Economics 101

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Economics 101: Crisis of Confidence
by Mark Alexander
From Patriot Post Vol. 08 No. 39; Published 26 September 2008
found at: http://patriotpost.us/alexander/edition.asp?id=610

"(Editor's Note: For updated information, see "Bailout v. Workout" -- The continuing crisis. Also see "Commentary on the Financial Crisis" for supplemental opinion on this subject.)

"For years I have been concerned about the regulatory structure that governs Fannie Mae and Freddie Mac ... and the sheer magnitude of these companies and the role they play in the housing market. ... If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole." --John McCain arguing in 2005 for passage of the Federal Housing Enterprise Regulatory Reform Act (S. 190), which he sponsored.

While Sen. McCain is being pilloried by his opponent, Barack Obama, for asserting (correctly) in recent weeks that the fundamentals of most U.S. economic sectors are sound, clearly, Sen. McCain has understood for years that irresponsible lending practices for U.S. housing posed "enormous risk ... to the housing market, the overall financial system, and the economy as a whole."

Obama was out politicking the week the meltdown began (ostensibly itching for a debate that he'd been avoiding all summer), McCain suspended his campaign to work with Republicans in Congress, outlining conditions for an agreement that would both protect the American taxpayer and thwart a meltdown of the U.S. economy. So, "Country First" is not just a campaign slogan...

The enormous risk that Sen. McCain warned of in 2005 has now manifested as a financial crisis of staggering proportions. This crisis can trace its roots to Democrat initiatives to undermine free market banking practices in favor of targeted constituencies.

The Community Reinvestment Act was passed by Democrats of the 95th Congress and signed into law by Jimmy Carter in 1977. It coerced lending institutions to make loans "to the entire community," undermining means testing to qualify applicants for mortgages.

In 1989, President G. H. W. Bush signed the Financial Institutions Reform Recovery and Enforcement Act increasing public oversight of the process of issuing CRA ratings to banks, in the wake of the savings and loan debacle of the 1980s. That helped restore some integrity to the CRA.

However, Bill Clinton's signature on legislation making it easier for minority constituents with bad credit to obtain mortgages really reseeded the crisis.

On 20 November 1994, Clinton signed the United Nations International Convention on the Elimination of All Forms of Racial Discrimination. Article V(e)(iii) of that treaty asserts that all people have a "right" to housing.

A year later, in order to comply with the treaty and win the hearts and minds of millions of low income constituents, he had his Treasury Secretary, Robert Rubin, rewrite the lending rules for the CRA, opening the Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) subprime flood gates.

In other words, mortgage lenders were able to make millions of loans to borrowers who, subject to free market lending practices, would not have been able to qualify for loans.

Clinton's legislation, in effect, applied affirmative action to the lending industry, which is to say that the current crisis is NOT a "free market failure" but the result of socially engineered financial policy by the central government. The mortgage markets welcomed their new customers with open arms, fueling a real estate boom across the board.

These so-called "subprime mortgages," which were offered at variable interest rates, were widely perceived as good investments by financial institutions, which bought bundled mortgages from Fannie Mae and Freddie Mac.

Investors used the high-risk bundled mortgages to secure assets in other markets fueling profits for investment banks and mortgage lenders. The subprime market expanded rapidly and the mortgage instruments were used by other firms as collateral for investments in stocks, commodities and the like.

In 1999, financial analysis by The New York Times noted, "Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.... In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the [thrift industry] savings and loan industry in the 1980's."

Indeed, the article quoted economist Peter Wallison from the conservative American Enterprise Institute, who warned, "If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry."

But the S&L bailout was a drop in the bucket compared to the gathering storm over mortgage lending practices.

In 2001, the administration of George W. Bush raised caution flags about lending by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, noting in its '02 budget request that "financial trouble of a large GSE could cause strong repercussions in financial markets, affecting Federally insured entities and economic activity."

In 2003, the Bush administration upgraded its concern, requesting much stronger oversight. According to testimony by then Treasury Secretary John Snow, "We need a strong, world-class regulatory agency to oversee the prudential operations of the GSEs and the safety and the soundness of their financial activities."

The New York Times reported in September of '03, that the administration's plan was "the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago," and "an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac -- which together have issued more than $1.5 trillion in outstanding debt -- is broken."

But Democrats, particularly Rep. Barney Frank, now chairman of the House Financial Services Committee, would not support additional oversight or restrictions. On 10 September 2003 Frank declared in congressional hearings: "These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis. The more people exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. And even if there were a problem, the federal government does not bail them out."

Rep. Maxine Waters added, "We do not have a crisis at Freddie Mac and particularly Fannie Mae under the outstanding leadership of Frank Raines." (That is the same Frank Raines who directed enormous campaign contributions to Democrats John Kerry and, you guessed it, Barack Obama.)

