund fails. Banking regulation must be replaced with consumer education. In fact, even if WaMu deposits were not insured, depositors would still get back around 90% of their assets. They estimated write offs of $19 billion, but total deposits were $189 billion.



Common Criticisms


I will now address some of the most common criticisms of this thesis.


First of all, I fully acknowledge that some level of regulation is necessary. For example, anti-monopoly regulation is critical, and breaches of fiduciary duty should be strongly prosecuted.


A common argument for regulation is that it is required to counteract the level of greed on Wall Street, and it’s apparent focus on short term gain over of long term viability. But there will always be greed and short-sightedness on Wall Street (and everywhere else). Furthermore, people will always make mistakes, and even smart regulators can’t prevent that from happening. The best we can do is ensure that these people are not gambling with our money or government-guaranteed funds. And the only way to do that is to take responsibility for how we invest our money and to end government guarantees.


One might be tempted to blame China for it’s role in lowering interest rates (by purchasing Treasuries), thereby making it ‘too easy’ to purchase homes. Certainly this contributed, but it was only the housing market that ballooned during this time: no other segment of our economy enjoys such deeply entrenched government policies. (China wisely stayed out of the real estate market in the US.) It would also be a mistake the blame the Democrats. Republicans as well encouraged the ‘ownership society’.


Finally, while it could be argued that previous economic crises occurred in times of low regulation, these were also times of limited consumer knowledge and power. If the consumer is educated and takes responsibility for their financial choices, this will in itself provide the necessary regulation to keep businesses competitive and robust.



Regulation Can’t Work

2009-12-28 08:47:11

Financial regulation can’t work.  No matter how you try it’s bound to fail.  Here’s why.


Financial regulation can’t work for several fundamental reasons.

First, financial wizards are smarter than regulators.  Financial analysts have a massive financial incentive to work around regulation. Regulation is a bureaucratic activity that requires a more regimented and less flexible kind of thinking, and there is little incentive to go above and beyond the call of duty. If a regulator was as smart, he would be in finance where he could make a lot more money.  The finance wizards will always figure out a way to get around the regulations and outsmart the regulators.  Even if a smart regulator realizes that something is wrong, he has little power to change the regulations.

Second, to make matters worse for the regulator, the cozy relationship between big business and government will prevent it.  Furthermore, there were lots of smart people watching the economy, but very few realized it was headed for collapse.  In fact, most of the top financial wizards didn’t realize it until too late.

Third, while it’s easy to spot the problems in hindsight, it’s almost impossible to choose the people with the right foresight and put them in charge.  In fact that would be a big mistake.  Even Nobel Prize winners, like the managers at colossal failure of a company, Long-Term Capital Management, can make economy-busting mistakes.  That’s the problem with ‘flexible regulations’.  The experts are often wrong, and certainly would never agree on what needs to be changed and how.

Fourth, regulations are created in the wake of a crisis.  They may prevent the same crisis from recurring, but there are too many ways to undermine an economy.  It is impossible to predict all of them and set up regulations to prevent them, without putting a stranglehold on business.  Already businesses are overloaded with regulations such as Sarbanes-Oxley.  They cannot be competitive with even more regulations.  Either they would lose out to foreign competitors, or non-regulated businesses would simply move into the field by creating new unregulated markets, as has happened in the Bahamas, the Isle of Man, and elsewhere.

Effective regulation would require that the government be more motivated to prevent a catastrophe than the smartest industry types are motivated to make money.  That will never happen. (Not to mention that the government be as smart as big business – will never happen.)

Financial regulations can’t work.  It’s a law of nature.  There’s no way around it.

The only way to solve the problem is to end government’s “100% guarantees” on financial instruments, which would obviate the need for regulation.   In the case of the credit crisis, banks would still be able to lend if AIG failed, because they would not be bound by inappropriate reserve requirements (based on AIG-insured bond ratings).  This would have greatly mitigated the credit crisis.  Best of all, the taxpayer would not be on the hook.

Now with that having been said, some basic regulation is good.  Certainly anti-monopoly regulation is very important.  No one business should be allowed to control any single market.  Competition is the life-blood of capitalism.  As well, all businesses should be required to uphold their fiduciary duty to their shareholders.  The rule of law must prevail, and that requires a strong government.

So now you might wonder, why does regulation work in the case of such things as health and safety?  First of all, in these cases, the interests of industry and government are fundamentally aligned.  For example, airlines and the government work together cooperatively to develop maintenance regulations.  It’s in neither party’s interest if a plane crashes.  Nor, with respect to health codes, if a patron at a restaurant gets sick from incorrectly prepared food.  Secondly, the taxpayer is not on the hook if the business fails (bailouts of airlines and auto companies notwithstanding).  And finally, no industry has the short-term profit potential as the financial industry.  The financial industry would never cooperate with the government to create regulation, and if they did, one would be wise to be suspicious.

Kill the Mortgage Interest Tax Deduction

2009-12-31 01:01:59

The Mortgage Interest Tax Deduction (MITD) is one of the most destructive and unfair pieces of tax policy ever created.  It disproportionately hurts poor people and renters, and it is in large part responsible for the current financial crisis.  This tax policy must be repealed.


The tax deduction costs about $80 billion each year, and most of that money goes to the wealthiest homeowners with the most expensive houses.  Renters, and less wealthy homeowners who don’t deduct (the majority of the US population) do not benefit at all, and effectively subsidize the shortfall.  This discredits the MITD’s most popular justification as a policy that improves neighborhoods through homeownership, when the people who need it most see no benefit. In fact, the genesis of the MITD is more historical accident than social engineering.  Prior to 1984 all personal interest was tax-deductible, but when this policy was ended, the home deduction somehow survived.  It is now time to kill this one too.


Inflating the bubble


In addition to being unfair, it is also one of the direct contributors to the inflated housing price bubble that, when it burst, resulted in the Financial Crisis of 2008.  According to the National Association of Realtors,  the repeal of the MITD would result in a 15% decline in housing prices in some areas.  But this of course is the flip-side of the coin that the policy inflates housing prices by 15%.  Also, second homes are eligible for the deduction.  This inflated the housing bubble further over the last 10 years, as investors and speculators bought second homes with cheap money.  The government is essentially subsidizing housing market arbitrage.


MBS and CDO nightmare


The MITD makes longer term loans more desirable by reducing the effective interest rate.  Because of the deduction, one can borrow the same amount of money for the same overall cost, but for a longer time.


To better understand this, consider the relatively simple example of a multi-millionaire who is purchasing a $500,000 home.  He could pay for it in cash.  But why should he?  With the MITD he can borrow money for effectively below-market rates, and put it in higher yielding investments.  The tidy spread, perhaps 1 or 2 percent, compounded over 30 years, will make a nice profit.


Of course not everyone is a millionaire.  But even if you’re not, the same dynamic holds true.  As long as you have excess income, you can save it in higher yielding investments instead of paying down the principal.


Unfortunately, long terms loans are much more volatile, first of all because the chance of default is greater (simply because there is more time in which to fail to make a payment), and secondly they are more sensitive to interest rate fluctuations.  This makes loans much more difficult to value.  Securities that were created by bundling up the loans – Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO) – were the biggest problem in the 2008 financial crisis, in part because they were so difficult to value.  Some of them had gone to zero, but for others it wasn’t known if they are worth only 10% or 50%. It will take 20 years to know the true value for some of these.  These types of financial instruments simply wouldn’t exist without the MITD, because most home loans would be around 10 or 15 years.


