I've been pretty vocal in my belief that the economy is going to double dip into another recession. Or, to be more precise, continue the recession that hasn't really ended. To me it seems not only obvious, but inevitable. But most people don't agree. Most economists today say that this recovery looks like it will slow down (is slowing down), but they feel that the chances of a double dip are slim. I'll just take some time here to explain why I think the worst is still to come.
As I touched on in the previous two posts, the main thing that happened during the last decade or so is that people lived beyond their means. Because credit was so cheap it was far too easy for people to go up to their eyeballs in debt. It's just that they didn't care as long as the value of their house kept rising. Or until they lost their job and couldn't make payments. Once that bubble popped and things came crashing down, people's debt bit them in the ass.
Now, a few things needed to happen after the bubble popped. First, housing prices needed to go down. Obviously they did, that was the popped bubble after all. But they didn't go down enough. After a couple decades of a bubble housing market, there were a shitload of houses scattered across the country. A lot of people owned investment property. A lot of people has 2nd and 3rd houses, vacation houses, etc. When they started defaulting on their mortgages the banks snatched them up. A lot of people who were barely able to make payments lost their job and the bank snatched up their house. Think about it, there were a lot of fucking houses out there and very few buyers. Why so few buyers? Because 70% of America already owned a home, or at least had a mortgage. Once they started to get evicted and once their houses were repossessed, there weren't enough people with money to pay a considerable sum for the house. There is a huge supply and very little demand. They would have to be sold for pennies or torn down to build something else. But the government didn't let that happen. Bailing out the banks, mortgage companies, etc as well as paying people $8,000 to buy a house and guaranteeing the mortgages with government money caused prices to remain artificially high. They weren't allowed to bottom out, but they will have to happen eventually. I'll get to that in a second.
After the housing/financial bubble, a lot of companies found themselves in hard times. Some were doomed to fail, others needed to get rid of jobs to stay solvent. But again, the government intervened and didn't let it happen the way it needed to. Don't get me wrong, if the government did nothing, then things would have been really bad. Maybe 20+% unemployment. Maybe 5,000 DOW. We were drunk on credit for a long time, and the hangover was going to suck. But if the government was able to let things play out and not get too involved, the companies and the economy in general would have emerged much stronger because of it. GM would have been sold and/or a real restructuring would have taken place. Banks would want 30% down payment and reasonable interest rates to protect their ass because they would have learned their lesson. Housing prices would have gone low enough for the average person to save for a 20-30% down payment. People would have paid down their debt and lowered their consumption to do so. Again, things would have been really bad for a couple years, but it would be a good thing in the long run.
But because the government bailed out the banks and car companies, they didn't allow the systemic changes to happen that needed to happen. The Fed is still keeping interest rates at 0%, encouraging people to take on more debt so they can continue to consume based on the promise of future earnings. But what happens if those future earnings aren't there? Didn't our last President tell us to go shopping and buy shit after 9/11? We did and it bit us in the ass because we lived beyond our means for far too long. With the Fed issuing free money to people, they're essentially telling us to do the same thing. People are trying to save and trying to pay down debt. The savings rate has risen and debt has dropped. But again, not enough. And not as much as they would have if the government had not intervened. With the Fed keeping interest rates low, it makes no sense for someone to put their money in the bank and lose the value of it to inflation when they could use that cash to pay down a loan for something and keep the purchasing power of their money. This is the same terrible policy that led to the housing/financial collapse.
Speaking of housing, the main problem I see happening is that the problems with Fannie Mae and Freddie Mac have not been addressed, which is ridiculous because they were a major part of the problem. The government has essentially guaranteed the mortgages and securities that these companies own, thereby forcing the taxpayer to assume all the risks of these high-risk loans. It makes no sense that someone can be responsible with their money, and be forced to pay for someone who was irresponsible and defaulted on their mortgage. Having the government guarantee the mortgage also keeps housing prices artificially high and lending standards too relaxed. Fannie and Freddie already received a trillion dollar bailout. They might need up to 5 trillion more before it's all over. We have the worst of capitalism and the worst of socialism at the same time. The taxpayer assumes all the risk and pays for all the losses while the few people who head these businesses get to keep whatever profit they make. You couldn't design a more fucked up situation if you actually sat down and attempted to do so.
A year or so ago, the government bought a lot of troubled assets (securities, mortgages, treasury bonds, etc.) from Fannie and Freddie. At the time, the discussion was over what the exit strategy would be for the Fed to offload these assets and shrink the balance sheets. The thing is, the underlying problems with the housing market were not addressed, and the truth of the matter is that the Fed had no plan whatsoever in clearing their sheets. Once they start to sell these assets back, it'll expose the fundamental problems again, collapse the financial firms that they bailed out, and take away the artificial legs that are propping up the housing market. And now, just a couple weeks ago, the Fed officially admitted that they were going to maintain it's balance sheet, precisely for these reasons.
