Download Lecture Notes - School of Cooperative Individualism

For the first time since the Great Depression of the 1930s, an
overwhelming majority of households in the United States have little or
no liquid savings. We are drowning in debt, with foreclosures and
bankruptcies at record levels.
And, government is spending almost without consideration of where the
funds will come from to service a skyrocketing national debt.
This presentation discusses some of the key reasons – the “triggers” –
that have brought us to this precarious position.
TRIGGER: Creation of the Money Market Funds
The first money market mutual fund was created in the early 1970s.
From assets of $300,000 in 1972 this fund grew to $390 million in just
three years.
By 1981 the assets of all money market mutual funds had grown to
approximately $80 billion.
At the same time, interest rate regulations prevented Thrifts the (the
savings and loan associations and savings banks) from paying
competitive interest rates on deposits and then passing on these costs to
their mortgagors.
Every time market interest rates increased, more and more deposits were
withdrawn by consumers for placement in instruments with higher rates
of return. Within a few short years many of the nation’s Thrifts faced
insolvency.
Finally, in 1980, the Depository Institutions Deregulation and Monetary
Control Act removed many of the distinctions between different types of
depository institutions and ultimately removed interest rate ceilings on
deposit accounts. An additional “reform” was an increase in the deposit
insurance limit to $100,000 from $40,000, protecting the wealthier
individuals and families who had been able to set aside greater sums
from their ongoing expenditure needs.
The funds peaked in 2008 at $3.9 trillion and have been falling in size
since then. In mid-January of this year, the combined total of all U.S.
money market funds stood at nearly $3.3 trillion – remaining a perceived
“safe harbor” for investors, despite negative inflation-adjusted rates of
return.
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Money market funds are today in a precarious position. The shares of
one fund, Reserve Primary Fund, fell below $1 in September of 2008
after having to write-off debt issued by bankrupt Lehman Brothers.
Although the Lehman paper represented only a small portion of the
Reserve Fund's assets (less than 1.5%), investors pulled their money out
of the fund, which saw its asset decline by nearly two thirds in about 24
hours. Unable to meet redemption requests, the Reserve Fund froze
redemptions. When that failed to stem the run on the fund, it was forced
to suspend operations and commence liquidation.
More than a dozen additional fund companies were forced to step in to
provide financial support to their money market funds against the threat
of losses on commercial paper issued by other banks and Wall Street
firms. In response to a run on the funds, the U.S. Treasury made
insurance available to the money market funds to guarantee the $1 net
asset value.
This chart shows the movement of cash into and out of the money market
funds. When investors are convinced a bull market is underway, they
have consistently moved out of the money-market funds.
In 2010 there are few growing market segments in which to invest. In
troubled times, there is always gold, which has increased in selling price
by some 300% since 1999.
Silver price increases have also reflected the widespread feeling of
economic uncertainty. Earlier this year silver hit a new 31-year high at
$35.33. The record high price for silver -- $50.35 -- was reached in March
of 1980.
TRIGGER: Central Bank Policy Shifts
A primary role of the Federal Reserve Banks is to hold reserves of
member banks and ensure they have access to funds when needed. A far
greater challenge for the Fed has been to keep the flow of credit and the
general price level from rising.
Our history suggests that either the Fed’s tools are insufficient or its use
of those tools inconsistent. It may also be that other players in the
financial markets are always one step ahead of the Fed’s actions.
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Critics of the Federal Reserve System have a strong case. The purchasing
power of the U.S. dollar is in an almost continuous state of decline. What
else should we expect from a currency that is, by definition, a promise to
pay nothing in particular.
However, what is not conveyed by the above chart is that a significant
number of individuals and households have managed to obtain nominal
dollar incomes that have increased at a rate equal to or greater than the
annual loss in purchasing power of the dollar.
This, in part, accounts for the fact that millions of households have a far
higher standard of living than households in 1913. All but the poorest
among us have access to better housing, food, clothing, transportation
and other necessities than their 1913 counterparts.
With his Presidency plagued by rising inflation and recession, Jimmy
Carter (reluctantly) appointed Paul Volcker chairman of the Federal
Reserve Board in 1979.
Volcker’s challenge was to use the Fed’s powers to bring down inflation,
even as the economy continued to experience an unprecedented drift into
stagflation (that is, rising inflation and high unemployment occurring
simultaneously).
Interest Rates Climbed While the Economy was Pulled into a Recession.