On 25 September 2003, Frank again insisted, "I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists."

And a week later, Rep. Waters again: "I have sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn't broke. Housing is the economic engine of our economy, and in no community does this engine need to work more than in mine. [W]e should do no harm to these GSEs."

In the Senate, Charles Schumer objected to concerns about the solvency of Fannie Mae and Freddie Mac: "My worry is that we're using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie's mission. And I don't think there is any doubt that there are some in the administration who don't believe in Fannie and Freddie altogether, say let the private sector do it. That would be sort of an ideological position."

In February of 2004, Federal Reserve Chairman Alan Greenspan testified: "What we're trying to avert is we have in our financial system right now two very large and growing financial institutions which are very effective and are essentially capable of gaining market shares in a very major market to a large extent as a consequence of what is perceived to be a subsidy that prevents the markets from adjusting appropriately, prevents competition and the normal adjustment processes that we see on a day-by-day basis from functioning in a way that creates stability."

In 2005, Secretary Snow urgently called for GSE reform, noting that recent events "reinforce concerns over the systemic risks posed by the GSEs and further highlight the need for real GSE reform.... Half-measures will only exacerbate the risks to our financial system."

Fed Chairman Greenspan also warned again, "Enabling [Fannie Mae and Freddie Mac] to increase in size ... we are placing the total financial system of the future at a substantial risk. If we fail to strengthen GSE regulation, we increase the possibility of insolvency in crisis."

It was at this time that John McCain was arguing for passage of the Federal Housing Enterprise Regulatory Reform Act (S. 190), which he sponsored.

But again, Democrats on the Senate Banking Committee thwarted efforts to increase accountability for the GSEs. Sen. Schumer asserted, "I'll lay my marker down right now. ... I don't think Fannie and Freddie need dramatic restructuring in terms of their mission, in terms of their role in the secondary mortgage market, et cetera. ... I think Fannie and Freddie over the years have done an incredibly good job and are an intrinsic part of making America the best-housed people in the world. If you look over the last 20 or whatever years, they've done a very, very good job."

In 2006, Sen. McCain again went to the Senate floor warning, "The GSEs need to be reformed without delay." However, every Democrat on the Senate Banking Committee voted against regulatory reforms.

Now, it is abundantly clear that there was, in fact, a looming crisis, the result of subverting the free market with mortgage subsidies. It is equally clear that Democrats, blinded by the desire to accommodate their special interest constituencies, blocked efforts to get to reform the GSEs.

In October of this year, Bill Clinton admitted, "I think the responsibility that the Democrats have may rests more in resisting any efforts by Republicans in the Congress to put some standards and tighten up a little on Fannie Mae and Freddie Mac."

Democrat Rep. Artur Davis was a bit more direct: "Like a lot of my Democratic colleagues, I was too slow to appreciate the recklessness of Fannie Mae and Freddie Mac. In retrospect I should have heeded the concerns in 2004. Frankly I wish my Democratic colleagues would admit that when it comes to Fannie and Freddie, we were wrong."

Economics as political fodder?

Despite insistence by Democrats on the one hand, that "all is well with Fannie and Freddie," on the other hand, between 2006 and 2008, Democrat candidates, most notably Barack Obama, did what democrats are predisposed to do every election cycle -- they wantonly played the "economic fear card," in order to keep their liberal constituencies in line. One staple of the Democrats' political playbook is the use of scare tactics to rally their dependents.

Obama and other Demos have been dishing out a steady stream of dire economic rhetoric and, undoubtedly, all that economic hyperbole has influenced public perception of, and confidence in, our economy. On that note, I mention again Barney Frank's assertion, "The more people exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses..."

Chances are slim to none that Obama will cease and desist using volatile housing and financial markets as political fodder, but then, few Democrats have ever put country first.

Our economic foundation begins to crumble

By 2008, because of eroding confidence in our economy, the housing market became saturated and free market prices did what prices do when there is more supply than demand -- they began to drop.

The housing "bubble burst" leading to the first big collapse of a mortgage lender, Countrywide, the nation's largest subprime lender. Then banks and mortgage lenders large and small began downsizing, dumping assets and closing their doors, which triggered a further drop in housing prices and mortgage defaults.

A few months later, Bear Stearns filed for bankruptcy. By the summer of '08, Fannie Mae and Freddie Mac, holders of trillions of dollars in mortgages, were bailed out with 200 billion taxpayer dollars. Lehman Brothers filed for bankruptcy, and insurance giant AIG was given an $85-billion taxpayer prop to keep it solvent.

