Capitalism and Oligarchy

James K. Gailbrath takes the Obama administration to task on their handling of the bailouts.  Economically, I tilt towards the folks over at Econolog, but like Arnold Kling, this post resonated with me:

Up to a point, one can defend the decisions taken in September-October 2008 under the stress of a rapidly collapsing financial system. The Bush administration was, by that time, nearly defunct. Panic was in the air, as was political blackmail — with the threat that the October through January months might be irreparably brutal. Stopgaps were needed, they were concocted, and they held the line.

But one cannot defend the actions of Team Obama on taking office. Law, policy and politics all pointed in one direction: turn the systemically dangerous banks over to Sheila Bair and the Federal Deposit Insurance Corporation. Insure the depositors, replace the management, fire the lobbyists, audit the books, prosecute the frauds, and restructure and downsize the institutions. The financial system would have been cleaned up. And the big bankers would have been beaten as a political force.

Team Obama did none of these things. Instead they announced “stress tests,” plainly designed so as to obscure the banks’ true condition. They pressured the Federal Accounting Standards Board to permit the banks to ignore the market value of their toxic assets. Management stayed in place. They prosecuted no one. The Fed cut the cost of funds to zero. The President justified all this by repeating, many times, that the goal of policy was “to get credit flowing again.”

The banks threw a party. Reported profits soared, as did bonuses. With free funds, the banks could make money with no risk, by lending back to the Treasury. They could boom the stock market. They could make a mint on proprietary trading. Their losses on mortgages were concealed — until the fact came out that they’d so neglected basic mortgage paperwork, as to be unable to foreclose in many cases, without the help of forged documents and perjured affidavits.

But new loans? The big banks had given up on that. They no longer did real underwriting. And anyway, who could qualify? Businesses mostly had no investment plans. And homeowners were, to an increasing degree, upside-down on their mortgages and therefore unqualified to refinance.

These facts were obvious to everybody, fueling rage at “bailouts.” They also underlie the economy’s failure to create jobs. What usually happens (and did, for example, in 1994 - 2000) is that credit growth takes over from Keynesian fiscal expansion. Armed with credit, businesses expand, and with higher incomes, public deficits decline. This cannot happen if the financial sector isn’t working.

The GOP is making noise about more robust financial oversight of Fannie and Freddie.  That's a positive development, but unfortunately, there are no signs they are ready to take on the banking oligarchy.  I don't see any real attempts to deal with the moral hazard accompanying the bailouts, either.  Alan Greenspan has finally joined the chorus of pointing out moral hazard plus fraud has become an issue we need to deal with in the banking sector. My own view of the causes of the economic crisis is here, which came about as a a confluence of several factors. It spears some sacred cows on both the Left and Right but ultimately, crony capitalism emerges as the common theme.

Chart of the Day: Housing Price Trends Since 1890

From the Atlantic's Daniel Indiviglio:

Conclusion: Indiviglio believes home prices may drop by another 25%:

This is a pretty fascinating picture. First, it shows just how incredibly absurd the housing boom was. Beginning in the 1940s, inflation-adjusted homes prices have settled around the 110 value according to the Case-Shiller index. Yet, the index value exceeded 200 in 2006. Prices began a descent when housing collapsed, but as of May the index remained well above the natural value of 110. 

Eyeing the chart, the value looks to have hit around 147 in May. For it to drop back down to 110, home prices would have to decline another 25%. That's still a pretty long way to fall.

More homebuyer tax credits are not going to solve this.

Chart of the Day: Homeowners with Negative Home Equity

From Marginal Revolution.

 

Calculated Risk chart that shows negative equity by state:

The financial reform legislation didn't touch Fannie and Freddie. About that, the WSJ reports Paul Volcker says:

[SmartMoney]: What’s missing [from the financial-regulatory overhaul]?

Mr. Volcker: People talk about Fannie Mae and Freddie Mac. That’s a challenge for next year and year following. We are going to have to reconstruct the whole mortgage market and you can’t do that overnight. The mortgage market now is almost a wholly owned subsidiary of the United States government. Almost all the mortgages made now are insured by the government, bought by the government, and the guys at Fannie Mae and Freddie Mac are the market.

Not much exists without the government running it. I don’t think that’s what we want. A lot of problems surround the whole mortgage market. It’s clear Fannie Mae and Freddie Mac need to go. [emphasis added]. We don’t need these hybrid institutions. You don’t know whether they should be responsible to the government or to stockholders. It’s an unfortunate invention.

On the legislation, the IMF released its assessment summarized in the NYT:

The financial overhaul bill signed by President Obama last week failed to simplify the complicated regulatory architecture that oversees the banking and securities industries, according to an assessment by the International Monetary Fund.

The assessment, which is being released Friday along with a periodic I.M.F. review of the American economy, found that the effectiveness of the Wall Street reform act will rely heavily on how it is carried out.

The assessment also found that the United States faces hard choices in determining the future of Fannie Mae and Freddie Mac, the two mortgage-finance entities that were seized by the government in 2008. It suggested that the government break up and privatize current portfolios of the companies while transferring their responsibilities for promoting home affordability to a new government agency.