The reasons for the spike in interest rates are easy to identify. Tight
credit and inflationary expectations dominated the credit markets as the
Carter Presidency came to a close.
During 1979 and 1980 the Federal Open Market Committee, under
Volcker's leadership (and with some on the Fed’s board influenced by the
economic ideas of Milton Friedman), abandoned efforts to control
interest rates and tried to meet strict money supply growth targets, an
objective that proved impossible given the global nature of currency
markets, the amount of U.S. dollars in foreign hands, as well as other
technology and policy limitations. By December 1980 the prime rate of
interest hit 21.5 percent.
TRIGGER: Reaganomics – Supply-Side Expectations
Ronald Reagan’s election in 1980 ushered in the removal of many
regulations on business, a significant lowering of tax rates on capital
gains and on high marginal incomes.
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Price controls on fossil fuels, which hampered the delivery of supply,
were also eliminated. But, not everything went according to plan.
Supply-side economic theory as developed by economist Arthur Laffer
and promoted by Jude Wanniski and Jack Kemp was partially adopted,
on the prediction that lower tax rates would stimulate economic growth
and thereby yield increased revenue to the Federal government.
Unfortunately, Reagan’s tax policies ignored any distinction between
earned and unearned income flows, allowing investors to choose options
where the highest rates of return could be obtained regardless of the true
economic implications. As a result, most of the increased disposable
income flowing back to the highest income recipients went into highly
speculative investments – into the stock market, into commodity futures,
into the property markets (generally) and into land.
TRIGGER: Reaganomics and an Escalating Government Debt
Increasing defense spending and falling federal revenue brought on
budget deficits and a rising national debt.
The top marginal tax rate on individual incomes was reduced from 70
percent to 28 percent. The corporate income tax rate was reduced from
48 percent to 34 percent. To help make the middle income workers feel
they were not being excluded, individual tax brackets were indexed for
inflation.
Reagan, a committed anti-Communist, spearheaded huge increases in
defense spending even as the lower tax rates took effect. The result of
these policies was a $41 billion Federal deficit in 1981, rising to $64
billion in 1982. The U.S. economy slid deeper into recession, with official
unemployment climbing to 10.7 percent in 1982 (but real unemployment
certainly much higher).
On the plus side of the Reagan program, most of the poor were exempted
from the individual income tax. Yet, what continues to go unnoticed by
most economists is the strong tendency for any increases in disposable
incomes to be capitalized into higher land prices, which, for the working
poor translate into higher charges for housing, whether rented or owned.
Guided by the principle that less government is almost always better,
Reagan and the Congress gradually curtailed the programs to encourage
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job-creating capital goods production by providing targeted investment
tax credits. The result was that more after-tax income was channeled into
financial instruments and other speculative investments that stimulated
little or no real economic production.
Conservatives continue to reflect with a strong sense of satisfaction on the
accomplishments of the Reagan years. What actually occurred is more
sobering to anyone with an objective perspective.
By November 1982 well over nine million people were unemployed, the
highest number since the Great Depression. 17,000 businesses failed, the
second highest number since 1933. Countless farmers defaulted on
mortgage loans, went into bankruptcy and lost their farms.
Homelessness escalated, estimated in a 1984 study by the U.S.
Department of Housing and Urban Affairs to be between 250,000–
350,000 persons. Low-income families began to experience homelessness
because of declines in the availability of publicly-subsidizes and other
low-rent housing units.
TRIGGER: Thousands of mainstream financial institutions failed
With each passing month, a growing list of financial institutions
experienced financial problems, became insolvent and closed their doors.
As profit margins for businesses began to disappear, new property
developments failed to attract needed lessees; developers in increasing
numbers defaulted on construction loans. Other property-related loans
became delinquent as well, including a considerable number of mortgage
loans made to homebuyers. Negative spreads resulted in losses of $4.6
billion in 1981 and $4.1 billion in 1982.
From 1980 thru 1983, 118 S&Ls with $43 billion in assets closed their
doors, costing the FSLIC an estimated $3.5 billion to make depositors
whole.
Before the end of the financial crisis, more than 1,000 Thrifts failed.
Economist John Kenneth Galbraith described the situation as:
"the largest and costliest venture in public misfeasance, malfeasance and
larceny of all time.“ Galbraith did not live long enough to reconsider his
judgment based on current conditions.