Time to repeal


Certainly, the repeal of the policy would decrease housing prices.  Although painful in the short term, this is a good thing, because it creates more affordable housing for everyone.   However, it would significantly increase effective monthly mortgage payments for wealthier buyers.  These people would have to buy smaller houses.  There will be fewer mansions.


One of the biggest challenges in banking is a problem known as ‘maturity mismatch’: banks take short term deposits (money that can be withdrawn at any time) and lend it out for long-term loans.  A lot can happen in the life of the loan, and the risk of a liquidity problem is greater with longer term loans.  Shorter term loans (10 to 15 years) greatly reduce the maturity mismatch problem, and would improve the stability of the banking system.


In fact, maturity mismatch was the main cause of the S&L crisis in the 80’s.  S&L’s were originally limited by statute and regulation to fixed-rate home mortgage loans.  However, inflation in the mid-80’s greatly reduced the value of the 30 year loans, making many banks insolvent.  In an attempt to fix the problem, banks were allowed to diversify into other short term real estate loans, but by then it was too late.


Repeal of the MITD will also greatly reduce the popularity of impossible-to-value toxic assets – MBS’s and CDO’s.  These things would never have been created in the first place without the MITD, and no one would miss them if they disappeared.  It is no coincidence that they are created only in the US – one of only a handful of countries that still permits the MITD.


Most economists, both conservative and liberal, agree that the MITD is bad policy.  Although it was challenged a few times in the past, currently there is no strong political desire to eliminate it.  However, given that it is bad for the majority of Americans, it should be possible to overcome the interest groups and lobbyists to create the momentum to kill it.


The MITD need not be repealed overnight.  The benefit can be reduced over a period of 10 years (for existing homeowners) to reduce the shock to the system, and can be coupled with an overall decrease in the tax rates for everyone.

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2009-12-31 23:21:27

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End the ratings agency cartel

2010-01-01 21:50:53

Rating agencies were one of the biggest contributors to the Financial Crisis of 2008.  By stamping a ‘AAA’ grade onto low quality subprime Morgtgage Backed Obligations (MBOs), they turned them into investment grade securities.  Trillions of dollars’ worth of these securities were sold around the world, to commercial and investment banks, hedge funds, and pension funds.  Government and financial institutions alike relied on the trusted names behind these ratings – Moody’s, Standard & Poor’s, and Fitch.  The money from the sale of these bonds often went right back into the housing market, inflating prices further.  But once the housing price bubble finally collapsed and people started defaulting on their mortgage payments in huge numbers, many of the bonds became worthless. The buyers of these products suffered huge losses, threatening the solvency of many financial institutions, and initiating the federal bailout for hundreds of billions of dollars.



The state of Ohio is now suing Moody’s for $457 million due to losses in their pension funds, claiming that they relied on the AAA ratings, and alleging fraud and abuse at the agencies.  Other states with similar losses are not far behind.


Investment banks that bundle up the mortgages into securitized MBOs, like Goldman Sachs and Lehman, must pay the ratings agencies for the ratings.  This is a huge conflict of interest.  The ratings agency has the incentive to charge more for a better rating (or for the company selling the bond to pay more) because a highly rated bond will sell much better.  Furthermore, the ratings agencies can charge for consultation services, which show the bond-sellers how to structure or fine tune their offerings for the highest ratings.  And finally, if a bond-seller is not happy with the rating they received, they can shop around to the other ratings agencies for a better deal.


The history of ratings agencies


The big ratings agencies all started as subscriber services.  Moody’s for example, started in 1900 by John Moody, published a book of information and statistics on stock and bonds, and it was sold directly to the public.  Circulation increased rapidly, as there was a huge demand for this information by the investing public.  Later, Moody included the established letter grading system into his analysis.  Thus the ratings agencies were directly accountable to the public and competed between themselves for customers based on quality and accuracy.  Although there may have been errors and abuses, the free market held them in check, because investors could easily switch to another provider if they felt that one was not being honest.


However, all this changed in 1970.  After some people were burned in the bond market, the government required that all bonds must be ‘investment grade’ in order to be sold to the public.  They chartered the big 3 agencies: Moody’s, S&P, and Fitch, to provide the ratings that would be used for this purpose.  Thus, bond sellers were required to get a rating from the agencies, and effectively they became a cartel.  They could charge companies directly for access to the credit markets.  And that’s exactly what they did.  This was seemingly great for the public as well, because they wouldn’t have to pay for ratings.  They would be provided for ‘free’.


Unfortunately this well-intended regulation paved the way for the huge conflict of interest that contributed significantly to the housing price bubble that resulted in the Financial Crisis of 2008.  Many fixes have been proposed to make the companies more accurate and accountable.  However, these ‘fixes’ often require new levels of oversight and bureaucracy, or the fixes are so complicated as to be almost comical.


Disband the cartel


The solution here is not to make it more complicated.  The solution is to make it simpler.  The ratings cartel must be disbanded.  Companies should be allowed to sell bonds with or without a rating.  Investors should check ratings (purchasing them if necessary) before buying bonds.  If they cannot afford to purchase the ratings or do the research on their own, they should not purchase bonds.  Companies should, however, be required to issue a prospectus, just like they do with new stock offerings.  As has been shown in comparative studies of banking systems, government has an important role in fostering information transparency in the markets, which enables market discipline of companies by the public — the most effective form of regulation.  Government can also take a role in educating the public about the dangers of investing in ungraded bonds.


This would bring bond ratings more in line with stock ratings, which are often offered through independent subscriber services such as Morningstar.  There are still potential conflicts of interest.  For example, during the tech bubble in the late 90’s, many companies such as Enron were rated too highly by the investment banks that also supplied underwriting and consulting services.  These conflicts of interest must always be disclosed, and investors must always be wary.


There is no substitute for market discipline and investor scrutiny.  Anyone who relies on ‘big brother’ government to secure their investments or to learn which ones to make, is likely to be disappointed.  Investors must do their homework and take responsibility for their investment decisions.  They must be willing to pay a fee for ratings if they cannot evaluate the investment independently.  And they must continually evaluate the objectivity of the rating agencies themselves.  But because the ratings agencies know that objectivity is their lifeblood, they will always strive to maintain it.  No ratings agency would have given a triple-A rating to junk bonds under their original business model, and this alone would have significantly reduced the size of the housing bubble.


However, if ratings agencies are allowed to continue to operate as a cartel, then two things will happen.  First of all we will see history repeated, as the agencies treat investor lawsuits are simply a ‘cost of doing business.’  This may take 5 years or 20 years, but it will happen.  Secondly, if more government regulation is enacted to mitigate the conflict of interest, it will create entirely new unanticipated problems and complexities that will result in future crises.  And the people and the politicians will call for even greater regulation, in an endless, hopeless cycle.


Finance consumer ed ideas

2010-01-02 08:12:36

These can be done in multiple languages to protect the most vulnerable.


“It’s ok to walk away” – you can morally walk away from your mortgage – you are not a slave to the mortgage company – but you should know the consequences (e.g. credit score)


“Don’t pay your mortgage with your credit card.” – If you are getting behind on your mortgage, you should seriously consider defaulting and walking away.  Rent a place until you get back on your feet.



Finance Story Ideas

2010-01-02 08:14:51


Regulation graveyard – well-intentioned regulations that are no longer exist due to unanticipated consequences – regulation Q, usury, ARM prohibition, interstate banking – and regs that should be overturned: ratings agency, salary caps



We asked for it – we are responsible for government spending (to bail out the banking system, medicare, SS, housing bubble, etc) – because these are policies we wanted, at least at the time


Rescue of big companies (Bear Stearns, AIG) – justified as necessary to prevent failure of commercial banks – but is this true?