About Those Tax Cuts

One has to question the political wisdom of the Obama administration's decision to let the Bush tax cuts expire on those making over $200,000 annually. While our exploding deficit will probably require a combination of entitlement reform (cutting spending) and raising taxes in the future, letting the tax cuts expire this year while the recovery has stalled and we're still hovering around 10% unemployment will impede growth in the short term. The Obama administration may be resigned to large GOP gains in the midterm election, and will probably use the tax cut issue as a foil against the GOP who they'll charge as hypocrites for posturing as deficit hawks, and chanting forever more it's a return to the failed policies of Bush.  However, it's a double-edge sword for the administration if the tax raises hurt the economic recovery, which in all likelihood, they will. And the GOP can always comeback by not appropriating funds for Obamacare if they win the House.

Bernake recently told Congress he supported more short term stimulus for the economy, saying these tax cuts would be a way to help strengthen the recovery, although he qualified they needed to be offset. While Greenspan is in favor of letting the cuts expire in order to tackle the deficit, he also admits it will probably slow growth. A CNBC article notes that analysts at Deutche Bank believe letting the tax cuts expire will hurt economic growth quite a bit:

Deutsche said the drag on gross domestic product should they lapse could be as much as 1.5 percent, with the more likely impact at 1.1 percent.

The impact would be worse, the analysts said, if Congress fails to fix the Alternative Minimum Tax, which was enacted in 1969 to make sure rich people pay taxes but was never indexed for inflation, and thus is now hitting middle-income workers.

"In a worst-case scenario, allowing the Bush tax cuts to expire and failing to fix the AMT could result in (1.5 percent) of fiscal drag in 2011 on top of the 1 percent fiscal drag we expect to occur as the Obama fiscal stimulus package unwinds," Deutsche said in a note to clients. "If the recovery remains soft/tentative through early next year, this additional drag could be enough to push the economy to a stalling point."

This on the heels of a AP survey of economists who believe the GDP will grow weakly at less than 3% for the remainder of the year, and unemployment will be unchanged. Economists say the economy has to grow at least 5% a year for unemployment to come down 1 percentage point.  As AP notes, consumer spending is still tepid; raising taxes on high earners isn't going to give it a shot in the arm. And as the Bloomberg article points out, Bernake doesn't have much room left to maneuver in monetary policy; the federal funds rate is already at 0.25%.

Further, the raises in marginal tax rates will hurt many small businesses who fall within the top two rates, as noted by Americans For Tax Reform. While liberal think tanks like the Tax Policy Center like to tout that only a small percentage of small businesses make over $200,000, they don't like to mention that these are the small businesses that employ the most people.  Industry standards for small businesses in some sectors of the economy like manufacturing and mining employ up to 500 people. Moreover, most small businesses are organized as either a sole proprietorship or as a pass through entity for tax purposes. That means while the dollar amount of profit may sound high as reported to the IRS, it is often split among ownership and then taxed at personal rates. Much profit is also reinvested back into business for purchasing new equipment, advertising, more hires, etc.  Finally, profit from one good year can ride out a bad year (like the current one) and prevent forcing business owners into layoffs.

Harvard Economics Professor Greg Mankiw has written a thoughtful article that examines whether  government spending or tax cuts would be more effective in stimulating the recovery.  Some major points:

1) Research shows that broad cuts in marginal rates are a better stimulus for the economy than government spending. One study showed they were 4x as potent as government spending.

2) A stimulus needs to be injected quickly in the economy. Government spending often goes through so much bureaucratic red tape before it actually is spent, and is often allocated inefficiently. Tax cuts can be felt immediately by small business owners (a sector that accounts for the majority of job creation) who will allocate the returns more efficiently.

3) Not all tax cuts are created equal. While Obama's stimulus plan had some tax cuts and tax credits, narrowly targeted cuts like, for example, providing tax credits to businesses who make new hires are difficult to implement. Some industries like construction are so far below their baseline of employees to be eligible for tax credits, that it will not offer them any additional incentive to hire new employees. It may even cause existing businesses to layoff employees and instead contract services out to new startups to be eligible for the credit. The lesson here is that tax cuts should be implemented broadly, at marginal rates.

The bottom line is that while taxes will eventually have to go up to cover the deficit, it would be sensible to take a pause and delay the expiration of the Bush tax rates until the recovery is more solid. Democratic Sen Bayh explains why this is his position with Larry Kudlow. The money quote is around 4:45 where Bayh specifically rejects class warfare rhetoric and points out we're all in this together.

Where's My Recovery?

Well there's not much economic good news for the Obama administration. The economic recovery seems to be fizzling. As the AP notes:  

Unemployment claims are up, home sales are plunging without government incentives and manufacturing growth is slowing.

No surprise there. As this WSJ oped points out, the market hates uncertainty. And with an exploding deficit, the expectation that Obamacare will cost much more than projected, the anticipation of tax hikes to deal with our entitlement binge, and the dangling of cap and tax legislation, there's much to be uncertain about if you are a small business owner.  And as such, consumer confidence has cratered.

The House, feeling the voter ire on government spending in the polls, has refused to pass a budget this year. Richard Rahn, economist and senior fellow at Cato, vents from the Washington Times on this:

"Irresponsible" refers to Congress and the Obama administration - and here's why. For thousands of years, businesses, organizations, governments and even individuals have relied on a basic tool to make sure they do not spend or borrow more than they can service - it is called a budget. Yet, for the first time since 1974, when the current rules were put into effect, the U.S. House of Representatives does not intend to pass a budget resolution. The main purpose of the budget resolution is to set discretionary spending caps for the coming fiscal year.