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Mergers and acquisitions significantly reduced the number of banks
Deregulation permitted mergers and acquisitions, creating mega-bank
holding companies. European and Asian banks entered the U.S. market
as major players. The perceived benefits to the banks included the
opportunity to disperse risk geographically and across industries and
consumer segments. The risk management challenges associated with
lending on a global scale were not thought to be a serious problem. This
proved to be a miscalculation.
TRIGGER: Prolonged high interest rates brought down land prices by
creating a huge inventory of unsold housing units
The one important distinction between the markets for existing
residential properties and newly-constructed units is that homeowners
often have the option of pulling their property off the market to wait for
the property price cycle to again climb upward.
Builders with inventory to finance and payrolls to meet are in a far more
vulnerable position when they acquire land for development at or near
the top of the land market.
As interest rates came down after 1983, a “window of affordability”
opened. Property markets began to recover and resumed an upward
climb.
Recovery occurred but not because households had accumulated greater
amounts of savings or were experiencing rising incomes. New financing
innovations made credit more available. Down payment requirements
were lowered and, in certain cases, eliminated.
The amount of monthly household income thought prudent to devote to
carrying mortgage debt, property taxes and homeowners insurance was
allowed to climb. Homebuyers were approved for financing with little or
no cash in reserve after closing. All these measures were adopted in order
to keep loan volumes growing even as property prices escalated. The
door was opened for even more exotic forms of mortgage financing
options.
TRIGGER: The Conventional Secondary Mortgage Market Responded
to the Need for Liquidity and Uniformity
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With the deregulation of interest rates and the shift in policy by the
Federal Reserve Banks to money supply growth management, Fannie
Mae and Freddie Mac were put in great jeopardy, as they held fixed rate
mortgage loans in portfolio while their cost of funds was subject to shortterm swings.
As a consequence, new options were needed to generate fee income, offset
low-yielding assets and raise capital. Pooling mortgage loans and issuing
mortgage-backed securities generated “guarantee fees” – essentially
insurance premiums – for Fannie Mae and Freddie Mac. Wall Street
provided the investors and the financial capital, so that the GSEs did not
need to access the credit markets directly or take on interest rate risk for
this portion of their business.
The other major innovation was a group of mortgage products that
allowed for periodic adjustment in the rate of interest, tied to U.S.
Treasury debt and other indices. For consumers, the benefits depended
on how and when rates could adjust and whether they had the income to
handle increases in monthly payments.
The issuance of collateralized mortgage obligations (CMOs) was first
introduced in 1983 by Fannie Mae.
CMOs countered prepayment risk to investors that occurred when
interest rates were falling and borrowers refinanced to lower rate
mortgage loans. CMOs created classes of securities that offered principal
repayment at varying speeds, so that investors were able to acquire an
interest in cash flows with advantageous accounting tax implications.
TRIGGER: An Explosion of Speculation Erupted at the Close of the
1980s
Then, once again, property markets – fueled by the ready availability of
credit and lower creditworthiness standards -- experienced rapid
increases in prices that eventually ran up against the limited ability of
businesses and homeowners to take on the additional amount of debt
required. The acquisition of property as a short-term investment,
acquired only secondarily for shelter or the generation of cash flow, to be
resold at huge profits within a few years, drove the property markets
toward yet another crash.
We should also remember that in September of 1985 representatives of
the major industrial nations of the world met and agreed to coordinate
economic policy. Tariffs and other restrictions on international trade
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were gradually lowered. The Japanese agreed to reduce taxes on imports
and to stimulate domestic demand. The signatories also pledged to
intervene in foreign exchange markets in an effort to drive down a U.S.
dollar widely perceived as overvalued.
On the 19th of October, 1987, the stock market experienced its largest
one day decline in history – to that point. The Dow lost 22.6% of its
nominal value, or $500 billion. In truth, no one really knows what the
aggregate value of corporate shares really is. All it takes for nominal
values to decline is enough shareholders who believe the market is about
to fall and keep falling to generate a major sell-off at lower and lower
prices. Investors pulled billions of dollars out of the stock market and
shifted to real estate.
As interest rates fell during the 1980s, the financial affordability created
was capitalized into increasing property (i.e., land) prices.
By the end of the decade, the property markets became overheated and
regional downturns developed. Commercial property vacancies increased
in many cities, and property values fell in many regions of the United
States, in some cases by as much as one-third. In 1989, the number of
new homes constructed dropped to 1 million, the lowest number since the
Second World War.