The truth is that the recession never really ended like some people want to suggest. The recession was only interrupted by stimulus and bailouts. All we did was postpone it while we accumulated a lot more debt in the process, so now we're facing a bigger problem than the one we had before. And I'm not sure that the Fed is simply going to maintain their balance sheets. Once the weak economic data starts to filter through, and once unemployment continues to rise and more people start to default on their mortgages because they lose their income, the Fed is going to increase their balance sheet and buy up more debt because that's all they know. Printing money is the only weapon they have to try to fight this, so that's what they'll do. It's not like they can slash interest rates anymore because they're already at 0%.
Also, we recently saw the largest trade deficit ever, at something like $50 billion a month. And that's during a weak economy. Imagine what would have happened if the stimulus has worked and Americans were spending money. That number might have been twice as high. What we really need is to create more stuff. But we can't use any of the stimulus money to invest in production, all we can do is buy stuff the Chinese or the Japanese make and increase the trade deficit. And since the trade deficit takes away from the GDP it's only going to create a weaker economy and we will be seeing negative growth again in the near future. Probably the 2nd quarter of next year at the very latest. By that time we'll be seeing unemployment head above 10% and maybe even reach 11+% sometime in the year. That will probably mean more stimulus from the government and low interest rates for a longer period of time which is all extremely bad for the economy in general and the dollar specifically. And if all of this happens, we'll probably be seeing the value of the dollar start to fall faster than Tiger Woods' golf score has ever since he got busted banging every girl he met. At some point down the road the value of the dollar has got to decline. We can't just keep printing money indefinitely, keep interest at historically low rates, and borrowing money from overseas without eroding the value of the dollar.
We have become dependent on cheap credit and low interest rates. The banking sector certainly is. They borrow from the Fed nearly for free and they loan to the treasury and make the spread on interest. That's about the only way banks can make money right now. They're certainly not investing in business. The housing market is being held up by the lowest mortgage rates ever, the artificial lending and the support of Fannie and Freddie. Our national debt is only able to grow because it can be financed short term with low rates. If rates go up then this whole house of cards comes crashing down and the Fed knows this. At some point this is going to happen, interest rates cannot remain this low forever, and we'll all be saying goodbye to the value of our dollars. If you think the latest housing/stock market bubble was bad, just wait until the bond bubble explodes and we stop finding people/countries that are willing to finance our debt and consumption.
Finally we are going to have a lot of tax increases next year. Ever since this became apparent, it has been really interesting to watch all these companies report higher earning, which in turn has led to a boost in the value of their stocks. But they know that they have lower tax rates this year than they will next year. So what are they doing? They're acting rationally and artificially boosting their earnings report this year, earnings that they would have otherwise claimed next year, so they pay taxes on it now. Next year when those higher taxes hit they'll have less earnings to report, the stock prices will fall and another round of layoffs will start. They could possibly even start laying off employees en masse at the end of 2010 because they know how 2011 will go. Another round of layoffs means less people earning money, more people becoming unable to pay their bills, less consumer spending, and more government stimulus. It could be 2008 all over again, only much worse.
Simply put, the government is doing everything in its power to revive a broken and dead economy. Instead of allowing it to turn to shit, getting out of the way, and allowing it to restructure into a much more viable economy (one where we actually produce, save and invest), we're trying to rebuild a phony economy that shouldn't have existed in the first place. This will only serve to make the crash much more painful and devastating. The recession that we have been trying to avoid for the past year or so is going to eventually catch up to us. I just hope we don't have to find a new name for The Great Depression when it's all said and done.
I know this post is all over the map but I'm too lazy to change anything. Maybe I'll go into more detail on some of the finer points later on, mostly the bond bubble that we're in. Just keep this in mind for the next few years: A house chimney can easily be converted into a gun turret.
Tuesday, August 31, 2010
Monday, August 23, 2010
The Economy: what happened, what's happening, and what will happen (Part 2)
Imagine you owned a hotel. You typically kept the place 70% full and were making a pretty good living in the process. Then, one day you suddenly got an unexpectedly large number of people that wanted rooms. The next day, the same thing happened. Now you are suddenly forced to turn people away because you are renting out all the rooms. When this happened again on the third day you decided to take out a loan and build another hotel so you could double your capacity and not be forced to turn away customers. All the extra money you were making would easily pay for your loan. For the next 3 or 4 days you were filling up both hotels, hired a lot of extra employees, and business was really doing good. But then the next day things went back to normal and you were only filling up 70% of the first hotel while the other one stayed empty. It turns out that the circus was in town for a week and all the extra people in the area were renting out your rooms. You misinterpreted all the sudden demand for hotel rooms as something other than a temporary bubble. Once the circus moved on and the bubble popped, you suddenly found yourself with a loan you couldn't afford and employees you had to fire.