Without a budget resolution, members of Congress are, in essence, able to spend as much money as they wish, subject only to the limitation of getting half plus one of the other members to go along with the spending proposal. The budget procedure was put in place to make sure members of Congress would not spend money as irresponsibly as many teenagers might if they were given unlimited credit cards. If teenagers were in charge of the federal budget, we might end up with a $1.5 trillion deficit this year. Ah, but we are going to have a $1.5 trillion deficit this year - and who's in charge?

In the face of the unprecedented congressional spending binge, President Obama has been asking Congress to spend even more. Not content with actively promoting the eventual bankruptcy of the United States, Mr. Obama is urging foreign leaders also to increase their government spending - which is truly bizarre. Look at the facts. All of the major European countries have been increasing government spending and deficits at unsustainable rates. The talk for the past couple of months has been about which countries would follow Greece in going over the financial cliff. Responsible economists, financial leaders and, most important, the markets have been telling European leaders they must cut government spending. Over the past couple of weeks, a number of those leaders have responsibly and courageously come forth with real spending-reduction programs. Britain's new government, despite being a coalition government, has proposed a 25 percent cut in most government departments. Can you imagine the howls from Congress and the U.S. news media if a U.S. president proposed even a 5 percent cut, though a far larger one is needed?

Now that legislation extending unemployment benefits has failed to pass in the Senate, MaxedoutMama comments on the absurdity that passes for our politics:

Last but not quite least, the fruits of the housing tax credit (due to be extended by your witless Cr_tt_r any day now) are worth looking at. We paid a great deal to book a lot sales far more quickly than otherwise, but anyone who looks at the pending home sales report is going to realize that it was a very expensive (and elitist) exercise in "Let's Pretend". Nationally SA sales dropped 30% on the month and 15.9% on the year. The more money we spend to try to prop up home sales the worse it gets. We might as well quit and take our licking now.

The irony and the tragedy of yanking extended unemployment benefits with unemployment around 10% while giving thousand of dollars a pop to people who were either going to buy anyway or really can't afford to buy and will most likely default is beyond belief.

One of the reasons the average person doesn't want to hear "stimulus" any more is because stimulus has been very badly spent. The housing tax credit in particular is an exercise in witless, very expensive legislation. The results are as predictable as the results of cutting off benefits to unemployed.

I am beginning to feel like I got drunk and woke up in a S&M club. I want out. [emphasis added].

All I can say to that is, Amen.

Where Americans Are Moving

Forbes has an interactive map where you can click on any county to see migration in/out of that location during 2008.  AEI highlights some major trends:

Texas’s low-cost, liberty-loving atmosphere has become an attractive alternative to California’s oppressive public sector and dysfunctional policy environment. No amount of heart-melting vistas, celebrity sightings, or traipses through wine country can make up for what almost appears a strategic attempt by one of the nation’s largest states to drive businesses and productive people away....


If we look at Harris County, Texas, where Houston is located, we can practically hear a giant sucking sound as the state’s largest city pulls people southward from the northeast, the Midwest, and elsewhere. Most of the outmigration is regional, with some identifiable patterns to the upper northwest. You get a similar picture when you look at the migration patterns to Dallas and Austin.

 Now let’s look at California. Aside from the appeal of Los Angeles to people living in the high-cost northeast (you might as well have good beaches and sunny weather if you’re paying high taxes for bad services), it appears the city of angels is losing its heavenly radiance in a massive way. San Diego also looks very red. San Francisco (not included here) has a surprisingly black hue to it in defiance of that beautiful city’s high cost of living, but it has a noticeably lower volume than the other great California cities.

People vote with their feet. And they clearly are voting for states with low taxes that are friendly to businesses.

Chart of the Day: The Moocher Index

Via International Liberty (H/T: Ace of Spades).  The chart below shows income redistribution to non-poor people. The researchers subtracted the poverty rate to compare states on income redistribution.

 

A few quick observations. Why is Vermont (by far) the state with the largest proportion of non-poor people signed up for welfare programs? I have no idea, but maybe this explains why they elect people like Bernie Sanders. But it’s not just Vermont. Four of the top five states on the Moocher Index are from the Northeast, as are six of the top nine. Mississippi also scores poorly, coming in second, but many other southern states do well. Indeed, if we reversed the ranking and did a Self-Reliance Index, Virginia, Florida, and Georgia would score in the top 10. Nevada, arguably the nation’s most libertarian state, is the state with the lowest number of non-poor people signed up for welfare.

This chart helps in clarifying the distinction between altruistic redistribution (a help up) and egalitarian distribution (a hand-out) that I blogged about recently. 

Survey: Liberals Are the Least "Economically Enlightened"

In a red meat nugget for this weekend, No Oil for Pacifists links to a study published in this month's Econ Journal Watch.  Zeljka Buturovic, research associate with Zogby International, and Daniel B. Klein, professor of economics at George Mason University, surveyed over 4800 American adults to gauge their "economic enlightenment." One of the variables they looked at was political ideology. From the study:

In the tables that follow, using the two-point scale, we report on the percentage of response that are INCORRECT. Thus, in the tables that follow, high numbers are bad. We focus on incorrect responses to highlight the problem of “people knowing what ain’t so.” Table 1 again shows that, for people inclined to participate in such a survey, going to college is not correlated with economic enlightenment. With the large sample size, all but the smallest of differences are statistically significant at the 0.05 level. 