MBS market – artificial support inflating the MBS bubble, which will burst again ($1.25 t from NY Fed + Fannie & Freddie support)


Zombie Banks – Citigroup is a zombie, and probably the other big ones too – sucking the life out of the financial system – early detection and resolution is the key to reducing overall costs


Obama – why is he so angry about the wall street fat cats?  he’s the one who gave them the money – what did he expect? – trying to deflect from the real issues


Bad regulators – where you least expect it (Madoff, S&L, subprime mortgages)


Housing glut – high vacancy rates in homes and rental units will take years to resolve, and housing prices will continue to fall until it does – continue to affect economy


FDIC – moral hazard – the problem with insurance (S&L, Citigroup) – associated with financial instability in other countries


Next bubble – what will happen when the next bubble pops (housing, commercial RE, consumer debt, etc) – how to prevent continuing bailout of big banks


Hidden subsidization – how banks are being subsidized – FDIC, Fed discount window, Fed asset purchases, and what will happen if the subsidies are ended


Rewarding failure – ensures future failure (big investment banks – Bear Stearns, AIG)


30 year loans shouldn’t exist – they are unpredictable and create great instability in the financial system (toxic assets impossible to value) – created by Mortgage Interest Tax deduction – at the heart of the financial crisis


Too Big to Fail – It’s a myth based on the Great Depression and/or to protect big companies – who can explain this concept other than Hank Paulson – and in non-apocalyptic terms (but with taxpayer guarantees they are Too Expensive to Fail)


Promoting home-ownership in the US – Fannie & Freddie, FHLB, S&L, MITD – who is behind this?


Temporary suspension of cash withdrawals – what would be the impact on the economy if banks had this ability (one money market fund recently did this)


Government by the rich, for the rich – MITD (Mortgage Interest Tax deduction), FDIC insurance, big bank bailouts, entitlements


“Government hands off my Medicare” – right wing hypocrisy


Social Security – the biggest Ponzi scheme in history


Banking opacity – no one knows the true status of banks today (are they solvent?) due to accounting complexity and lack of information – and how market discipline would enforce transparency


Credit Crisis of 2008 – a temporary ‘restriction on loans’ is simply a back door ‘restriction on payments’ – the failure of FDIC and the Federal Reserve (which were created to prevent bank runs and restrictions on payments)



The ultimate arbitrage – Goldman Sachs and other big investment banks can now borrow from the Fed discount window at near zero percent, and use the money to invest in risky assets, pay back TARP, and even pay themselves – how much money have they borrowed? – and are average Americans subsidizing this through low savings interest rates and ultimately a potential taxpayer bailout?


Regulations fairy tale – try to fix one thing and another thing breaks – in an endless cycle – but each time we think it’s now fixed


‘You wouldn’t understand’ – The financial mess is too complicated to understand, so just sit back and let the experts handle it.


‘Give me Armageddon’ – If there is another fall in house prices, the banks will be in renewed distress.  The fed & treasury will threaten Armageddon if we don’t continue with trillions of dollars of bailouts.  Let the banks fail.  We’ll take Armageddon.


Responsible banking – Find a country with low regulation and no deposit insurance.  Is their banking system stable?  Do people know their money is not insured?  Do they care?


Sallie Mae – inflating the tuition market just like Fannie & Freddie inflated the housing market.  If the funds weren’t government guaranteed, then people wouldn’t take out so much loans and school would be cheaper.  Third parties give out loans knowing that many students unlikely to repay, then sell off to Sallie.


Fannie and Freddie aid speculation by financing up to 10 home per person – find a speculator who did this.  How many F&F loans were in the vacation home market?


FHA insures mortgages as low as 3.5% downpayment – how are they faring?


Sarbanes-Oxley – Generated billions in fees for accountants but did nothing to prevent the Financial Crisis of 2008. Why?  Because it kept managers focused on the irrelevant details instead of the big picture, and focused on protecting themselves from criminal prosecution.



Arianna’s “Move Your Money” Campaign is a great idea but….

2010-01-04 04:00:51

Arianna Huffington, Rob Johnson and colleagues recently created the “Move Your Money” campaign (, the idea of which is to encourage people to move their money from the big banks into smaller, healthier banks, in an effort to stabilize the financial system.   It’s a really clever idea, and certainly the right thing to do, given that it takes power away from the ‘Too Big to Fail’ zombies.  The campaign is coupled with a video montage from “It’s a Wonderful Life,” the Jimmy Stewart movie about how he saves his local building-and-loan from a big bank that comes in to the community and nearly destroys it.  Unfortunately, however, the campaign is only a short term fix to a deeper underlying problem: the moral hazard of FDIC insurance.



The biggest banks these days (Citigroup, Bank of America, JP Morgan Chase, and Wells Fargo) are zombies: they are supported by government bailout money in the form of the Fed discount window and the multi-trillion-dollar Fed & Treasury support for their deeply devalued mortgage backed assets (MBOs).  They are probably insolvent, and have received a grade of ‘F’ from Institutional Risk Analytics, the company hired by the FDIC to analyze their required quarterly bank filings and evaluate the health of each of the 8000 insured banks nationwide.  Don’t be fooled by their repayment of the TARP money last year: they simply borrowed the money from the Fed discount window to repay it – perhaps the best ‘carry-trade’ of all time, financed by taxpayers and savers in low interest accounts.


Normally the FDIC is happy to shut down failed banks, but these big guys are considered ‘Too Big to Fail’.  Their friends in the Federal Reserve and Treasury (under the leadership of Bernanke, Paulson, and Geithner), perhaps think that the failure of these banks would result in the utter collapse of the American financial system, and cause Great Depression II.  Or perhaps they just have friends there.  However, they certainly would not admit that the banks are insolvent.  If they did, the FDIC would have to take over, and either find a healthy bank to buy them (which is unlikely considering the unknown value of their MBOs), or they’d have to close them and wind them down, which would require liquidating the MBOs, counteracting the Fed and Treasury core strategy for combating the recession.  However, keeping them alive is just throwing good money after bad, increasing the national debt, and worst of all, allows them to continue their risky behavior, something which every indication shows they are doing.


So it’s a great idea to get people to move their money out of these banks.  First of all it supports local, healthier banks.  With the help of Institutional Risk Analytics, you can type in your zip code and get a list of banks with grade ‘B’ or above in your area.  Secondly it takes the power out of the ‘Too Big to Fail’ argument: if no one has a deposit in these banks, then how can they be considered too big?  Also, reducing deposits forces the bank to try to sell their assets, which could force a more timely foreclosure — unless of course they are permitted to just borrow more from the Fed.


But there are some fundamental problems with the campaign.  First of all, the video is based on the premise of rooting for the little guy (like Jimmy Stewart).  Although this has broad appeal, when it comes to economics, often bigger is better.  After all, most of us shop at Walmart and other superstores, even when they crush the smaller, local competition.  So we are justifiably suspicious when an ad campaign appeals solely to our emotions.  Secondly, even if we understand the threat of the zombie banking system, we don’t have a real, economic incentive to move our money.  After all, our money is insured and protected by the FDIC.  In fact, the web site assures us that the listed local banks are also FDIC insured, so we still don’t have to worry if we switch.