When it comes to a boom and bust cycle, it's a common misconception that the boom is the good part and the bust is the bad part. That way of looking at things is simply wrong. When the economy is booming, particularly in an inflated bubble economy, many things are actually being done wrong. Business owners typically expect the boom to continue indefinitely and manage their business accordingly. Good businesses will do this in a smart way and not get swept up in the hype, keeping their eye on the long-term instead of the short-term. Bad businesses will try to cash in on the boom as quickly and as much as they can, paying no attention to the long-term consequences of their actions or planning for not-so-rosy days. In the economic boom, far too many businesses get short sighted and begin to become mismanaged. It's not until the bubble bursts that these bad business practices are exposed. But, on the bright side, the bust creates a good and necessary opportunity for much needed changes to take place within poorly managed businesses. That's why the bust is actually a good thing. Businesses that were poorly managed fail and get swallowed up by businesses with smart management, thereby making the overall economy stronger and more sound in the long run. At least, that's how it's supposed to work.
After the tech bubble burst at the end of the Clinton administration, it exposed a lot of poorly run businesses, and a lot of poor decisions made by individuals. The recession that followed should have been a lot worse than it actually was. What happened was the Bush administration, along with Fed chairman Alan Greenspan, made some extremely poor decisions in an attempt to prop up the economy. Bush didn't want to be a one term president, and he knew he probably would be if the economy didn't recover. So, in an effort to kick the can down the road, he told Americans to spend. And Americans did spend, but they had to go into debt to do it. In a typical recession, people spend less, save more and pay off their debt. This time Alan Greenspan lowered interest rates and printed money which made getting credit far too easy and cheap, so we had a recession where people went into debt instead of paying it off. And the federal government started spending money at an insane rate as well. The national debt skyrocketed, as well as personal debt. But the economy was recovering, housing prices were soaring, and wall street was booming. The only bad thing was that it wasn't real. It was all occurring on a pile of debt. And far too many businesses continued to be poorly managed. Effectively, we only made a down payment on the next bubble.
Then it happened again, only much worse. Had the economy been allowed to tank the way it should have in 2000, the recovery would have been relatively quick and painless. And, as a result, we would have emerged stronger and with a better foundation. Instead, we just took on a lot of debt and artificially spent our way out of it. Then in 2008 a similar economic collapse occurred, but this time it was far worse because we accumulated a lot of debt in the process and business practices weren't forced to change. The housing and financial bubble I talked about last time only made the whole thing much much worse.
And then the federal government reacted in pretty much the same way as it did nearly a decade earlier. Interest rates dropped to zero and the federal budget deficit went through the roof. This time around, however, individuals and families decided to spend less and save more. This was a good thing, but it cost a lot of people their jobs in the process. But Americans were at least making some effort to build a sturdier financial foundation for themselves. The problem is that the federal government negated what individuals were doing by spending their money for them. A lot of cash was injected into the system thereby artificially propping it up and not allowing the systemic changes to occur that needed to occur while also putting the country deeper and deeper into debt. The Bush budget deficits were terrible. The Obama budget deficits are catastrophic. They are a short-term solution that only makes the long term problem that much worse. Government once again kicked the can down the road, leaving a bigger mess for some other day.
It's like if you have a heroin addiction. When you first start to mess up your life, kicking the habit would suck but it is necessary for your long term survival. But instead of sobering up and throwing away the needle, you just do more of the drug. Sure, it feels good right away and you're not putting yourself through the pain of cleansing your system, but you're only guaranteeing that when you do kick the habit it'll be far worse. It's the same with our economy. There are fundamental flaws. Most notably, we borrow too much, spend too much, and produce too little. What we need, and what a recession would provide for us if we allowed it to happen, is to actually produce more goods, save more of our money, and consume less. But the federal government continues to entice us to spend, consume and borrow. We're shooting up with the same drug that's causing our problems and the only thing we'll accomplish is to guarantee that the crash will be far worse when it strikes again.
This "recovery" we're experiencing is not a real recovery at all. It's all occurring on borrowed money. Nobody is hiring workers, business is stagnant, and the consumer isn't spending (relatively speaking anyway). This is actually supposed to be happening, and should be happening, but in a far more devastating way. It's a hard pill to swallow, but we need the catastrophic to happen in order to purge out the toxins and rebuild a much more sturdy economy. The sooner we allow it to happen, the less severe it'll be. By trying to fight it, all we're doing is guaranteeing that it happens even worse the next time around. All of this government spending is designed to keep the economy from doing what it needs to do (cut jobs, reduce consumption, etc). If we had a stronger foundation, then the spending and stimulus of the past 2 years would have had better short-term results. The fact that the economy is not seeing the results that Obama is striving for, despite unprecedented spending, should tell you something about how fundamentally bad the economy is.