The line at the bottom reports for each ideological group the average number of incorrect answers. Adults self-identifying “very conservative” and “libertarian” perform the best, followed closely by “conservative.” Trailing far behind are “moderate,” then with another step down to “liberal,” and a final step to “progressive,” who, on average, get wrong 5.26 questions out of eight.

Here again we should acknowledge that none of the eight questions challenge typical conservative or libertarian policy positions, and that had some such questions been included, the measured economic-enlightenment means by ideological groups may well have been somewhat different.

Nonetheless, we think that the measurement as-is captures something real. At least since the days of Frédéric Bastiat, many have said that people of the left often trail behind in incorporating basic economic insight into their aesthetics, morals, and politics. We put much stock in Hayek’s theory (Hayek 1978, 1979, 1988) that the social-democratic ethos is an atavistic reassertion of the ethos and mentality of the primordial paleolithic band, a mentality resistant to ideas of spontaneous order and disjointed knowledge. Our findings support such a claim, all the caveats notwithstanding. Several of the questions would seem to be fairly neutral with respect to partisan politics, particularly the questions on licensing, the standard of living, monopoly, and free trade. None of those questions challenge policies that are particularly leftwing or rationalized on the basis of equity. Yet even on such neutral questions the “progressives” and “liberals” do much worse than the “conservatives” and “libertarians.”

MaxedOutMama points out the demographics of the sample size are not representative:

It is very skewed toward the male, it is very skewed toward higher education, it is hugely skewed toward voters, etc. 

She also notes: 

It is weirdly fascinating in some awful ways. Note particularly the better performance among Walmart shoppers as opposed to non-Walmart shoppers, wealthier households as opposed to poorer households, high-frequency religious service attenders as opposed to non-service-going, and atheist/realist/humanists/Christians as opposed to Jewish/Muslims. The last two are driving me to the data; the dataset might be hugely skewed on the smaller groups.

Some other interesting things the survey found:

• College education is not correlated to economic enlightenment, although this contradicts findings from some other studies 
• McCain voters did better than Obama voters, non-union members fared better than union members, married better than singles, folks who answered whether they were considered a resident of "America" did better than those that considered themselves citizens "of planet earth," military members did better than non-military members, NASCAR fans did better than non-fans, and males outscored females.

Update: If you had trouble viewing Table 1, here it is:

Here are the questions:

The statements of the eight questions used are the following: 

1. Restrictions on housing development make housing less affordable. 

• Unenlightened: Disagree

2. Mandatory licensing of professional services increases the prices of those services. 

• Unenlightened: Disagree 

3. Overall, the standard of living is higher today than it was 30 years ago.

• Unenlightened: Disagree 

4. Rent control leads to housing shortages.

• Unenlightened: Disagree 

5. A company with the largest market share is a monopoly.

• Unenlightened: Agree

6. Third-world workers working for American companies overseas are being exploited.

• Unenlightened: Agree

7. Free trade leads to unemployment.

• Unenlightened: Agree

8. Minimum wage laws raise unemployment.

•  Unenlightened: Disagree

Chart of the Day: National Debt Exceeds $13 Trillion

From CBS news:

$13 trillion equates to nearly 90% of the US GDP.  When do we need to start worrying?  Right about now, according to Michael Boskin, professor of economics at Stanford University who chaired the Council of Economic Advisors under Pres. George H.W. Bush:

Ken Rogoff of Harvard and Carmen Reinhart of Maryland have studied the impact of high levels of national debt on economic growth in the U.S. and around the world in the last two centuries. In a study presented last month at the annual meeting of the American Economic Association in Atlanta, they conclude that, so long as the gross debt-GDP ratio is relatively modest, 30%-90% of GDP, the negative growth impact of higher debt is likely to be modest as well.

But as it gets to 90% of GDP, there is a dramatic slowing of economic growth by at least one percentage point a year. The likely causes are expectations of much higher taxes, uncertainty over resolution of the unsustainable deficits, and higher interest rates curtailing capital investment.

The Obama budget takes the publicly held debt to 73% and the gross debt to 103% of GDP by 2015, over this precipice. The president’s economists peg long-run growth potential at 2.5% per year, implying per capita growth of 1.7%. A decline of one percentage point would cut this annual growth rate by over half. That’s eventually the difference between a strong economy that can project global power and a stagnant, ossified society.

Will the Euro Survive?

It looks like  Germany has approved its share of a trillion dollar rescue package for the Euro. Additionally, the EU has announced it will look at enforcing stiffer fines against countries that break its Stability and Growth Pact's deficit limits.

The Euro project was built with collectivist dreams from elitists who ignored voter concerns,  despite numerous countries rejecting the EU by referendum.  The EU dreamers thought they could ignore the geopolitics and residual nationalism in Europe and graft a superstate structure over it, binding everyone together for a more peaceful union.  Now we see the fault lines that arise in the Euro's project: the inevitable dilution of state sovereignty and widening democracy deficit between Brussels and individual voters.  Clive Crook from The Atlantic gets to the heart of the problem in his post, "Europe's Missing Foundations":

History and ordinary prudence dictated that the union might be broad and shallow (a free-trade area, with embellishments, capable of taking in all-comers) or else narrow and deep (an evolving political union, confined to countries willing to be led there). Of the two, I always believed that the first was better. But the architects did not even have the brains to choose the second. They recognized no limits to their ambitions. They set about creating a union that was both broad and deep. A federal constitution, a parliament, a powerful central executive, one central bank, one currency - all with no binding sense of European identity.  As for scale, well, the bigger the better. Today Greece, tomorrow Turkey. And why stop there? Madness.