But even if the campaign is successful, it only punts the problem down the field.  The reason is that there will always be more banks that are on the verge of going bad, including the recipients of our fresh dollars.  And so there will always be a need to keep the public informed of who they are, and continue the campaign to warn them.  Either the do-gooders behind the campaign will run out of steam, or people will get tired of the message and do nothing, having discovered that it doesn’t really make a difference.


The core problem here is simply FDIC insurance.  As long as we know our money is insured, we don’t have a powerful incentive to monitor our banks carefully for financial misconduct and move our money to healthier banks if necessary.  However, if our deposits are no longer insured, we must take responsibility for the health of our banks — market discipline — which will force them to behave responsibly.  Under the current system, the taxpayer will have to pay the price for our laziness.  Given the current bailouts, the price may be a couple trillion dollars.



Bernanke’s next power grab

2010-01-04 06:20:30

Ben Bernanke was Time’s Man of the Year in 2009 for supposedly saving the world economy from Armageddon.  He’s also the most powerful man in the world.  Now King Bernanke wants more power.  If he hasn’t already sowed the seeds for the Great Depression II, with even more power, it is all but inevitable.


Many people blame Bernanke for the housing price bubble, claiming that Fed policy was too loose over the last 10 years.  The cheap money went into speculation in the housing market.  There is some truth to this, but I think overall loose money is fine, as long as it doesn’t cause inflation.  So I think this criticism is unfair.


Bernanke defends his monetary policy in a recent speech on monetary policy here.  However, he blames the housing price bubble on failure of regulation.  If only we had been more vigilant about preventing banks from making bad loans, this whole problem could have been avoided:


Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.


The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.


Of course, the housing price bubble was caused by both easy money and lax regulations.  But the biggest problem, which he conspicuously omits, was the involvement of government sponsored entities (GSE) in the housing market: Fannie and Freddie, FHLB, and FHA inflated the market recklessly.  They made lots of money while things went well, and investors in their bonds continued to pour money in, knowing that they had an implicit taxpayer guarantee backing them up if things went bad.   (And the Obama administration will continue to support the GSE bonds for at least the next 3 years.)  Certainly private banks contributed as well, but without the government involvement, the bubble would not have been so huge, and certainly the taxpayer would not be on the hook for losses when it popped.  (Private banks were similarly protected through FDIC.)


Asset bubbles happen.  In fact, some economic theorists think they are inevitable as economies flourish, and wealthy investors seek higher yielding assets with their excess funds.  The problem is not the bubble, and the problem is not when the bubble bursts.  The problem is when the taxpayer has to foot the bill.  This is fundamentally the problem with GSEs.  If not for them, the housing bubble would have hurt much fewer people, and certainly would not have left a bill for generations of taxpayers.  For example, the tech bubble of 2000 did not have long lasting consequences except for relatively few rich investors and unwise speculators.


The stock market crash of 1929 is another example, and is often considered to be the cause of the Great Depression.  However, most economists now agree that the depression was caused not by the crash, but by the government’s strict adherence at the time to the gold standard, along with overly tight monetary policy by the Fed.  Bernanke is a student of the Great Depression, and contributed important research showing how the failure of banks worsened the depression as a result of impaired lending, upon which the economy depends. The only people hurt in the stock market crash, for the most part, were wealthy investors and speculators.  The average person was not directly hurt, and certainly they were not responsible for losses suffered by the victims of the crash.


The story today is very different.  Because of Freddie and Fannie, and FHA, and FHLB, and more recently the opening of the Fed discount window and purchases of MBO’s, the US taxpayer is responsible for any losses.  These could total in the trillions, and generations of taxpayers will be paying for it.  For this reason especially, Bernanke should stop the bailout.


Bernanke is committed to avoid the mistakes of the past.  Easy money is important in a recovery – this most of us agree.  However, he goes a step further: the banking system must be rescued at all costs, even if the cost is in the trillions of dollars.  However, this is the wrong conclusion.  The bad banks must be allowed to fail, because even though that will cause temporary pain, the cost of keeping the zombies alive ultimately will be far greater.


Bernanke concludes that fundamentally the problem is bad regulation – loose lending standards.  This is really scary, because he is really arguing for more powerful government control over banking.  But even the FBI was aware of widescale fraud and abuse in 2004, and did nothing.  There is no reason to believe that a regulatory agency will do any better.  It’s ridiculous to think that a ‘Systemic Risk Council’, presumably staffed by brilliant economists and Nobel prize winners and otherwise well-qualified political appointees could ever detect legitimate ‘systemic risks’, much less do anything about them until it’s too late.  Government doesn’t work this way and never will.  In fact, financial regulation can’t work, as explained here.  These types of agencies ultimately will make bad decisions that enrich themselves at the expense of the average person.


This speech is simply an attempt at another huge power grab.  Regrettably, he will probably get what he wants from a Congress that is all too eager to have its own influence on powerful new agencies.  They will continue to back reckless and economy-busting policies with taxpayer money.  The result will be huge deficits, an unpayable debt, hyperinflation and a bankrupt government. The man who is now being credited with preventing the Great Depression II will actually have caused it.


Bailout Scorecard

2010-01-07 22:39:23

The bailout so far totals nearly $2 trillion in aid and guarantees to banks and housing market support.  Here is an accounting of all the main bailout programs, along with the possible potential loss of each.  If the housing market falls modestly, the taxpayer stands to lose at least $1.1 trillion, not just from the bailout funds, but from losses from government mortgage guarantees.


Most of the bailout money is in the form of loans and guarantees, so if all goes well, losses will be low.  The best case scenario is a loss of $150 billion in ‘Giveaways’ (see below). However, in addition to bailout loans, the government also guarantees GSE-related debt.  So if the housing market continues to fall, then assuming a 10% loss in housing price securities, the taxpayer stands to lose $1.1 trillion (sum of ‘Loss’ and ‘Giveaway’).  This number could be much higher if the housing market falls further, or if the government pours more money into the bailout.


Not included are a small number of smaller bailout programs (less than $5 billion).  As well, this list doesn’t include stimulus spending, which is about $700 billion.  All dollar amounts below are in billions.


The amounts below are current as of January 7, 2010.


Capital Purchases

These are the large purchases of stock by the government with the resulting percentage ownership in the company. The government also provided capital to thousands of banks under TARP, but most of that money has been returned, with the exception of $25 billion from Citigroup. Although the companies are required to pay back the government eventually, there is no indication that any of these companies will be able to do so any time soon. Our optimistic estimate is that the taxpayer will be repaid 50%. All amounts in billions.


Percentage owned by government
AIG $40 80%
GM $53 61%
Chrysler $14 10%
GMAC $17 56%
Citigroup $25 26%
Total $148
Loss (50%) $74


Mortgage Purchases and Guarantees

The government owns or guarantees about $7 trillion in home mortgage assets. Also, it continues to purchase more mortgages and mortgage obligations since Sept 2008 to provide more cash for the housing market. This activity keeps house prices high and mortgage rates low. How long the government will continue to support the market in this way remains to be seen. If housing prices fall significantly, the government (i.e. The taxpayer) will be on the hook for billions of dollars. The liability estimate here assumes housing prices will continue to fall, resulting in a 10% loss in the portfolios. Technically the government is responsible only for FHA insurance. However, in practice it backs the bonds and insured securities of all GSEs as well.