Far too many economists feel that Americans need to simply consume more. After all, 70% of our economy is based on consumption. That's the idea behind the government programs that give people money to buy a house or to buy a car. That's why we're spending so much money to keep jobs. It's not the jobs that they're trying to save, it's the money that the employee gets to spend after earning a paycheck that we're trying to save. Do whatever it takes to keep people buying shit. What they don't realize is that it's not a good thing to have 70% of an economy to be based on consumption. We need to actually produce things. Consuming goods is the reward someone gets for producing something and earning a paycheck. Instead, we're having the Chinese workers produce all our good so we can consume them. And on top of that, we have to borrow the money the Chinese make from those goods in order for us to consume those goods.
Imagine 6 people, 5 Chinese and 1 American, are stuck on an island. They immediately start to divide up the jobs so they can survive. One Chinese fishes, one hunts, one farms, one gathers firewood, and one cooks. The American, meanwhile, hangs out on the beach all day and consumes everything the Chinese people have created. He eats as much as he can and leaves just enough left over for the Chinese to stay healthy enough to gather his food again the next day. Most modern economists would say that the American is the key to the whole system. Were it not for his consumption, the 5 Chinese people would have nothing to do. Well that is patently absurd. Were it not for the American getting fat off the work of the Chinese, the Chinese would be able to consume what they create. They could even spend less time gathering food and more time enjoying the fruits of their labor or perusing other interests.
But politicians don't like to tell their potential voters that they have been living beyond their means. And voters don't like to hear that from their politicians. Nobody is going to vote for the guy who says "We're fucked. We could spend a ton of money and it might help us for a little bit, but eventually we just need to let the economy tank. We've consumed too much, produced too little and gotten into a pile of debt in the process. It's time for Americans to live within their means, and right now that means a lower standard of living. It sucks but we need to take the medicine, no matter how hard it is to swallow." I'd actually like that to be part of the next Presidential Inaugural Address, whoever it might be. But it won't happen, because we don't want to hear it even if it's the truth. Instead, we'll get "Here, take this money and buy yourself something shiny! Everything is fine, just fine!" Perhaps we're just getting what we deserve.
When it comes to a boom and bust cycle, it's a common misconception that the boom is the good part and the bust is the bad part. That way of looking at things is simply wrong. When the economy is booming, particularly in an inflated bubble economy, many things are actually being done wrong. Business owners typically expect the boom to continue indefinitely and manage their business accordingly. Good businesses will do this in a smart way and not get swept up in the hype, keeping their eye on the long-term instead of the short-term. Bad businesses will try to cash in on the boom as quickly and as much as they can, paying no attention to the long-term consequences of their actions or planning for not-so-rosy days. In the economic boom, far too many businesses get short sighted and begin to become mismanaged. It's not until the bubble bursts that these bad business practices are exposed. But, on the bright side, the bust creates a good and necessary opportunity for much needed changes to take place within poorly managed businesses. That's why the bust is actually a good thing. Businesses that were poorly managed fail and get swallowed up by businesses with smart management, thereby making the overall economy stronger and more sound in the long run. At least, that's how it's supposed to work.
After the tech bubble burst at the end of the Clinton administration, it exposed a lot of poorly run businesses, and a lot of poor decisions made by individuals. The recession that followed should have been a lot worse than it actually was. What happened was the Bush administration, along with Fed chairman Alan Greenspan, made some extremely poor decisions in an attempt to prop up the economy. Bush didn't want to be a one term president, and he knew he probably would be if the economy didn't recover. So, in an effort to kick the can down the road, he told Americans to spend. And Americans did spend, but they had to go into debt to do it. In a typical recession, people spend less, save more and pay off their debt. This time Alan Greenspan lowered interest rates and printed money which made getting credit far too easy and cheap, so we had a recession where people went into debt instead of paying it off. And the federal government started spending money at an insane rate as well. The national debt skyrocketed, as well as personal debt. But the economy was recovering, housing prices were soaring, and wall street was booming. The only bad thing was that it wasn't real. It was all occurring on a pile of debt. And far too many businesses continued to be poorly managed. Effectively, we only made a down payment on the next bubble.
Then it happened again, only much worse. Had the economy been allowed to tank the way it should have in 2000, the recovery would have been relatively quick and painless. And, as a result, we would have emerged stronger and with a better foundation. Instead, we just took on a lot of debt and artificially spent our way out of it. Then in 2008 a similar economic collapse occurred, but this time it was far worse because we accumulated a lot of debt in the process and business practices weren't forced to change. The housing and financial bubble I talked about last time only made the whole thing much much worse.
And then the federal government reacted in pretty much the same way as it did nearly a decade earlier. Interest rates dropped to zero and the federal budget deficit went through the roof. This time around, however, individuals and families decided to spend less and save more. This was a good thing, but it cost a lot of people their jobs in the process. But Americans were at least making some effort to build a sturdier financial foundation for themselves. The problem is that the federal government negated what individuals were doing by spending their money for them. A lot of cash was injected into the system thereby artificially propping it up and not allowing the systemic changes to occur that needed to occur while also putting the country deeper and deeper into debt. The Bush budget deficits were terrible. The Obama budget deficits are catastrophic. They are a short-term solution that only makes the long term problem that much worse. Government once again kicked the can down the road, leaving a bigger mess for some other day.