Today's Telegraph predicts failure:

This is why the euro, in its current form, is finished. The game is up for a monetary union that was meant to bolt together work-and-save citizens in northern Europe with the party animals of Club Med. No amount of pit props from Berlin can save the euro Mk I from collapsing under the weight of its structural dysfunctionality. You cannot run indefinitely a single currency with one interest rate for 16 economies, when there are such huge fiscal disparities.

What was once deemed unthinkable is now, I believe, inevitable: withdrawal from the eurozone of one or more of its member countries. At the bottom end, Greece and Portugal are favourites to be forced out through weakness. At the top end, proposals are already being floated in the Frankfurt press for a new "hard currency" zone, led by Germany, Austria and the Benelux countries. Either way, rich and poor are heading in opposite directions.

It seems Germany and the EU elites are doubling down to save it. From the WSJ:

Berlin is now determined to push through a package of reforms both in Brussels and at the Group of 20 summit next month. These would cover stricter regulation of financial markets, a tax on financial institutions, and greater budgetary discipline.

But the German moves this week are already unsettling some. Says Struan Stevenson, a member of the European Parliament from the U.K.: "Clearly, the Germans were expecting other EU nations to dance to their tune and are no doubt enraged that others, including France, have chosen to ignore them.

"It's make-or-break time for the euro zone, with the tensions exposed by this crisis threatening to tear the single currency apart.

"My hunch is European leaders will not risk a market meltdown and bow to German pressure for full fiscal union—with Brussels and the European Central Bank in Frankfurt having the final say on state tax and spending plans across the euro zone."

Berlin would thus have achieved in months what has eluded the champions of the single currency since its inception.

As the WSJ notes, there is bound to be resistance from other member states to this.  The Euro will be unstable for the foreseeable future.

Charts of the Day: Mortgage Delinquencies Up, Slack Still Present in the Economy

Via Calculated Risk:

About 14% of mortgages are delinquent or in foreclosure. Rates by state:

As CR notes:

This highlights a couple more points that Brinkmann made this morning: 1) the largest category of delinquent loans are fixed rate prime loans, and 2) this is not just a "sand state" problem. Brinkmann argued the foreclosure crisis is now being driven by economic problems as opposed to the bursting of the housing price bubble - and this is showing up in prime loans and all states. Although Florida and Nevada are very high, notice that the blue bar (new delinquencies) are higher in many other states.

Brinkmann is MBA's Chief Economist. He explains factors that are dragging down economic growth. Currently, US growth has been revised downward due to the Euro crisis. As the dollar has appreciated against the Euro, it has made our exports more expensive and less competitive.  Additionally, while unemployment has leveled off, it still remains high. Strategic defaults are a clear trend:

Recent research, mainly from the credit bureaus, has also documented the increased incidence of "strategic defaults," where borrowers who could make their mortgage payments decide to pay other bills ahead of their mortgage loan, said Michael Fratantoni, MBA's vice president of research and economics. Typically, these are borrowers who owe more on their mortgage than the current market value of their home. 

"If you look back three, four years ago, it was always the case where a borrower would pay the mortgage first before the second mortgage or credit card debt," Fratantoni said during a conference call with reporters. Today, for some groups of borrowers, that's no longer true. "It runs counter to what anyone would typically expect and the historical experience," he said.

Last week, Business Week reported that strategic defaults made up at least 12% of the defaults in February. Commercial real estate is also hurting. Bloomberg notes commercial property values have dropped in the biggest metropolitan areas, and are down 42% compared to their peak in Oct 2007.  Bloomberg also reports that the Fed is in no hurry to sell off its mortgage backed securities.  This last article is a good summary of the US's overall economic picture.  Bottom line is the Fed expects:

“Even though the recovery appeared to be continuing and was expected to strengthen gradually over time, most members projected that economic slack would continue to be quite elevated for some time,” according to the Federal Open Market Committee report, which doesn’t identify the specific governors or regional-bank presidents making comments.

More on those GSEs

Russ Roberts takes on Barry Riholtz on the notion that Fannie and Freddie had nothing to do with the economic meltdown:

But Ritholtz ignores why subprime was so profitable. And part of the answer is that Fannie and Freddie had been buying up a lot of mortgages made to low-income buyers pushing up the demand for low-income housing. That in turn pushed up the price of houses in low-income areas.

He provides this chart and explanation that shows how aggressive the GSEs came in purchasing low-income loans:

He maintains that as the GSEs pushed into this market, creditors expected to be bailed out as subprime became more profitable.

Charts of the Day: Negative Home Equity

Calculated Risk's chart below (H/T: Marginal Revolution).  Wondering how your house fares? Punch in your address at Zillow.

So how soft is the housing sector? Zillow's chief economist has the report. The bottom line: it's still soft.  The tax credit for home buyers is helping lift sales but inventory supply is increasing. As CR notes:

Research has shown that once negative equity exceeds 25 percent "owners begin to default with the same propensity as investors", and it is these 4.9 million borrowers - with $656 billion in debt - that are most at risk for foreclosure.

This chart on their blog sums it up; more than 10% of homeowners nationwide have negative equity at or exceeding the 25% level:

 On a brighter note, the Fed's Lacker sees we're heading into a sustained recovery, although one should note that over half the uptick in April's unemployment numbers are due to the hiring of Census workers (see NYT). MaxedoutMama concurs on the economic recovery.  NOFP has links to economists' opinions and charts that show the stimulus had nothing to do with the recovery.