TRIGGER: The Clinton Administration’s Third Way
Campaigning for the Presidency, Bill Clinton told an audience at the
Wharton School at the University of Pennsylvania that the economy
hadn't really been working since the early 1970s, that the recession had
simply aggravated problems that existed long before George H. W. Bush
took office.
"Even when the Bush recession ends," Mr. Clinton said, "most Americans
will find themselves worse off.“ He offered a Third Way up and out of the
quagmire.
Not long after the election, Clinton declared:
"We're Eisenhower Republicans here. We stand for lower deficits, free
trade, and the bond market."
Looking closely at Clinton’s economic program, Jack Godwin concludes
in his book published in 2009:
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"Clinton was the fixer, the policy wonk who reengineered the Reagan
Revolution evolution, effectively solved problems such as welfare and the
budget, and offered a coherent governing philosophy equal to the global
era.“ If that were only true.
Between 1993-2000, the unemployment rate fell steadily from 7.5 -- 4.0
percent, as measured by government agencies (yet, many workers were,
in fact, underemployed and experiencing declining incomes and benefit
packages).
The official inflation rate, reported to be 1.6 percent for 1998, ignored
what was happening to land prices and the effect on property prices,
which were now escalating at a much higher rate. Production of goods of
high quality now came out of countries with lower wage and lower land
costs, establishing global prices U.S.-based firms had to meet or lose
market share.
In 1994, Laura D'Andrea Tyson, the President Clinton's chief economic
adviser, pronounced the economy:
"squarely on a path of sustainable growth.“ What, in fact, was meant by
“sustainable” was not defined.
The President claimed the economy produced 1.6 million private sector
jobs in 1993. Yet, almost every major company domiciled in the United
States had moved or was in the process of moving operations to other
countries, with India becoming the leading destination for U.S. high-tech
firms. These and other firms have also moved their customer service
functions to English-speaking but lower wage locations.
While rising underemployment was a concern for the Clinton
administration, his economic advisers embraced the principle of
“creative destruction” by which we continuously find ways to produce
goods and services with less expense. As an example, while 70,000
computer programmers lost their jobs between 1999 and 2003, 115,000
computer software engineers found higher-paying jobs during that same
period. Also, in some cases the cost savings experienced resulted in higher
compensation to employees working in the U.S.
At the same time, foreign-owned companies have always had a presence
in the United States. Today, these companies employ some 5.3 million
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U.S. residents (roughly 3.5 percent of all workers) spread across the 50
states in sectors from manufacturing to retail and publishing.
What is clear is that neither our elected representatives nor their
economic policy teams know what is required to turn a geo-political
region into a sustained enterprise zone.
TRIGGER: Home Equity Drives a Resurgence in Consumer Spending
As the 1990s unfolded, we entered a prolonged period of frenzied
property speculation. When this latest land market cycle peaked, we
experienced a collapse that is still unfolding.
A sustained period of low interest rates and deregulation of the financial
services sector triggered an explosion in the volume of home equity
mortgage loans – for purposes of debt consolidation, home
improvements, college tuition for children and to cover uninsured
medical expenses. Credit card debt also exploded for those who did not
own a home or owned a home already heavily mortgaged.
As this chart shows dramatically, the amount of consumer debt
collateralized by property value skyrocketed after the middle of the
1990s.
What this meant for credit card issuers was greater risk users, dramatic
increases in charged fees and very high rates of interest on carried
balances.
Delinquencies on credit card balances have a strong correlation to
household income interruptions, unexpected expenses for which savings
are not available, or basic mismanagement of one’s financial matters.
During the 1980s, charge-off rates averaged about 2.6%, according to
Federal Deposit Insurance Corp. data. In the early 1990s recession, those
rates peaked at 4.98%. Charge-offs rose to 5.39% in the late 1990s and
then hit their most recent peak of 7.69% in the first quarter of 2002.
TRIGGER: Emerging Demographic Patterns
In 2006, as the first boomers turned 60. Ironically, personal savings was
reported to be negative for the first time since the great depression. Most
vulnerable to even minor financial setbacks are an estimated 35 million
people categorized as poor by the U.S. government. Yet, it is worth
mentioning that controversy exists in how poverty is measured.