It's like if you have a heroin addiction. When you first start to mess up your life, kicking the habit would suck but it is necessary for your long term survival. But instead of sobering up and throwing away the needle, you just do more of the drug. Sure, it feels good right away and you're not putting yourself through the pain of cleansing your system, but you're only guaranteeing that when you do kick the habit it'll be far worse. It's the same with our economy. There are fundamental flaws. Most notably, we borrow too much, spend too much, and produce too little. What we need, and what a recession would provide for us if we allowed it to happen, is to actually produce more goods, save more of our money, and consume less. But the federal government continues to entice us to spend, consume and borrow. We're shooting up with the same drug that's causing our problems and the only thing we'll accomplish is to guarantee that the crash will be far worse when it strikes again.
This "recovery" we're experiencing is not a real recovery at all. It's all occurring on borrowed money. Nobody is hiring workers, business is stagnant, and the consumer isn't spending (relatively speaking anyway). This is actually supposed to be happening, and should be happening, but in a far more devastating way. It's a hard pill to swallow, but we need the catastrophic to happen in order to purge out the toxins and rebuild a much more sturdy economy. The sooner we allow it to happen, the less severe it'll be. By trying to fight it, all we're doing is guaranteeing that it happens even worse the next time around. All of this government spending is designed to keep the economy from doing what it needs to do (cut jobs, reduce consumption, etc). If we had a stronger foundation, then the spending and stimulus of the past 2 years would have had better short-term results. The fact that the economy is not seeing the results that Obama is striving for, despite unprecedented spending, should tell you something about how fundamentally bad the economy is.
Far too many economists feel that Americans need to simply consume more. After all, 70% of our economy is based on consumption. That's the idea behind the government programs that give people money to buy a house or to buy a car. That's why we're spending so much money to keep jobs. It's not the jobs that they're trying to save, it's the money that the employee gets to spend after earning a paycheck that we're trying to save. Do whatever it takes to keep people buying shit. What they don't realize is that it's not a good thing to have 70% of an economy to be based on consumption. We need to actually produce things. Consuming goods is the reward someone gets for producing something and earning a paycheck. Instead, we're having the Chinese workers produce all our good so we can consume them. And on top of that, we have to borrow the money the Chinese make from those goods in order for us to consume those goods.
Imagine 6 people, 5 Chinese and 1 American, are stuck on an island. They immediately start to divide up the jobs so they can survive. One Chinese fishes, one hunts, one farms, one gathers firewood, and one cooks. The American, meanwhile, hangs out on the beach all day and consumes everything the Chinese people have created. He eats as much as he can and leaves just enough left over for the Chinese to stay healthy enough to gather his food again the next day. Most modern economists would say that the American is the key to the whole system. Were it not for his consumption, the 5 Chinese people would have nothing to do. Well that is patently absurd. Were it not for the American getting fat off the work of the Chinese, the Chinese would be able to consume what they create. They could even spend less time gathering food and more time enjoying the fruits of their labor or perusing other interests.
But politicians don't like to tell their potential voters that they have been living beyond their means. And voters don't like to hear that from their politicians. Nobody is going to vote for the guy who says "We're fucked. We could spend a ton of money and it might help us for a little bit, but eventually we just need to let the economy tank. We've consumed too much, produced too little and gotten into a pile of debt in the process. It's time for Americans to live within their means, and right now that means a lower standard of living. It sucks but we need to take the medicine, no matter how hard it is to swallow." I'd actually like that to be part of the next Presidential Inaugural Address, whoever it might be. But it won't happen, because we don't want to hear it even if it's the truth. Instead, we'll get "Here, take this money and buy yourself something shiny! Everything is fine, just fine!" Perhaps we're just getting what we deserve.
Friday, August 20, 2010
The Economy: what happened, what's happening, and what will happen (Part 1)
I was going to comment on some current economic trends and make some predictions, but I ended up writing a whole lot of shit so I decided to break it down into a few parts and maybe make it more organized in the process. Before I get into the current shit that's happening, I'll give my take on what happened in order to get to this point. I can't take credit for much of the information here since I read it (basically stole it) from other sources. But I think it gives a pretty good rundown on the 4 main events that led to the housing boom and bust.