Endeavoring to avert economic disaster, on 24 September 2008, President Bush, addressed the nation with a concise explanation of the unfolding crisis:

"This is an extraordinary period for America's economy. Over the past few weeks, many Americans have felt anxiety about their finances and their future. I understand their worry and their frustration. We've seen triple-digit swings in the stock market. Major financial institutions have teetered on the edge of collapse, and some have failed. As uncertainty has grown, many banks have restricted lending. Credit markets have frozen. And families and businesses have found it harder to borrow money. We're in the midst of a serious financial crisis... So I've proposed that the federal government reduce the risk posed by these troubled assets, and supply urgently needed money so banks and other financial institutions can avoid collapse and resume lending. This rescue effort is not aimed at preserving any individual company or industry -- it is aimed at preserving America's overall economy. It will help American consumers and businesses get credit to meet their daily needs and create jobs. And it will help send a signal to markets around the world that America's financial system is back on track."

President Bush sent to congress a "Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets" authorizing up to $700 billion in Treasury securities in exchange for at risk mortgages. In effect, this proposal was designed to relieve lenders of liability for those mortgages -- which constitute about five percent of all mortgages.

A day later, as Congress debated whether to craft the President's plan into a Democrat-backed "bailout" or the Republican-backed "workout," Washington Mutual Inc. was seized by the Federal Deposit Insurance Corporation (FDIC) after collapsing under the weight of reams of bad mortgages. (WaMu, listing $307 billion in assets, is the largest bank failure in U.S. history. The FDIC sold WaMu's assets for $1.9 billion to JPMorgan Chase & Co., which bought Bear Stearns Cos. earlier this year.)

The serious economic calamity confronting our nation, and the world, is being labeled a "credit crisis." But we are on the verge of a crisis of cascading confidence in the U.S. economy, which, in the absence of aggressive intervention which includes free market reforms, could result in a dramatic recession affecting every sector of the U.S. and, eventually, world economy.

The potential catastrophe looming just over the horizon is indeed that big, and we must all hope that the solution is big enough to interrupt the domino effect already underway. But the "quick action" called for by President George Bush will likely not be forthcoming as Republican and Democrats debate free market v government solutions, respectively.

Of course, a government solution begs the question, "Is the people's confidence in their government is sufficient to thwart cascading confidence in our economy?" In the inimitable words of Ronald Reagan, "Government is not the solution to our problem. Government is the problem." Of course, the only institution big enough to address a problem of this magnitude is the one that created it -- our central government.

Perception v. Reality

Essentially, perception defines value, and the shared confidence in our perception of the value of one major sector of our economy, the housing market, has eroded dramatically.

To understand the notion of perceived value, consider all that paper we call currency. If I walk into a store and pull out one of these pieces of paper with Ben Franklin's picture handsomely printed upon it, the store proprietor will accept that paper in trade for some of his products or services because he believes it to have intrinsic value (which it once did, when it was backed by hard assets -- gold and silver). But make no mistake: The value of that piece of paper is nothing more than it is perceived to be. Thus, if the proprietor's confidence in that perception becomes diminished, he may begin to think such a piece of paper is worth only half its face value, or perhaps nothing at all.

And if my paper is perceived to have no value, I will not be able to do commerce in this or any other store.

For two decades, our confidence in the perceived value of pieces of paper called mortgages has been growing rapidly, and because the prevailing perception has been that a house will be worth more tomorrow than it is today, financial institutions have aggressively enabled buyers to assume mortgages to purchase houses. (Actually, mortgages are now traded electronically as binary data -- value that!)

However, in the past 18 months, confidence in the perceived value of real estate has far outpaced economic realities, and consequently, mortgage defaults have trended upward. That realization has resulted in what now has become a precipitous erosion of confidence in the value of residential real estate, and consequently, housing market values have collapsed in many areas of the country where values were unduly inflated.

While perception can be shaped and molded, reality is finite. The reality, in this case, is that a house and its outstanding mortgage are worth not a nickel more than a buyer is willing to and capable of paying for it.

Thus, the devaluation of mortgages has had an enormous financial impact on institutions that trade in "packaged mortgages," and consequently, on other institutions that trade with them, and, well you get the picture. The dominos have begun to fall.

Moreover in an effort to keep their dominos standing, because of the potential that any new lending would result in additional foreclosure exposure if the housing market continues to decline, banks have restricted lending in order to preserve the capital necessary to cover the cost of a growing number of foreclosures. The constriction of the money supply extends far beyond the housing markets, as loans for business development and expansion are also drying up.

This combination of events creates the perfect economic storm, and the rain is falling.

Consequences of cascading confidence

Confidence in the perceived value of financial instruments, which are the foundation of our economy, is calculated minute by minute by indices such as Dow Jones, Standard and Poor's, and other measures of financial markets. These measurements amount to investor confidence indices, polls of investor perception about the strength and stability of the economy. The stability and direction of these indices are a good indication of investor confidence.