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A Heritage Foundation report in 2004 highlighted the facts that 46% of
households labeled as poor were homeowners, 76% had air-conditioning
in their homes or apartments and more living space than the average
enjoyed by residents of many cities throughout Europe. The majority of
the poor in the U.S. also owned other assets, including one or more
automobiles.
The primary reasons why some children are poor is that they are part of
families where the adults are not employed full-time or not regularly
employed or reside in single-parent homes; some 1.3 million children are
born out of wedlock each year. And, the most important variable
determining child poverty is living in a female headed household.
As interest rates fell so did the interest income received by the nation’s
households with savings accounts and money market fund accounts.
Many retirees experienced significant declines in investment-derived
income, causing for some sufficient financial stress forcing them to sell
their residence – downsizing or relocating to a lower cost region of the
country. Roughly a half million American retirees actually left the United
States altogether to live in Mexico, Costa Rica or other countries where
American enclaves were being established.
The need for income created a growing market for reverse mortgages,
most of which were made under the government-insured program,
HECM, developed by the Federal Housing Administration. HECM
volume increased steadily, from 37,000 loans in 2004 to 107,000 in 2007.
Despite the credit crisis and tightening credit requirements in the
mortgage market, the Department of Housing and Urban Development
reported that over 115,000 HECMs closed during 2008 and 118,000 in
2009. This indicates that despite falling property values, many seniors
continue to have sufficient equity positions to trade that equity for an
income supplement. Miami, Los Angeles and Tampa were the top 3
HECM markets.
However, according to a recently released report by HUD, the Federal
Housing Administration is projecting that reverse mortgage endorsement
volume will decline in 2010. It would be the first year over year decline
the industry has experienced in at least a decade. According to the
report, FHA estimates the industry will endorse 107,000 HECMs during
HUDs fiscal year 2010 which represent a 7% decline from endorsements
in 2009.
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TRIGGER: Falling interest rates benefited millions of U.S. Households
In 2004, Alan Greenspan, still serving as Chairman of the Federal
Reserve Board looked back on the decade of low interest rates:
“Indeed, the surge in mortgage refinancings likely improved rather than
worsened the financial condition of the average homeowner. ...”
“Some of the equity extracted through mortgage refinancing was used to
pay down more expensive, non-tax-deductible consumer debt or used to
make purchases that would otherwise have been financed by more
expensive and less tax-favored credit. Indeed, the refinancing
phenomenon has very likely been a supportive factor for the general
economy.”
And, for those who had purchased property when mortgage rates were
double-digit, refinancing increased their monthly disposable income or
allowed them to reduce the number of years remaining on their mortgage
debt.
For millions of others, whose household income had become stagnant or
had fallen, the debt relief was soon overwhelmed by rising costs of living.
In many communities, property taxes climbed upward as the costs of the
public school systems escalated. One result was increasing pressure on
state officials to shift the revenue from wage and sales taxes to support
the public schools.
Refinancing to lower mortgage payments and/or to generate cash for
other purposes climbed steadily during the 1990s but skyrocketed during
the current decade.
TRIGGER: Accelerated financial deregulation
For both fiscal and philosophical reasons, the Federal and state
governments in the United States were employing fewer and fewer
resources in regulatory oversight of financial institutions. The result was
inevitable: an exponential increase in the amount of fraud,
misrepresentation, embezzlement, predatory lending practices, falsified
property appraisals, substandard construction methods, and other types
of criminal behavior.
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Conservative and quasi-libertarian policy advocacy groups, such as Cato
Institute feared that the Clinton administration would invigorate the
government’s regulatory capability with disastrous consequences.
Catherine England, an American University professor of economics,
argued the case for further deregulation of the financial sector. Her
analysis of the savings and loan crisis was that:
“Excessive regulation was the initial cause of the S&L industry's
problems” and that “Federal deposit insurance was ultimately
responsible for the high costs of the debacle.”
As I have attempted to show, piecemeal deregulation set the stage for the
S&L crisis, but the collapse was also made inevitable by long-standing
destructive public policies and law. Professor England also concluded
that:
“Government-sponsored efforts to protect the industry only invited
abuses and increased the ultimate cost of restructuring.” And, of course,
little was learned from this disaster.
Throughout the 1990s mortgage purchases and securitizations by the two
GSEs skyrocketed as refinancings and new home sales rebounded.