Update:  The HuffPo has an article where the nation's 2nd largest bank, JPMorgan Chase, is warning investors that underwater homeowners may walk away.

Lessons from Greece

The Star has a round-up of photos from the Greek riots:

A riot policeman falls after being hit with a molotov cocktail in Athens during a nationwide strike by civil servants protesting the announcement of draconian austeristy measures. May 5, 2010  (REUTERS/John Kolesidis)

A medic prepares to remove the body of a person who perished in a bank that was set on fire during demonstrations in Athens. Three people died in the fire. Greece faced a day of demonstrations during a nationwide strike by civil servants protesting the announcement of draconian austeristy measures. May 5, 2010.   (REUTERS/Pascal Rossignol) 

A riot policeman runs from angry protesters in the northern Greek port city of Thessaloniki. May 5, 2010. (AP Photo/Giorgos Nissiotis)

As credit default swaps on European banks bonds reached record levels today, surpassing the level triggered by the collapse of Leman Brothers, Nouriel Roubini, professor of economics at NYU who predicted the recent financial crisis, writes this warning in the Christian Science Monitor titled "Greece Debt Crisis is Only the Tip of the Iceberg":

Historically, we have seen a series of defaults and sovereign debt crises in both advanced and emerging market economies. If you are a country like the US, the UK, or Japan that can monetize its fiscal deficits, then you won’t have a sovereign debt event but high inflation that erodes the value of public debt. Inflation is therefore basically a capital transfer from creditors and savers to borrowers and dissavers, essentially from the private sector to the government.

While the markets these days are worrying about Greece, it is only the tip of the iceberg, or the canary in the coal mine of a much broader range of fiscal crises. Today it is Greece. Tomorrow it will be Spain, Portugal,Ireland, and Iceland. Sooner or later Japan and the US will be at the core of the problem, shaking the global economy.

We need to recognize that we are in the next stage of financial crisis. The coming issue is not private-sector liabilities, but pubic-sector liabilities.

Revived economic growth alone will not generate enough tax revenue to relieve this sovereign debt crisis. Fiscal deficits are huge and structural. They are not due solely to a cyclical downturn in growth but to long-term commitments such as pensions, Social Security and health care. To avoid default or high inflation, the advanced economies will require some combination of raising revenues through taxes and cutting government spending.

In Europe, where tax rates are already very high, the right adjustment is cutting spending instead of raising taxes further. In the US, the average tax burden as a share of GDP is much lower than in other advanced economies. The right adjustment for the US would be to phase in revenue increases gradually over time so that you don’t kill the recovery while controlling the growth of government spending.

 What worries me most is the political gridlock in Washington. While everyone agrees that $10 trillion deficits (by the Obama administration’s own estimates) for the next decade are not sustainable, there is no political will to act. The two parties are completely divided. Effectively, the Republicans are against any form of revenue increases. The Democrats are against spending cuts, especially of entitlements. [emphasis mine]

USA's oped puts the current crisis in perspective:

To be sure, there are huge differences between Greece and the United States. Here, the federal government represents about 20% of the U.S. economy, whereas the Greek government is about 40% of its economy. Washington's big spending is on benefit programs such as Medicare and Social Security, rather than on compensation for a massive and militant cadre of public employees. And, perhaps most important, the USA doesn't share a currency with other countries, giving the nation more flexibility to print money if needed.

Before Americans get too smug, however, they should note the obvious: Debt is debt. If too much Greek borrowing can send world financial markets into turmoil like that of the past couple of days, imagine the damage a U.S. debt crisis would inflict.

Washington's public debt is nearly $8.5 trillion, which comes to about 58% of the U.S. economy, compared with ratios exceeding 100% in places like Greece. But the U.S. debt is rising fast, and its true size is masked by the surplus run by the Social Security trust fund. Factoring that in, the total national debt is about $13 trillion, or 90% of the economy. Including unfunded liabilities for such programs as Social Security, Medicare and Medicaid, the federal government is looking at a long-term shortfall of about $62 trillion, or about $200,000 for every American, according to thePeter G. Peterson Foundation, a group devoted to promoting awareness about public borrowing.

These numbers should come as a shock. But in Washington, there appear to be two acceptable responses — denial and finger-pointing.

Greg Mankiw links to the CBO's projected US spending by 2020:

 

We certainly are not Greece as USA's oped points out--not just from a debt perspective, but cultural perspective as well.  However, it remains to be seen whether politicians from either party will be able to talk to American voters like they're adults or continue to infantilize them, telling them that yes, we can cut taxes (except for those greedy rich), and continue to keep our entitlements.  This recent poll indicates Americans aren't too keen on entitlement spending: 83% blame the government for increasing the deficit through spending, while only 18% of them are willing to raise taxes to lower the deficit. 58% believe the health care bill will raise the deficit and therefore, support its repeal.  Some other polls put the favor for repeal lower, and instead call for an "amend and modify" approach.  


Despite the opposition to increased spending, it's unlikely many Americans, particularly seniors, will want major changes or cuts to their entitlement programs. Talk about cognitive dissonance.  I don't think we're at the point of California yet--the state is practically ungovernable. But as boomers retire, the window of action for real reform of federal spending is narrowing.