Guarantees on GSE mortgages


FNMA Fannie Mae bonds $800 Outstanding Bonds
FDMC Freddie Mac bonds $700 Outstanding Bonds
FNMA Fannie Mae guarantees $2,400 Guarantees on MBS owned by third parties
FDMC Freddie Mac guarantees $1,500 Guarantees on MBS owned by third parties
FHLB Federal Home Loan Banks $1,150 FHLB mortgages (implicit guarantee on FHLB bonds)
FHA Federal Housing Administration $725 Insurance on mortgage loans
Total $7,275
Loss (10%) $728


Federal purchase of private MBS

The government has also purchased $500 billion of private-label MBS (non-GSE MBS) from banks to support the housing market, avoid failures of certain big businesses, and increase credit liquidity.


current maximum
Bank of American loan-loss backstop Treas, Fed & FDIC $118 $118 Government backing of assets from Merrill Lynch merger in exchange for fees & shares
TAF Term auction facility Fed $200 $450 Purchase MBS from banks for short term 1-3 month cash
AIG TARP $50 $50 MBOs bought from GS and other banks to cancel AIG’s CDS contracts
TSLF Term securities lending facility Fed $30 $200 Exchange MBS for gov’t securities (1 month)
Bear Stearns bailout Fed $29 $29 Toxic assets now managed by BlackRock, sold over time
PPIP Public-Private Investment Program Treas $20 $30 Joint program to create MBO purchasing investment vehicles – 50-50 pubic money and private money. Principal can be wiped out under 6x leverage.
PPIP Public-Private Investment Program FDIC $0 $240 PPIP issues FDIC guaranteed debt
Total $447 $1,117
Loss (10%) $45 $112


Fed Repurchases

The Fed is purchasing assets from GSEs in order to provide liquidity for more loans, to continue to support housing prices and keep interest rates low. However, this does not increase the government’s liability since these loans are guaranteed by GSEs and may be held until maturity.


GSE MBS purchases Fed $1,100 $1,250 Purchase MBOs from Fannie & Freddie & Ginnie (to be completed March 2010). In the case of default it is unknown if the Fed will request payment from F&F.
GSE direct debt purchases Fed $100 $100 Purchase Fannie & Freddie, FHLB bonds


Housing Market Giveaways

These programs are simple tax credits or cash giveaways. There is no expectation of repayment.


current maximum
MHA Making Home Affordable $27 $75 Payments to servicers & GSEs to renegotiate mortgages (refinance, extend, or reduce principal)
FTHBC Homebuyer credit $14 $20 Homebuyer credits up to $8000/home through March 2010
FDIC FDIC bailout 0 $1000 The FDIC has unlimited liability to resolve failed banks, but its insurance fund is under $40 billion. Currently large banks like Bank of American and Citigroup are zombies, and will probably never return to solvency. When they finally fail, they will require huge government infusions to pay back insured deposits.
F&F Fannie & Freddie bailout $110 $400 Unlimited funding to keep them solvent: Preferred stock purchase agreement likely to be as much as $400 billion
Loss $151 $1495



Future Expenditures

These are programs that are in the government toolkit, and could be implemented in a future crisis.


Credit union deposit insurance guarantees
Money market guarantee This program covers previously uninsured money market funds. It was implemented temporarily in October 2008.



Bank Liquidity Guarantees

These programs guarantee bank operations so that investors will feel safer when purchasing bank bonds or making deposits. The loss assumes 10%, since not all banks will survive the current financial environment.


current maximum
FDW Fed discount window Fed unlimited Very low borrowing rates for banks which can be invested in risky assets (carry trade)
TLGP DGP Temporary Liquidity Guarantee Program – Debt Guarantee Program FDIC $313 FDIC guarantee of debt issued by 57 banks, e.g. Goldman Sachs
TLGP TAGP TGLP – Transaction Account Guarantee Program FDIC $760 FDIC guarantee of accounts over $250,000 through June 2010
AIG AIG loans Fed $43 $60 Loans that AIG is expected to repay (recently they proposed giving Fed $25b of it’s subsidiaries of unknown value)
TALF Term asset-backed securities loan facility $200 1 month loans for asset-backed securities like credit cards
Total $1116
Loss $111

Ally Bank: The First Zombie

2010-01-08 07:44:37

You’ve probably seen the Ally Bank commercials.  In one of them, a child is given a new bike, but then is not permitted to ride it anywhere.  In the others, the children are teased variously with a toy truck and a pony.  The commercial ends by touting one of the benefits of Ally Bank, such as its ‘No Penalty CD’ or high interest rates on savings accounts.  Then, “Ally Bank.  It’s just the right thing to do.” The implication, of course, is that other bank customers are suckers.


The commercials are funny and well produced.  They obviously spent a lot of money on them, as well as on a huge advertising budget.  This company must be doing quite well.  A high interest rate on CDs would imply they’re healthy and making lucrative investments. Normally banks must charge a penalty for the early withdrawal of a CD in order to reduce risk: if everyone withdrew their CDs at the same time (such as if interest rates went up) the bank could have a serious liquidity crisis.  But no worries here.  This is one of the best capitalized banks in the country, according to their web site (  It’s good to see banks advertising again – and trying to do right by us.  Quite a change from the greedy and reckless old banks of the past.  It must be that we’re finally emerging from the long financial crisis.


Or so you might think.


In fact, the company is the banking arm of GMAC, the recipient of $17 billion of bailout money from the federal government.  The US taxpayer is now the proud owner of 56% of GMAC.  The company is insolvent due to bad mortgages by its lending arm, Ditech, but it is kept afloat because of its ‘systemic importance’ to the auto industry.  And perhaps as well to keep the auto workers on the Democratic side ahead of midterm elections.


So at this point we can only watch as the company fritters away our tax money in lavish ad campaigns to attract FDIC-insured deposits of customers who would otherwise go to healthier banks.  One hopes that a bank such as this would have learned its lesson about investing in risky assets, but that would be wishful thinking.  Instead of buckling down and getting back-to-basics, the company is betting on a high-growth strategy to boomerang back into profits.  It is quite likely that they are simply making more risky bets, such as its ‘No Penalty CD’.  And why not?  We’ll continue to back them up because now they are even more ‘Too Big to Fail.’


This risky and desperate behavior is typical of zombie banks, which feed off taxpayer funds and steal business from healthy banks.  History shows, however, that the longer we wait, the more expensive will be the final cleanup, as with the S&L crisis of the 80’s and Japan in the 90’s.  Zombies do not return from the dead, and forbearance, the policy of waiting and hoping, simply doesn’t work.


The ultimate loss to the taxpayer is hardly limited to $17 billion.  The FDIC is responsible for bank deposits up to $250,000, and Ally is happy to show you how a family of 4 can insure up to $2.55 million (here).  And under the Temporary Liquidity Guarantee Program, which was part of the financial rescue package of 2008, the bank’s bonds are FDIC insured as well.  Clearly we are throwing good money after bad.  A far better solution would have been to liquidate the company and sell its auto financing operations to another bank.


Zombie banks can be identified by their ultra-life-like appearance.  It will be interesting to see which other banks follow.


I’ll Take Armageddon – Preparing for the Big One

2010-01-08 22:03:14

The Fed has pumped $2 trillion into the banking sector and housing market over the last year and a half (see the Bailout Scorecard) to keep the banks running smoothly and to jump start the housing market.  These initiatives are unsustainable and will fail.  It may be next month or it may be next year.  But the Fed is running out of weapons in its arsenal.  The housing market will crash again, and when it does, we’ll be in a new financial crisis.  Banks will cut off lending, businesses and people will panic.  The politicians will demand action.  And the Treasury and Fed will relaunch their ‘scare the s**t out of them strategy’ that worked so well last time: if we don’t take immediate multi-trillion dollar action right now, there will be economic Armageddon.