A major factor in the growth of the securitization market was repeal of
the Glass-Steagall Act of 1933, permitting commercial and investment
banks to consolidate. Banks also went to a spending spree purchasing
finance companies that specialized in second mortgage lending. Recently
interviewed on his economic legacy, Bill Clinton stated he did not object
to these measures because of the political strength of Alan Greenspan’s
opinions on economic matters.
TRIGGER: Investors shift from high-tech to bank stocks
Another minor trigger occurred in late 1999, when stock analysts began
to pull investors out of the high tech stocks, particularly those of start-up
internet businesses, in favor of bank stocks and indexed bond funds.
In early 2000 the NASDAQ fell from 5,000 to 2,000 and by 2002
stabilized at around 800. Investors rapidly moved their financial reserves
from the stock market into income-producing property, real estate
investment trusts and land. High income investors were acquiring farms,
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driving up the price of agricultural land in many of the best farming
regions of the United States.
TRIGGER: Household debt-to-income ratios climbed to dangerous levels
National median property prices increased by more than 45 percent in
the decade ending 2007. Median wages increased by only 10 percent in
the same period, and household savings particularly for potential firsttime homebuyers was often insufficient to meet minimum requirements
for a cash down payment and to cover closing costs.
U.S. households continued to accumulate high mortgage and other debt
until the economy came crashing down in 2007. However, this cannot be
interpreted as a long-term change in individual financial management
behavior.
As the most recent economic cycle ended, total household debt peaked at
roughly $13 trillion.
Homeowners borrowing for their children’s education, to pay medical
bills or to consolidate debt took on 2nd or even 3rd mortgage liens on
their primary residence. Some lenders provided financing resulting a
combined loan-to-value ratio well above 100%, gambling that property
values would continue to climb. Low income homeowners and renters
faced rising costs of living but stagnant or falling incomes.
Despite the availability of HECMs, the great majority of seniors received
relatively little income from pensions or investments. Rather than a
safety net, Social Security benefits represent two-thirds or more of the
household income of seniors.
TRIGGER: The subprime mortgage market
Aggressive telemarketing, television and radio advertising, and internet
marketing generated an explosion in the subprime mortgage market -from almost nothing in 1994 to nearly one loan in four in 2006.
A growing concern of regulators was the high number of borrowers
qualified for prime loan terms who were processed as subprime
borrowers because of mortgage broker fees tied to higher interest rates.
Yet, state banking commissioners and other regulators were slow to
intervene on behalf of consumers.
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The parallel between what occurred when investment in the money
market funds exploded at the expense of the thrifts and the dramatic
increase in sub-prime lending at the expense of conventional and FHA
mortgage lending volumes is worth closer examination. Risk
management has in both instances been a casualty.
Pressure to meet aggressive loan volume goals resulted in millions of
loans made to borrowers who had minimum or no real ability for
repayment. What the U.S. Congress is just now coming to understand is
that mortgage loan originators and bank investment managers collected
fees and bonuses based on loan volume rather than on how the business
actually performed over time.
Subprime foreclosures actually fell 3 percent between the 2nd and 3rd
quarters of 2008. However, foreclosures of properties financed
conventionally jumped by more than 20 percent in the same time period.
By the second quarter of 2009, of the total foreclosures, nearly 60 percent
occurred because of the default of conventional mortgage loans.
Moreover, the largest segment, some 32%, involved fixed-rate mortgage
loans. California, Florida and Nevada continue to experience the highest
number of foreclosures, as the economies of these states continue to
evaporate.
To put this in perspective, the overall level of prime mortgage
foreclosures is still far lower than subprime foreclosures. As the economy
has fallen into a deeper recession, around 9% of conventional mortgage
loans have gone through foreclosure, compared to nearly 40% of
subprime loans.
Long-term unemployment is now the main cause of mortgagor defaults
on their loans. There are today an estimated 2.9 million households
seriously delinquent on their mortgage loans and likely to lose the
property.
TRIGGER: Predatory credit terms and outright fraud
The residential real estate sector and its mortgage financing arm have
always attracted criminal activity. Properties with serious structural
problems receive cosmetic repairs and sold as if renovated. Appraisers
falsify property descriptions and utilize inappropriate or fictional sales as
comparables in order to support a sales price. Mortgage originators
collude with borrowers to falsify employment, income and credit history
details. And, this list goes on and on.
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California, Nevada, Florida, Arizona and Washington are the states with
the highest incidence of predatory lending practices. One recent study,
reviewing the accuracy of income and employment information provided
by borrowers, found that one in four mortgage loans involved serious
misrepresentation. The worst states, including California, Nevada,
Arizona, New York, Illinois, Ohio and Michigan, averaged an incredible
one in three cases.