EVENT 1: In 1977, Congress passed the Community Reinvestment Act (CRA). This was passed because Congress didn't think banks were giving enough loans to poor people and minorities. The act stated that banks have "an affirmative obligation" to meet the credit needs of the communities in which they are chartered. That turned out to be too vague or something, and Congress wasn't seeing loans go to people that they wanted loans to go to (they assumed that was up to them for some reason), so in 1989 congress amended the Home Mortgage Disclosure Act. The amendment required banks to collect racial data on mortgage applications. Turns out that minorities were denied home loans at a higher rate than whites. Was this because banks love white people and hate brown people? No, minorities were turned down at a higher rate because they had weaker finances on average. But a Boston Federal Reserve study alleged that there was systemic discrimination. A University of Texas economics professor looked at the study and found it to be tremendously flawed. He showed that the data it used contained thousands of egregious typos, like loans with negative interest rates, and he found no evidence of discrimination on any basis other than creditworthiness. Think about it, if these banks are run by the greedy corporate type who is only interested in making a buck, then wouldn't they want to give out loans to people who pose a reasonable risk, regardless of race, in order to make money off the interest? If they're only interested in making money, that means denying loans to high risk people, and giving loans to low risk people. The relationship between race and loan approval was a blatantly spurious one while the relationship between risk and loan approval was real*. It just so happens that minoriteis tend to be higher risk. They were discriminating based on risk, not skin color. It turns out that banks don't "hate brown people and love white people", banks "love making low risk loans and hate making high risk loans" (At least they used to. More on that below). But that Boston Federal Reserve study became the standard on which government policy was based.
In 1995 the Clinton administration issued regulations that tracked loans by neighborhoods, income groups and race in order to rate the performance of banks. Regulators used the ratings to determine whether the government would approve bank mergers, acquisitions and new branches. The regulations also encouraged community groups like ACORN and the Neighborhood Assistance Corporations of America to file petitions with regulators, or threaten to file petitions with regulators, that would slow or even prevent banks from conducting their business by challenging how banks were making loans. This created a huge leverage over the banks and some groups were able to effectively extort banks to make huge piles of money available to the groups. Money these groups, along with the banks, used to make loans. Banks and community groups issued loans to low-income people who often had bad credit or insufficient income. These loans, which became known as "subprime" loans, made available 100% financing, didn't always require the use of credit scores, and were even made without documenting income. But damnit, minorities and low-income folks were getting extra money for some reason! The government insisted that banks, particularly those that wanted to expand, quit using their traditional loan-approval standards (Low risk people get loans, high risk people don't). CRA-elligible loans have been valued at $4.5 trillion
EVENT 2: In 1992 the Department of Housing and Urban Development pressured two government-charted corporations, known as Fannie Mae and Freddie Mac, to purchase (or "securitize") large bundles of these loans for the conflicting purposes of diversifying the risk and making even more money available to banks to make further risky loans (risky loans to some, fair and equal loans for everyone -- regardless of merit -- to others). Congress, in their divine wisdom, also passed the Federal Housing Enterprises Financial Safety and Soundness Act. This act mandated that these companies buy 45% of all loans from people of low and moderate incomes. What did this do? First, it created more incentives for banks to make risky loans since Fannie and Freddie would buy them. Second, it created a secondary market for these loans where they could be bought and sold. And then in 1995 the Treasury Department established the Community Development Financial Institutions Fund, which provided banks with tax dollars to encourage even more risky loans.
EVENT 3: All of this government intervention and social engineering created a financial instrument by-product known as the "derivative", which turned the subprime mortgage market into a ticking time bomb that would magnify the housing bust by orders of magnitude. A derivative is a contract where one party sells the risk associated with the mortgage to another party in exchange for payments to that company based on the value of the mortgage. They pretty much let people gamble on whether the mortgages would default or not. In many cases, investors who did not even make loans would bet on whether the loans would be subject to default. Although it's not the best example, derivatives can be understood as a form of insurance against risky loans. Derivatives allowed commercial and investment banks, individual companies, and private investors to further spread, and ultimately multiply, the risk associated with their mortgages. Some financial institutions like AIG invested heavily in derivatives.
EVENT 4: The Fed's role in the housing boom and bust cannot be overstated. The Fed slashed interest rates repeatedly starting in 2001 from 6.5% to 1.0% in 2004. Naturally, this started to create too much inflation for comfort so Greenspan and Bernanke began to steadily raise interest rates back up to 5.25% in 2006. This flluctuation in interest rates artificially and inappropriately manipulated the housing market by interfering with normal market conditions and contributed to a destabillization of an economy that was already in a very precarious position.
In 2008 and 2009 the federal government spent tax dollars at an astronomical rate in order to rescue the financial markets from their own mismanagement. TARP money neared $1 trillion and was originally set up so the government could buy risky or nonperforming loans from financial institutions. Just weeks later the government began using the money to buy equity positions in financial institutions, probably so they could inject cash directly into these entities. Oh, and $350 billion of the TARP funds cannot be accounted for.
On top of the TARP money, The Federal Reserve also gave $30 billion to Bear Stearns, $150 billion to AIG, $200 billion to Fannie and Freddie, $20 billion to Citigroup, $245 billion to the commercial paper market, and $540 billion for the money markets. The Bush administration also spent $152 billion on the 2008 stimulus and the Obama administration spent $787 billion on the 2009 stimulus. Billions were also spent on Cash for Clunkers, the Home Buyer Tax Credit, and a host of other government programs.