If the indices indicate significant instability of investor confidence, that instability can cause the financial markets to collapse in a single day. (See: "Great Depression.")

Here, it's important to note that the vast majority of Americans are among the "investor class." This isn't just about "the rich." Whether you are a billion dollar securities trader or a day laborer, you are a shareholder in our economy, and have a stake in the welfare of that place called "Wall Street."

With the economic consequences spread so broadly, should also be noted that one major stabilizing factor is, we, the people, have a fundamental desire for stability. Every member of our society, from that billion-dollar trader to the day laborer, is dependent on bread in the pantry and water from the tap.

The plan proposed by President George W. Bush and Treasury Secretary Henry Paulson -- and waiting for majorities in Congress to determine the details -- is an effort to stabilize investor confidence and, thus, our economy.

What about a free-market solution?

We should all hope that Republicans can succeed in crafting legislation that is more workout than bailout, the former relying heavily on implementation of market solutions and accountability, as proposed by Sen. McCain and former House Speaker Newt Gingrich. If not, the cure may be worse than the disease. After all, it was the suspension of free-market principles that got us into this mess.

But I agree with President Bush's comments regarding the necessity of intervention: "I'm a strong believer in free enterprise. So my natural instinct is to oppose government intervention. I believe companies that make bad decisions should be allowed to go out of business. Under normal circumstances, I would have followed this course. But these are not normal circumstances. The market is not functioning properly. There's been a widespread loss of confidence. And major sectors of America's financial system are at risk of shutting down."

If Republicans can extend the debate long enough to let rationality return to the securities markets, then maybe this will be a $200 billion workout rather than a $700 billion bailout.

But this warning from President Bush should not be underestimated: "More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. And if you own a business or a farm, you would find it harder and more expensive to get credit. More businesses would close their doors, and millions of Americans could lose their jobs. Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And ultimately, our country could experience a long and painful recession."

It is worth noting that $200-$700 billion is a bargain compared to the economic cost if the economy spirals into a severe recession -- or worse.

It should also be noted here that there are significant, albeit unspoken, national security implications of a precipitous economic decline in the U.S. Where our economy goes, the world economy follows, and there will be significant national security consequences. For example, if China's economy contracts more rapidly than at present, keeping pace with U.S. economic decline, the consequences will likely be some significant internal and external "mischief" scripted by the Communist Party. As for India and Pakistan...you get the picture.

(Memo to Congressional Republicans: As you consider how to salvage the financial markets, consider repealing Sarbox, the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act of 2002, which has maintained a choke hold on financial institutions and is high on the list of proximate causes for the failure of Countrywide and Bear Stearns.)

Can any of this colossal expense be recovered?

Fortunately, there are real assets backing up these mortgages -- bricks and mortar, and the land upon which the foundations rest -- but this is no "deal for taxpayers."

Yes, the proposal is to exchange Treasury notes for illiquid mortgage-backed securities, the latter being greatly depreciated now that the overinflated and over-leveraged real estate bubble has burst. And yes, most of those mortgages will be sold back to into the market for more than the government purchase price. But, to suggest that the "taxpayers will be paid back" is disingenuous, if not a massive, outright deception.

Congress is going to serve as the "watchdog" over the dispensing and recovery of these funds? Can you say, "fox in the henhouse"?

Even if Congress sets up a "trust fund" in order to use recovered funds to pay down the debt incurred to back financial institutions, we should consider that "lockbox" to be as safe as the Social Security Trust Fund lockbox. Every dime paid into Social Security has been spent on government programs, leaving that fund with a bunch of IOUs.

No doubt, every dime recovered from the private sector will be treated as revenue to expand government programs, and the debt will be left on the books.

To pay for the bailout, Democrats are sure to demand higher taxes from "the rich Wall Street fat cats who got us into this mess." While this mess clearly ended on Wall Street, it didn't start there, but, undeterred, the Democrats will always bank on this observation from George Bernard Shaw: "A government which robs Peter to pay Paul can always depend on the support of Paul."

And, of course, if the current plan to restore economic confidence does not succeed, you know the Demos have "Plan B." Don't ask..."

"(NOTE: For an update, read Bailout v. Workout -- The continuing crisis. Also see "Commentary on the Financial Crisis" for supplemental opinion on this subject.)

White House: Three page Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets

House of Representatives: 109 page LPTAPMR Discussion Draft

The U.S. Senate: 450 page Emergency Economic Stabilization Proposal

Contact: White House -- http://www.whitehouse.gov/contact/ Your Senator -- http://www.senate.gov/ Your Representative -- http://www.house.gov/ Congressional switchboard: 202-224-3121 "