Here’s my response: I’ll take Armageddon.



The housing market will crash again.  Although home prices have fallen 30% from their peak in 2007, they still have further to go, perhaps another 20%, before they return to their historical levels of the 1990’s.  Vacant housing inventory is still very high – 3% for homes and 10% for rentals.  The price for housing now should be much lower, but it’s kept artificially high by $2 trillion of government support, which represents a significant portion of the $14 trillion overall mortgage market.  When it will crash is impossible to say.  In March, the Fed plans to wind down its $1.25 MBS purchases.  However, this role can now be taken over by Fannie and Freddie, which by the Christmas Eve 2009 decree may continue to increase total assets.  The homebuyer tax credits will end in April 2010, and this may trigger the crash as well.  Regardless, whenever it happens, we must be prepared.


Another crash would devastate the zombie bank industry that is loaded up on mortgage-backed securities (so-called toxic assets).  It would force them into insolvency, requiring a huge taxpayer bailout of FDIC insured funds (the puny FDIC insurance fund is inadequate to handle losses at this level).


Unfortunately there is no easy way out of this problem.  It’s going to be painful no matter what.  But the longer we wait, the longer the zombie banks will accumulate more deposits and government guarantees, making the ultimate bailout more expensive.  Until then, economic activity will be anemic and unemployment will remain high due to uncertainty in the business environment, and as banks restrain lending for growth, hoarding money in preparation for the day of reckoning when they must reveal their true losses.


The only solution is to allow the big banks fail, as was done with Lehman.  This will be very expensive, as big banks like Citigroup and Bank Of America are propped up on all sides by government funding and guarantees – FDIC insurance on deposits and bonds, and the Fed discount window.  But they must be allowed to fail, and their assets slowly sold off or assumed by a healthier bank.  Yes this will be very disruptive to the economy.  But these banks are zombies and will never return to life.  Supporting these banks is throwing good money after bad.


When the housing market crashes again, there will be fear and panic.  Media will foretell the end of the world.  The government will come to the rescue, with TARP and a raft of other government programs that worked so well last time.  However, first of all, TARP didn’t actually work.  Although most of the money was paid back, it was done primarily by borrowing money cheaply from the Fed.  If TARP is done again, it will result in direct losses as bank equity goes to zero, or in backdoor losses as banks simply borrow more to pay it back.  Secondly, there are about $1.3 trillion in non-TARP government programs currently supporting the market with taxpayer backing (see the scorecard), and the Fed has bought over $1.5 trillion in mortgage related debt.  These programs are still actively underway, and the only way to keep the patient alive is to increase them further. So while they’ll claim that the programs worked, in fact they have succeeded only in postponing the crisis and increasing taxpayer liability.


These programs are not sustainable.  The market will crash, and the sooner the better.


So when the Fed and Treasury ask for more money, threatening financial Armageddon, we must be prepared to say, ‘We’ll take Armageddon’.  The worst thing would be to panic.  Be prepared for a period of difficult economic conditions as the big banks fail.  Put your money in healthier banks (Move Your Money).  Accept the market correction.  Perhaps it will be an investment opportunity for you.


Bernanke is a student of the Great Depression, and the lesson he seemed to learn is that the Fed must maintain stability of both asset markets (like the housing market) and the banking sector at all costs.  But the real cause of the Great Depression, as most economists agree, is not the crash of the stock market in 1929.  It was a combination of tight monetary policy, the requirement of a balanced federal budget, an impaired banking system, and adherence to the gold standard.  The Fed has an important role in providing easy credit during a recession – for all assets, not restricted to propping up the housing market.  But it was not necessary to specifically support zombie banks and the housing market as they are doing.  In fact it is counterproductive as it only delays the inevitable and increases the national debt – a huge price that will be passed on to future generations.


After the crash and correction, the American people can start to rebuild the economy in earnest, relieved of the burden of a dysfunctional banking system.


Foreclosure Documentary

2010-01-12 01:40:28

Do you have a property that has been foreclosed in the past year?  If so we want to hear from you.  We are doing a documentary on the causes of the foreclosure crisis and need to find people who have been foreclosed upon.


If you are interested, please send an email to and include the following information:


1. Your email or contact info.

2. The location and value of each property foreclosed.

3. The type of loan (subprime, ARM, etc) and name of the lender.

4. Was it an investment property or primary home?

5. Where are you living now?


Thank you!!



The problem with the bank tax

2010-01-15 07:32:59

The Obama administration recently proposed the “Financial Crisis Responsibility Fee”, a tax on big banks, which will raise about $100 billion over the next 10 years to pay back the US taxypayer for the cost of TARP and other government bailout programs.  The tax is on uninsured bank assets of 0.15%, and only applies to banks with assets over $50 billion.  Sounds like a great idea, right?


In fact it’s a terrible idea, but not for the reasons you might expect.  The Law of Unintended Consequences will come into play, again as it inevitably does.  And the taxpayer will have to foot the bill for multi-billion dollar losses caused by it.


The standard reasons to oppose the tax are that it will be passed on to consumers, it’s unfair to healthy banks, and anyway banks (except Citigroup) repaid their TARP funds.  The tax could hurt lending and therefore jobs and the economy.  The tax also doesn’t get to the root of the problem, which is the continued government support of the housing market.  These are all good reasons, and certainly should make politicians think twice before passing the tax.


But the biggest problem with the tax is the unintended consequence that no one is talking about.  The tax is on uninsured assets only.  It doesn’t apply to FDIC insured assets.  This gives banks tremendous incentive to get the assets insured, and that means that ultimately the government, and the taxpayer, will be responsible for even more of the junk that banks acquire.


The tax rate is 0.15%, as compared to the FDIC insurance assessment, which is as low as 0.07%.  Although this might not seem like much, it is the kind of spread that can make or break a bank.  It can significantly eat into profits.  In fact, in the 90’s, there were two bank insurance funds, the Bank Insurance Fund (BIF) and the Savings and Loan Insurance Fund (SAIF).  These two deposit insurance schemes were both backed by the government, but the SAIF was higher by a small amount (perhaps as low as 0.03%).  As a result, many banks merged in order to qualify for the lower rate.  Ultimately the two programs were merged.


With a spread as great as 0.08%, big banks will be under tremendous pressure to insure all their assets.


Primarily this will be done by attracting FDIC insured deposits away from other banks.  FDIC insured ssets have risen from $2.5 trillion to $4 trillion in the last 10 years, and will increase even more.  These deposits can be invested in risky assets such as residential and commericial mortgages, thereby increasing the risk for the taxpayer if the housing market falls further (and it probably will).


But potentially more damaging in the long run will be the reclassification of assets that are eligible for FDIC insurance.  Money market funds, for example, are not FDIC insured.  They invest in commercial paper, which is used to supply the cash flow for the daily operations of businesses.  They offer a higher return than FDIC insured accounts, and are considered too risky for FDIC insurance.  But under pressure from banks trying to avoid the tax, regulators and legislators could reclassify this investment.  Certainly this would not happen in today’s environment, but in 5 years it becomes much more likely as the memory of the financial crisis fades and new administrations are elected, appointing new regulators.  If you think it’s impossible that money market funds could ever be insured, think again: they were insured for a year after September 2008 by the Treasury to stabilize the banking system.  This temporary measure could become permanent.