And this all started in large part because Congress and the federal government decided to tell banks who they should loan money to. Numerous laws, regulations, entities and funds were created in order for the government to dictate to banks who should get loans and how they should be managed. To say that this problem occurred in a bubble of capitalism without regulation and interference from government is utterly ridiculous.** It's not difficult to see that the problem occurred because of government intervention in the free market, not because they were mysteriously absent. In fact, the only place government was absent was in controlling the terrible conditions that they created, and that's the unregulated part that got everybody upset. ""Government didn't regulate derivatives!" "There wasn't enough oversight!" That's true, but the fact of the matter is that government created derivatives and then failed to regulate them and government failed to oversee the shitty results of their own shitty policies. The banks and financial institutions did what they always do, they tried to make money in whatever condition they were place in. And politicians did what they always do, they (with good intentions) tried to get private businesses to do what they wanted them to do, created a shitty mess in the process, failed to properly deal with the shitty mess they created, and blamed the shitty mess on private businesses who only did what government told them to do. It's the new circle of life.
I mentioned earlier how much money was thrown at the problem. In the next post I'll explain why this was a bad idea, why it will not work in the long run, what actually should have been done and what the ultimate results will be. Yes folks, another random person on the internet knows how to handle the nation's economy!
*A classic example of a spurious relationship is deaths by drowning and ice cream sales. As ice cream sales go up, so does the number of people who drown to death. As ice cream sales go down, so does the number of people who drown to death. Does that mean that ice cream causes people to drown? Of course not. And minorities weren't routinely and systematically denied loans simply based on skin color. In both examples there is a third factor that needs to be considered. In the ice cream-drowning relationship, the missing factor is, of course, heat. As it gets warmer, ice cream sales as well as drowning deaths go up for obvious reasons. In the home loan example, the missing factor is creditworthiness. As creditworthiness goes up, so does loan approval. Minorities, on average, were less creditworthy so their loans were denied at a higher rate.
** In 2006 the official compilation of rules issued by the federal government contained 74,737 pages of regulations. I don't think a couple more was going to solve much.
EVENT 1: In 1977, Congress passed the Community Reinvestment Act (CRA). This was passed because Congress didn't think banks were giving enough loans to poor people and minorities. The act stated that banks have "an affirmative obligation" to meet the credit needs of the communities in which they are chartered. That turned out to be too vague or something, and Congress wasn't seeing loans go to people that they wanted loans to go to (they assumed that was up to them for some reason), so in 1989 congress amended the Home Mortgage Disclosure Act. The amendment required banks to collect racial data on mortgage applications. Turns out that minorities were denied home loans at a higher rate than whites. Was this because banks love white people and hate brown people? No, minorities were turned down at a higher rate because they had weaker finances on average. But a Boston Federal Reserve study alleged that there was systemic discrimination. A University of Texas economics professor looked at the study and found it to be tremendously flawed. He showed that the data it used contained thousands of egregious typos, like loans with negative interest rates, and he found no evidence of discrimination on any basis other than creditworthiness. Think about it, if these banks are run by the greedy corporate type who is only interested in making a buck, then wouldn't they want to give out loans to people who pose a reasonable risk, regardless of race, in order to make money off the interest? If they're only interested in making money, that means denying loans to high risk people, and giving loans to low risk people. The relationship between race and loan approval was a blatantly spurious one while the relationship between risk and loan approval was real*. It just so happens that minoriteis tend to be higher risk. They were discriminating based on risk, not skin color. It turns out that banks don't "hate brown people and love white people", banks "love making low risk loans and hate making high risk loans" (At least they used to. More on that below). But that Boston Federal Reserve study became the standard on which government policy was based.
In 1995 the Clinton administration issued regulations that tracked loans by neighborhoods, income groups and race in order to rate the performance of banks. Regulators used the ratings to determine whether the government would approve bank mergers, acquisitions and new branches. The regulations also encouraged community groups like ACORN and the Neighborhood Assistance Corporations of America to file petitions with regulators, or threaten to file petitions with regulators, that would slow or even prevent banks from conducting their business by challenging how banks were making loans. This created a huge leverage over the banks and some groups were able to effectively extort banks to make huge piles of money available to the groups. Money these groups, along with the banks, used to make loans. Banks and community groups issued loans to low-income people who often had bad credit or insufficient income. These loans, which became known as "subprime" loans, made available 100% financing, didn't always require the use of credit scores, and were even made without documenting income. But damnit, minorities and low-income folks were getting extra money for some reason! The government insisted that banks, particularly those that wanted to expand, quit using their traditional loan-approval standards (Low risk people get loans, high risk people don't). CRA-elligible loans have been valued at $4.5 trillion
EVENT 2: In 1992 the Department of Housing and Urban Development pressured two government-charted corporations, known as Fannie Mae and Freddie Mac, to purchase (or "securitize") large bundles of these loans for the conflicting purposes of diversifying the risk and making even more money available to banks to make further risky loans (risky loans to some, fair and equal loans for everyone -- regardless of merit -- to others). Congress, in their divine wisdom, also passed the Federal Housing Enterprises Financial Safety and Soundness Act. This act mandated that these companies buy 45% of all loans from people of low and moderate incomes. What did this do? First, it created more incentives for banks to make risky loans since Fannie and Freddie would buy them. Second, it created a secondary market for these loans where they could be bought and sold. And then in 1995 the Treasury Department established the Community Development Financial Institutions Fund, which provided banks with tax dollars to encourage even more risky loans.