TRIGGER: Raising Maximum Mortgage Loan Limits to Accommodate
Skyrocketing Land Prices
As property prices climbed, reflecting the skyrocketing increase in land
prices, mortgage investors were financing more and more land and less
and less housing. Land-to-total value ratios in many markets consistently
exceeded 50 percent. Existing residential properties in the most highly
speculative markets (e.g., Manhattan, Boston, or Washington, D.C.)
frequently involved land valued as high as 80-85% of the total price.
Thus, holders of residential mortgages were exposed to much higher
losses per default as the median loan amount skyrocketed. Loan amounts
that had been considered too risky for the conventional market were
accommodated in an effort by Fannie Mae and Freddie Mac to maintain
market share.
Most exposed were the private mortgage insurers, whose losses have
forced a dramatic increase in insurance rates charged to borrowers and a
significant tightening of creditworthiness standards.
Will the Crash Deepen?
Public policies and tax laws have long favored speculative investment
behavior over the production of goods and services. Investment in land is
particularly subsidized by low effective rates of taxation, allowing net
imputed income streams to be capitalized into higher and higher land
prices that TRIGGER market collapses.
With the recession, land prices in some markets have declined sufficiently
to permit builders to acquire land at a cost that permits construction of
housing people can afford. As yet, however, stagnant household incomes
and high unemployment are preventing the property markets from a
renewed inflationary upswing in prices; or, what is generally referred to
by economists interviewed in the media as a “housing recovery.”
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The U.S. banking laws authorize the Federal Reserve Banks to introduce
new currency into the economy in exchange for government debt, causing
inflation and a loss in the purchasing power of existing savings, an
important TRIGGER for inflation. There is nothing in the economic
stimulation package that recognizes the fundamental causes of the
meltdown of the property markets and the resulting failure of a growing
number of financial institutions.
As these charts indicate, the annual number of new residential properties
being constructed has stabilized at around 600,000. The median home
price, the point at which half of all homes are sold for more and half are
sold for less, increased all around the U.S. in March of 2011. Yet,
property prices in the Northeast in February were down by 3.0 percent
from 2010. Prices in the Midwest were down by over 7 percent, in the
South by 6.6 percent, and in the West by over 11 percent.
For households with liquid savings, good credit and stable income and
employment, this is a buyer’s market. Yet, as reported by the
Congressional Research Service:
“For the 40 months between January 2005 and April 2008, the personal
saving rate averaged 1.8%.”
Death by Debt Strangulation is Here!
We are living in an era when government spending has no relation to the
amount of revenue taken in by taxation.
Economists employed by successive U.S. administrations and congresses
have compliantly made the case that the escalating national debt is not a
threat to economic stability because debt has not increased when
measured against the size of the economy.
A serious problem with this perspective is that the measure of economic
growth relied upon by economists – Gross Domestic Product – includes
virtually every dollar spent by government, whether obtained by taxation
or from borrowings.
It is difficult to understand Paul Samuelson’s reasoning for describing
the GDP measurement as:
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“truly among the great inventions of the 20th century, a beacon that
helps policymakers steer the economy toward key economic objectives.”
Last year, Joseph Stiglitz issued a report of almost 300 pages criticizing
Gross Domestic Product as a measure of social welfare and proposing a
variety of alterations and alternatives. In an opinion piece from
September 2009, he wrote:
“In many cases, GDP statistics seem to suggest that the economy is doing
far better than most citizens' own perceptions. ...”
“Moreover, the focus on GDP creates conflicts: political leaders are told
to maximise it, but citizens also demand that attention be paid to
enhancing security, reducing air, water, and noise pollution, and so forth
– all of which might lower GDP growth.”
The question few are asking is whether the U.S. will be able to service its
skyrocketing national debt. The CBO estimates that the total national
debt will be $17.27 trillion dollars by 2019 under the proposed Obama
budget, versus $14.4 trillion forecasted by the Council of Economic
Advisers. If the Federal Reserve permits interest rates to increase, the
government’s ability to service this debt will require either a dramatic
increase in taxation or an erosion in the value of the U.S. dollar – perhaps
both.
The Weight of Household Debt
The illusion of prosperity over the last three decades has been based on
easy access to credit.