There are many other ways a bank could change the insurance rules, and they are masters of the game.  ‘Regulatory capture’ is behind many of the past financial crises, and is impossible to avoid because it requires eternal vigilance.  Ten years after a crisis the public and politicians have already moved on, and the banks are free to game the system through political manipulation.  On top of that, the government has shown great willingness to insure all aspects of the banking system, as can be seen in the Bailout Scorecard.


The Financial Crisis Responsibility Tax really should be levied on the government entities like Fannie & Freddie, the FHA, and the FHLB, which are at the heart of the financial crisis.  They artificially inflated the housing market, which created the financial crisis once the bubble burst (combined they guarantee 3/4 of the housing market).  Even worse, they left the taxpayer on the hook for the resulting decline.  The ultimate cost could easily be in the trillions.


It may take 10 years to realize the unintended consequences of this seemingly justified policy.  But as with all attempts to tinker with the free market, it cannot work and will ultimately fail – just in time to aggravate the next financial crisis and create more pain for the US taxpayer.


Ideal Documenatary

2010-01-25 06:20:21

Most people believe that evil Wall Street bankers and big financial companies wrecked the economy by creating complex financial instruments that caused the financial crisis of 2008. They believe that existing regulation failed, and that better, more stringent regulation is required. What’s worse, even supposed conservative economists seem to be going along with this interpretation. Ben Bernanke, for example, recently claimed that the failure was poor regulation in the mortgage industry. Alan Greenspan is not far behind.


This interpretation is completely wrong. The Federal government (both liberal and conservative) and its all-encompassing support for the housing market over the past 15 years caused the housing bubble that resulted in the financial crisis when it popped. There’s nothing complicated about it at all. This assertion is proven by the fact that 70% of the mortgage market is backed by federal guarantees (F&F, FHLB, FHA). The agencies made these guarantees under extreme political pressure (both liberal and conservative), and without these guarantees, most of these mortgages would never have been sold. What’s worse, because these agencies are government-guaranteed, the taxpayer is on the hook for the cost of the fall in house prices. This will likely add over $2 trillion to the national debt over the next few years. And to top it off, the government is still inflating the housing market through various mechanisms, and currently insures 90% of all current mortgages. It was not the free market that failed, but ill-advised and risky government policy.


The debt, when the home market falls again, will be a huge burden for generations of taxpayers. This will be the most protracted financial crisis the country will have ever experienced.


The government responded to the crisis in a terrible way, by supporting the big banks and businesses that caused the problem in the first place. It should have let them fail, and allowed the healthier, smaller banks replace them. It should not be propping them up with taxpayer funds, increasing taxpayer exposure to these insolvent and poorly managed behemoths.


The solution is not greater regulation and government involvement. This only makes big business bigger and the rich richer. The solution is to get government out of the housing market and banking industry and let the free markets function.


Bubbles come and go and business cycles boom and bust. This is healthy.


The taxpayer must accept responsibility for his own financial decisions and not expect the government to take care of him. As our current situation proves, the ‘nanny state’ is simply too risky and expensive.


The ideal documentary that I propose will be produced in multiple short segments, that possibly can be stitched together into one complete program. Each segment will attack one of the false tenants of conventional wisdom, creating a coherent and thorough argument in defense of the free market.







How government agencies caused the housing bubble:


Government agencies funneled money into the housing market and pumped it to unsustainable levels, causing the price bubble and the resulting foreclosure crisis.

Interview: home buyer with a low credit score and low income who got a sub-prime Fannie loan with down payment assistance, and was ultimately foreclosed. They say that they had nothing to lose, but looking back should have rented. They feel that they were pushed into home-ownership (such as Fannie Mae TV commercials).

Interview: house speculator/flipper, who had multiple guaranteed mortgages, and used MITD and cap gain exclusion.

Interview: the Countrywide agent who sold mortgages to these guys. “These mortgages were junk, but it didn’t matter because we just sold them to Fannie. We couldn’t sell them fast enough. We were simply agents of the government trying to satisfy its insatiable appetite. And yes they knew they were junk. The regulations were irrelevant and in fact they encouraged us to be creative to push them through.  Would we have bought these for our own books?  Never!”


Interview: Wall Street guy. “Look, our job is to make money. We worked with F&F to securitize the loans to sell them to others, and that’s what we did. And we made lots of money doing it. Yes these vehicles are very complex but we had to make them appetizing to the market. You can regulate them but it doesn’t get to the fundamental problem: the government was offering unlimited funds. We’ll always figure out how to get around regulations anyway.”


Graph: government guarantees 70% of the housing market.

Animated: Housing market bubble inflating with water from F&F, and taxpayer gets soaked when it pops.



How the government policies and regulations, both liberal and conservative, contributed to the housing bubble:


Liberal’s push for home-ownership for all, and Bush’s ‘Ownership Society’ paralyzed the natural free market forces that would have prevented the bubble. This piece is by experts, not average people.


Interview economist: Fed’s easy money went to housing (which is not included in inflation stats so did not trigger a tightening).


Interview housing market expert: Housing bubble triggered by: Clinton’s cap gains exclusion for home price, mandated increased low-income and very-low-income targets for F&F to 56% and 28%, and Wall Street’s ability to repackage the stuff.


Interview Wall Street guy: We packaged this stuff because people loved it – it’s backed by government – and we made tons of money off it.


Interview investment guy: I bought F&F bonds for my clients because of the implicit government guarantee. Yeah I knew housing prices were exploding, but I also knew that the government would stand behind these loans if prices fell.


Interview Fannie accountant: It was a huge scale fraud. But we were simply trying to achieve the objectives given to us by Congress. Of course, we made lots of money off the loans, at the time. We classified many subprime mortgages as prime. Even so we had $1 trillion in subprime by 2008.


Interview economist: When house prices dropped, the speculators were wiped out. When the economy started to slow and unemployment rose, the most vulnerable – subprime borrowers – lost income and were foreclosed. This caused the subprime crisis.


Interview economist: The regulations intended to increase home-ownership actually contributed to the housing bubble and the foreclosure crisis. The government created a fountain of money and it was simply a question as to how to exploit it.


Interview economist: Some people say that they should have done a better job regulating the industry through the regulatory agencies such as the SEC and the FDIC. These agencies warned about problems but nothing happened. Why? Because these agencies are themselves controlled, and their management appointed and fired, by Congress and the Executive branch. So the same politicians who were supposed to oversee these agencies were forcing F&F to sell more mortgages. Who was going to stop predatory lending? Even the FBI warned about problems but could do nothing.


Animated: Government pouring out money from a faucet, and banks and homeowners line up to receive it. FBI tries to stop it, but the government pushes them aside.



How Wall Street Contributed to the housing bubble:


Wall Street originated and sold its own mortgage securities that were not guaranteed by the government.  These were often rated AAA and sold to unwary investors.  These were only 30% of the housing market.  But overall the housing market was pumped up with government backed money, not private money.


Interview with someone who bought GS AAA junk.  “I thought it was fine.”


Interview with Moody’s analyst: “We would have rated anything AAA if they paid us enough.  But they had to pay to get listed.  The investor has no power over us because they don’t pay us.  If they don’t like our ratings let them go to Fitch.”


Interview with a pension fund asset buyer: By law we must buy AAA securities.  We can’t even look at lower rated securities, even if we think they are better quality.  As for the ratings, I guess it’s true, you get what you pay for.”


Explanation of the government chartered ratings cartel.