Brace Yourselves: More Bailout $$$ for Fannie and Freddie

From the AP (H/T from Hotair):

WASHINGTON – Freddie Mac is asking for $10.6 billion in additional federal aid after posting a big loss in the first three months of the year. It's another sign that the taxpayer bill for stabilizing the housing market will keep mounting.

The McLean, Va.-based mortgage finance company has been effectively owned by the government after nearly collapsing in September 2008. The new request will bring the total tab for rescuing Freddie Mac to $61.3 billion.

Erza Klein posits:

The problem is that Fannie and Freddie are not a direct and simple subsidy for the banks. They are private companies with a government charter. Rather than using taxpayer dollars to subsidize mortgages, they were borrowing money very cheaply because their quasi-governmental status assured the market that there'd be a taxpayer bailout in the case of any sort of collapse. That is to say, their business model relied on markets ignoring the risk of their activities. And then, because they were private companies with shareholders to please, they also got into slicing and dicing mortgage packages to make money like an investment bank rather than a housing policy. In theory this should've worried the markets where they borrowed their money, but again, the government backstop saved them. Forget too-big-to-fail. This was not-allowed-to-fail.

So, of course, they failed. As Raj Date of the Cambridge Winter Center put it to me, "anytime the debt markets aren't paying attention to your risk profile, you're doomed."

Their failure was not, as some would have it, the cause of the mortgage crisis, or even close. For one thing, only about 2 percent of their portfolio was subprime. For another, they didn't start backstopping the subprime market till long after it had taken off. And for a third, their greatest losses actually were in non-subprime loans.

But they were part of the problem. And the fundamental mismatch between their risk and activities will continue to cause problems. But solving the Fannie and Freddie problem is more complicated than it might appear. What you're talking about, essentially, is a massive subsidy for home ownership. That is to say, a massive subsidy for the middle class. So easy as it is to talk about the failure of Fannie and Freddie, it's a lot harder to talk about their elimination, as that's talking about the removal of a popular subsidy in a fragile market.

The WSJ doesn't take the role of Fannie and Freddie as lightly in the meltdown, and has a much higher number than the AP for total loss to the taxpayer.  Sens McCain, Shelby, and Gregg have introduced an amendment to deal with the 2 GSEs:

The Financial Crisis Inquiry Commission spent yesterday focusing on financial "leverage," using Bear Stearns as an example. But Fannie and Freddie were twice as leveraged as Bear, and much larger as a share of the mortgage market. Fan and Fred owned or guaranteed $5 trillion in mortgages and mortgage-backed securities when they collapsed in September 2008. Reforming the financial system without fixing Fannie and Freddie is like declaring a war on terror and ignoring al Qaeda.

Unreformed, they are sure to kill taxpayers again. Only yesterday, Freddie said it lost $8 billion in the first quarter, requested another $10.6 billion from Uncle Sam, and warned that it would need more in the future. This comes on top of the $126.9 billion that Fan and Fred had already lost through the end of 2009. The duo are by far the biggest losers of the entire financial panic—bigger than AIG, Citigroup and the rest.

From the 2008 meltdown through 2020, the toxic twins will cost taxpayers close to $380 billion, according to the Congressional Budget Office's cautious estimate. The Obama Administration won't even put the companies on budget for fear of the deficit impact, but it realizes the problem because last Christmas Eve it raised the $400 billion cap on their potential taxpayer losses to . . . infinity.

Moreover, these taxpayer losses understate the financial destruction wrought by Fan and Fred. By concealing how much they were gambling on risky subprime and Alt-A mortgages, the companies sent bogus signals on the size of these markets and distorted decision-making throughout the system. Their implicit government guarantee also let them sell mortgage-backed securities around the world, attracting capital to U.S. housing and thus turbocharging the mania.

The virtue of Mr. McCain's amendment is that it will give Senators a chance to vote on the kind of reform that Congress blocked for so long, notably with Senator Barack Obama helping the blockade. The amendment mandates that the current government conservatorship of Fan and Fred will end within 30 months. In the meantime, the companies will have to reduce their mortgage portfolios by 10% each year. If the terrible twosome can't stand on their own after conservatorship, they would then go into receivership and be liquidated.

If they can survive on their own, they would have three years before the expiration of their federal charters, during which time they would have new operating restrictions. Messrs. McCain, Shelby and Gregg would repeal the affordable housing goals previously legislated for Fan and Fred and which contributed to their terrible mortgage bets, and the companies would have to reduce the mortgage assets held on their books by nearly 50% within two years and raise their capital standards.

Fannie and Freddie would also have to start paying state and local sales taxes, lose their exemption from full registration at the Securities and Exchange Commission when they issue securities, and start paying fees to repay the taxpayer for the value of federal guarantees. The $400 billion limit on taxpayer assistance would be reinstated, and for as long as they are in federal conservatorship or receivership, they would have to be included in the federal budget.

In short, the McCain amendment precisely targets the problems that caused the mortgage crisis: If the housing giants are no longer subsidized, they will become small enough to fail. That means they will stop lending money to people who cannot afford to pay them back, and in turn they will stop endangering taxpayers.