EVENT 3: All of this government intervention and social engineering created a financial instrument by-product known as the "derivative", which turned the subprime mortgage market into a ticking time bomb that would magnify the housing bust by orders of magnitude. A derivative is a contract where one party sells the risk associated with the mortgage to another party in exchange for payments to that company based on the value of the mortgage. They pretty much let people gamble on whether the mortgages would default or not. In many cases, investors who did not even make loans would bet on whether the loans would be subject to default. Although it's not the best example, derivatives can be understood as a form of insurance against risky loans. Derivatives allowed commercial and investment banks, individual companies, and private investors to further spread, and ultimately multiply, the risk associated with their mortgages. Some financial institutions like AIG invested heavily in derivatives.
EVENT 4: The Fed's role in the housing boom and bust cannot be overstated. The Fed slashed interest rates repeatedly starting in 2001 from 6.5% to 1.0% in 2004. Naturally, this started to create too much inflation for comfort so Greenspan and Bernanke began to steadily raise interest rates back up to 5.25% in 2006. This flluctuation in interest rates artificially and inappropriately manipulated the housing market by interfering with normal market conditions and contributed to a destabillization of an economy that was already in a very precarious position.
In 2008 and 2009 the federal government spent tax dollars at an astronomical rate in order to rescue the financial markets from their own mismanagement. TARP money neared $1 trillion and was originally set up so the government could buy risky or nonperforming loans from financial institutions. Just weeks later the government began using the money to buy equity positions in financial institutions, probably so they could inject cash directly into these entities. Oh, and $350 billion of the TARP funds cannot be accounted for.
On top of the TARP money, The Federal Reserve also gave $30 billion to Bear Stearns, $150 billion to AIG, $200 billion to Fannie and Freddie, $20 billion to Citigroup, $245 billion to the commercial paper market, and $540 billion for the money markets. The Bush administration also spent $152 billion on the 2008 stimulus and the Obama administration spent $787 billion on the 2009 stimulus. Billions were also spent on Cash for Clunkers, the Home Buyer Tax Credit, and a host of other government programs.
And this all started in large part because Congress and the federal government decided to tell banks who they should loan money to. Numerous laws, regulations, entities and funds were created in order for the government to dictate to banks who should get loans and how they should be managed. To say that this problem occurred in a bubble of capitalism without regulation and interference from government is utterly ridiculous.** It's not difficult to see that the problem occurred because of government intervention in the free market, not because they were mysteriously absent. In fact, the only place government was absent was in controlling the terrible conditions that they created, and that's the unregulated part that got everybody upset. ""Government didn't regulate derivatives!" "There wasn't enough oversight!" That's true, but the fact of the matter is that government created derivatives and then failed to regulate them and government failed to oversee the shitty results of their own shitty policies. The banks and financial institutions did what they always do, they tried to make money in whatever condition they were place in. And politicians did what they always do, they (with good intentions) tried to get private businesses to do what they wanted them to do, created a shitty mess in the process, failed to properly deal with the shitty mess they created, and blamed the shitty mess on private businesses who only did what government told them to do. It's the new circle of life.
I mentioned earlier how much money was thrown at the problem. In the next post I'll explain why this was a bad idea, why it will not work in the long run, what actually should have been done and what the ultimate results will be. Yes folks, another random person on the internet knows how to handle the nation's economy!
*A classic example of a spurious relationship is deaths by drowning and ice cream sales. As ice cream sales go up, so does the number of people who drown to death. As ice cream sales go down, so does the number of people who drown to death. Does that mean that ice cream causes people to drown? Of course not. And minorities weren't routinely and systematically denied loans simply based on skin color. In both examples there is a third factor that needs to be considered. In the ice cream-drowning relationship, the missing factor is, of course, heat. As it gets warmer, ice cream sales as well as drowning deaths go up for obvious reasons. In the home loan example, the missing factor is creditworthiness. As creditworthiness goes up, so does loan approval. Minorities, on average, were less creditworthy so their loans were denied at a higher rate.
** In 2006 the official compilation of rules issued by the federal government contained 74,737 pages of regulations. I don't think a couple more was going to solve much.
Subscribe to:
Posts (Atom)