Some say GS originated loans and insured them by AIG, knowing that the housing market was going to fall.  Then the government bailed out AIG, repaying GS in full.




The $2 trillion dollar bailout of banks and the housing market:


This segments shows the huge cost of government backing mortgages when the market falls, as well as the additional cost of government backing up failed banks. This is done by experts. Compare with previous bubbles (stock market crash of 1987 and tech bubble), which did not result in economic catastrophe because these assets were not government guaranteed. This is the normal economic boom/bust cycle, big businesses fail, and recovery is normal.


Interview: taxpayer with children. “I would have preferred to take the pain now, than pass the cost on to my children. Each of them will have to pay $xxx. I hope that if there is another crisis, our government will let the big banks fail.”


Interview economist: The government enacted many new programs that increase the taxpayer liability. If there is another crisis, government could rush in the same as last time, increasing liability further, and this time it’s unlikely that any measures will prevent the further fall in house prices.


Interview Investment advisor: I’m glad the government bailed out Fannie and Freddie. My high net worth clients had significant savings in F&F and would have been hit hard if they failed. Nevertheless, they are diversified in other stock and bonds, so it wouldn’t have been devastating. But some foreign banks were highly leveraged and could have been destroyed if we didn’t step in.  China owns a lot of the stuff and would not have been happy either.


Interview GS manager: Thank god the government insured our company’s debt. Without that we might have failed, and who knows what would have happened to us. I would have had to sell my chalet in Switzerland. You know, last year we donated $50 million to charities, so we are very important for the economy.


Interview economist: Price bubbles are inevitable, and cannot be prevented. You really only know a bubble was a bubble in hindsight. However, they are part of the normal business cycle. Some unhealthy companies are taken down, and other innovative and healthy companies grow in their place. Generally the downturns affect the wealth of the richest investors because they are usually the biggest investors in the speculative bubble. However, this time the rich investors were protected from their poor investment decisions by the government, under the guise that they were protecting everyone.


Animation: Business cycle, of big companies growing and then collapsing, as small companies come in and grow in their place. Rich people losing money.




  1. Social Security:Interview young and old people about their attitudes toward Social Security. Use an animation to show how SS is a Ponzi scheme. Get the young and old people together to discuss their responsibilities to each other. 


  2. Agriculture policy:Show the effects of subsidizing corn for food and ethanol. Effect on other crops (e.g. sugar), farm land use, cost to taxpayers, obesity, injury to foreign countries’ domestic corn markets & hunger/reliance on US for aid. 


  3. FDIC moral hazard:The FDIC is supposed to keep money safe and prevent bank runs but effectively it destabilizes the banking system, protecting banks against risks and creating ‘too big to fail’. It creates a false sense of security. There are better ways to invest one’s money, both for safety and returns. Interview experts on different banking systems and show that there are safe ways to invest money. Interview manager of strong local bank. Interview citizen of another country that doesn’t have insurance. Show the importance of monitoring one’s local bank. Someone says, “How can I be expected to monitor my bank? I’m not an expert on Mortgage Backed Securities?” The response: “If your bank owns MBS or any other complicated investments that you don’t understand, then you should switch to another bank.” 
  4. Sallie Mae
  5. Medicare



The Housing Market Will Crash Again

2010-01-28 19:49:07

The housing market will crash again.  There are simply too many vacant and at-risk houses and not enough buyers.  The math is simple.


The housing market is currently being supported (inflated) by homebuyer tax credits of up to $8000 and the Fed’s $1.5 trillion MBS purchase program, which keeps mortgage interest rates at historically low levels.  These programs are scheduled to end by March or April, although interest rates will probably remain low as the Fed retains its Zero Interest Rate Policy (ZIRP).  But the pipeline of prospective homebuyers is being squeezed out.  Under these market conditions, anyone who is even thinking about buying a house has done so, or will do so by April, or has decided to hold off for a few years.  As a result, there will be few homebuyers after April.  The housing market will tank.


This is a matter of simple math. There are currently 6 – 7 million excess housing units in the country, about half of which are vacant,  and the other half of which are behind on payments or at risk of foreclosure.  So let’s say there are 4.5 million available units.


The population has been growing by about 3 million people a year in recent years.  However, about 1 million of that is immigration (legal and illegal), and much of that has been stemmed because of the downturn.  Assuming an average household size of 3 people, it will require 666,000 new houses per year to meet the demand.  With 4.5 available units, it will take 6.7 years to sop up supply.


The situation is worse than that, because new construction will increase the supply.  In 2009, over 500,000 new homes were built, and homebuilders will continue to compete with cheaper foreclosed properties using incentives such as warranties and upgrades.  New homes can accommodate most of the natural increase in homebuyers, maintaining the glut.  It would not be surprising for homebuilders to get bailouts or favorable tax treatment in light of the fact that the industry is threatened.


Several more factors aggravate the situation.  The main problem is a 10% vacancy rate in rental properties, which can supply another 4 million units.  Rental units are particularly attractive because they provide greater flexibility for an uncertain workforce.  If the recession continues, more people will be laid off and will foreclose, and will be forced into rental units due to impaired credit.  Then housing prices will fall further, and many people will simply walk away from underwater mortgages in a ‘strategic default’.  Because standards have been tightened, lenders will not be able to scrape the bottom of the barrel for poor credit homebuyers as they have in the past. Mortgage interest rates will tick up slightly after the Fed ends its MBS asset purchase program.  Finally, in a stressful and uncertain market, families will consolidate.  We will see the return of 3 generation households.


According to Fannie Mae chief economist Doug Duncan at a recent conference, “All this supply has to be worked off” and “we don’t believe the decline in home prices is over yet.”  Duncan projects that the excess supply will remain until the start of 2013, but this is probably a serious underestimate.


Housing is unlike other investments.  You can own several cars and TVs, and lots of stocks, but you only need one house.  The market is inelastic.  The administration’s attempt to ‘stabilize’ it will fail.  But that will not stop them from trying.  According to Timothy Geithner in a Treasury press release from October 2009, several new policies such as the extension of the homebuyer tax credit “will help support our efforts to stabilize the housing market by providing support for the recovery in housing prices, keeping mortgage rates low, and helping people who can afford their homes to avoid foreclosure.”  He’s like the little dutch boy who sticks his finger in the dike, but does he know that it’s about to burst?


Due to all these factors, house prices will fall well below historical market levels.  It will be a great time to buy if you really need a house, but not as an investment since rents will be low.  This environment will last for several years as the demand for housing slowly increases and the oversupply is bought off.


The foreclosure rate will increase and families will face renewed challenges.  But the worst part is that the decrease in home prices will go right onto the government’s balance sheet.   Currently the Federal government owns or insures 90% of new mortgages.  Many of these, like FHA mortgages, require only 3.5% downpayment, so speculative defaults are likely.  This will add trillions to the national debt, to be paid for by future generations.  Our country has experienced several asset bubbles in the past – stock market crashes of 1929 and 1987, and the tech stock crash in 2000.  This is the first time that government money guaranteed the losses of the gamblers.


Banks loaded up with mortgage-backed toxic assets may finally have to admit insolvency.  Let’s hope the government will finally allow the zombies to fail, even though the cost to the taxpayer will be enormous.  Only then can a sound economic base be established for future growth.


For more information:


Fannie Mae economist Duncan –

Population growth –

Wall Street Journal on immigration –

Housing starts 2009 –

Housing outlook & vacancy rates –,

Geithner on the homebuyer tax credit:

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