[emphasis mine]

It's time to get the government out of the housing business. Erza wants to tackle it in a separate housing bill, arguing those reforms won't be felt in the financial market as much as the housing market.  However, an astute reader points out a graph from Calculated Risk that shows just how much the GSEs subsidized the mortgage market as percentage of market share:

While I can follow Erza's logic that housing may be better dealt with via a separate bill, I have little confidence the Dems will actually break up their sacred cows. They will likely retain some type of government intervention in the housing market. Rep Barney Frank who once admitted that maybe Fannie and Freddie should be ended, sent a memo to the WH to defend the financial reform package and fight the GOP on the Fannie and Freddie narrative:

...Frank argues that Democrats have the facts on their side, and then need to do a better job of communicating them. 

Freddie and Fannie have already been reformed, to some extent, by virtue of being placed into conservatorship. 

“So the argument that we have ignored the need to change the operation of Fannie and Freddie in our rush to do financial reform is of course exactly backwards,” Frank wrote. “We did Fannie and Freddie first.” 

Frank also wrote that the Republican proposal to abolish Freddie and Fannie would remove an important government prop to the housing market. “It is the unanimous view of every profit and nonprofit entity concerned with the housing market in the United States that simply to abolish Fannie and Freddie, as the Republicans are proposing in the House bill, and not do anything to replace the functions they are now performing with a conservatorship, would be a disaster for housing, and therefore for the economy as a whole,” Frank said. 

Finally, Frank said that Freddie and Fannie are not losing money as they are currently operated – which means they aren’t making the deficit any worse. 

“This is an important point that has to be repeated – as Fannie and Freddie operate today, going forward, there is no loss,” Frank wrote. “The losses are the losses that occurred before we took the first step towards reforming them – we the Democrats – and nothing we could do today will diminish those losses.” 

In Wednesday’s earnings report, however, Freddie Mac said is lost $6.7 billion and was obliged to pay $1.3 billion in dividends on senior preferred stock held by the US Treasury. 

“Our first quarter 2010 financial results were driven significantly by the required adoption of new accounting standards, along with continued weakness in the housing market,” said Ross J. Kari, Freddie Mac’s chief financial officer.

Frank is referring to the Rep Jeb Hensarling's bill that was introduced a few weeks ago, which the Senate amendment is modeled on.  I predict Sen Reid will block the amendment from coming to the floor, and the GOP will have their ads to run in November.

Media Starting to Notice Flaws in the Senate's Financial Reform Bill

If you need a primer on current financial reform legislation, the Washington Independent has a good summary; both Republican and Democratic proposals are fairly similar. Daniel Indiviglio at the Atlantic sums up a NYT article that quotes experts questioning whether Sen Dodd's bill really gets to the causes of the economic meltdown, boiling it down to 3 glaring deficiencies:

• The bill does not deal with Fannie or Freddie, the GSEs that played a major role in the crisis (the Republican proposal begins to deal with the GSEs; Democrats say this needs to be addressed in a separate bill)
• The bill does not address the credit crunch that led to investor panic; banks were not able to turn over their short term debt
• The bill leaves it up to regulators to determine capital reserves and leverage requirements at a later date. There are concerns that regulators will be less aggressive as the economy recovers.

Erza Klein links to another proposal at the Econlog:

Here I'd direct you to Arnold Kling's 8-point FinReg fantasy. Kling is an adjunct scholar at Cato and a former economist at the Federal Reserve, but his plan -- which includes getting Fannie and Freddie out of the mortgage market, breaking up big banks, and making derivatives less attractive by deprioritizing them in bankruptcy hearings -- doesn't read like the Republican plan and it doesn't read like the Democratic plan.

The argument over the policy of financial reform -- which is distinct from its politics -- is not between Republicans and Democrats, or even liberals and conservatives. It's between people who think the financial sector needs to be changed and people who think we just need to give the regulators more information, power, and instructions so they can look after it better. Kling is a libertarian and I'm not, but we're probably closer on this than I am to either the Democratic or Republican proposal. 

Kling's proposal gets the government completely out of the mortgage market, except for some tax vouchers to the poor. He also ensures creditors hold debtors responsible for their behavior, which is what should happen in a functioning market economy: 

5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value--or lack thereof--of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don't think that getting them onto an organized exchange should be sought after as an end in itself.

Another alternative worth considering is in John Taylor's op-ed via the WSJ, "How to Avoid a Bailout Bill", which outlines changes in bankruptcy law to be able to deal with systematic risk type institutions quickly.  


I'm not really optimistic a "Council of Federal Regulators" will be able to stop systematic threats, or that current draft legislation will really end bailouts. Congress, current regulators and the Fed did not see the need to fundamentally change the rules in an attempt to avoid the crisis. Erza Klein points this out today when he posts to a transcript of Alan Greenspan and other Fed members in 2004, dismissing their own data on the housing bubble, believing economic fundamentals were sound.  Klein writes:

But this is why you need to be very careful with the idea that regulation plus information is sufficient. We had regulators and they had information. And it proved totally insufficient. When I asked Sen. Mark Warner how the bill would have stopped the crisis, the first thing he brought up was the Office of Financial Research, which is there to distribute real-time information. Maybe the OFR would put the dots together and maybe it wouldn't, but there's a serious chance that even if it did, the top-line regulators would find reasons to ignore the conclusions of these nameless quants who don't understand the sophistication of the risk analysis being performed on Wall Street, or the anger that the president and the Congress and the Wall Street Journal editorial page will turn on any regulator dumb enough to try and interrupt the good times based on a graph and a theory.

Unfortunately, I don't think we're going to get anything as sensible as Kling's proposal due the politics of upcoming midterm elections.