Escalating property prices required households to take on high levels of
mortgage debt, as shown in the chart on the right. And, just since the
year 2000, household debt doubled. Refinancing of high cost mortgage
loans is helping some households, but many others are making their way
through foreclosure and bankruptcy.
Total Household Debt
A combination of factors has resulted in a decline of total household debt
in the United States. Banks have tightened their creditworthiness
standards. Bad debts have been written off as individuals have made
their way through personal bankruptcy proceedings. Other households
have reduced their use of credit, dedicated more of their income to
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paying down or paying off debt, and postponing purchases in order to
build savings as a cushion against the potential for loss of employment.
An obvious concern for holders of mortgage debt is whether, in the event
of borrower default and foreclosure, the properties acquired can be
marketed at a price sufficient to recover the mortgage principal and
accrued interest, net of the amount recovered under whatever mortgage
insurance claim is warranted. The nominal collateral value of real estate
assets (including second homes and income-producing properties) has
been pulled down dramatically by the long list of hardest-hit regional
markets.
Housing Starts
2010 was the worst year for housing starts since the federal government
began tracking the data in 1959. The ripple effect throughout the U.S.
economy is considerable, given the extent to which employment, goods
production and services have been dependent upon a robust housing
market.
Employment
The April 2011 monthly unemployment figures put the official
unemployment rate increased at 9.0% with a gain in total jobs of 244,000.
Government employment actually fell by 24,000.
This past year was the worst year for housing starts since the federal
government began tracking the data in 1959. The ripple effect
throughout the U.S. economy is considerable, given the extent to which
employment, goods production and services have been dependent upon a
robust housing market.
74. Employment
The U.S. Bureau of Labor reported that nonfarm payroll employment
fell by 85,000 in December, and the unemployment rate was unchanged
at 10.0 percent. Employment fell in construction, manufacturing, and
wholesale trade, while temporary help services and health care added
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jobs. Some 15.3 million people are unemployed, one-third of whom have
been out of work longer than six months.
Our economy is not replacing the lost manufacturing employment with
jobs that have equal levels of compensation and benefits.
As of January, Nevada continued to experience the highest level of
unemployment, at over 14 percent, with North Dakota reporting the
lowest level of unemployment at 3.8 percent.
Bankruptcies
U.S. business bankruptcies declined slightly in 2010 from 2009. Over
323,000 businesses filed for bankruptcy from 2004 through 2010.
Analysts are forecasting that some 1.5 million people will file for personal
bankruptcy during 2011. Since the financial crisis began in 2007, the
number of people filing for bankruptcy protection has started to
approach the total number before bankruptcy laws were tightened in
2005.
Crashing Commercial Property Markets
In many markets across the United States, the prices of commercial
properties continue to decline, although the rate of decline has generally
slowed.
Part of the story can be found in the high vacancy rates experienced in
some large metropolitan markets. The U.S. office vacancy rate hit a 15year high in the fourth quarter of 2009, and landlords slashed asking
rents by the largest amount since at least 1980. Office vacancy rates
average 16.5 percent; however, rates in New York City and Honolulu –
the lowest in the U.S. -- are around 8 to 9 percent.
Recharging the Residential Property Markets
Again, there is widespread hope that residential property markets will
recover lost value but not escalate as they did during the last cycle. What
crashed were land markets. Unless the capitalization of location rental
values is prevented, the anticipation of profits to be gained from land
speculation will eventually trigger another cycle of volatile land prices.
Rising land prices will bail out some homeowners and some mortgage
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investors, but the effects on the general population and our very
structurally-weak economy could be catastrophic.
For 2010, the number of bank failures rose to 157, the highest number of
bank failures since 1992 and surpassing 2009 which saw a total of 140
bank failures. Furthermore, 860 institutions were on the FDIC’s problem
banks list, as of September 30, 2010, the highest number since 1992. The
estimated cost to the FDIC of these bank failures totaled $22.4 billion.
The FDIC's contingent loss reserve, which covers the costs of bank
failures, declined from $27.5 billion to $21.3 billion during the third
quarter, primarily as a result of these bank failures.
What we have experienced in the last two years is, in my assessment, little
more than pushing off into the near future an economic collapse of
historic proportions. With the time that remains, I suggest we discuss
what systemic reforms are needed to soften the almost certain economic
and social implosion with which are faced and set the stage for
sustainable, job-creating economic growth going forward.
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