Will companies that issued derivatives based on bundled student loans be the next financial dominoes that will require a government “bailout”? The country’s long dedication to education makes it a virtual certainty.
The emphasis of the role of government in education predates the establishment of the United States as a country. As early as 1642, a year before the founding of Harvard, laws of the Massachusetts Bay Colony broke with English tradition of purely private education and introduced a role for the state. The law essentially suggested that the colony’s government would assume the duty of teaching children if parents failed to do so.
A century later, the new Congress of the United States enacted the Northwest Ordinance of 1787. It set forth the role and obligation of the state in education. Article 3 of the Ordinance stated that
Religion, morality, and knowledge, being necessary to good government and the happiness of mankind, schools and the means of education shall forever be encouraged.
Early in the 19th century, Horace Mann took a leading role in the advancement of public education. Both as a Senator from Massachusetts and later as Secretary of the State Board of Education in 1837, Mann was instrumental in establishing textbooks and libraries, doubling the wages of teachers, and securing state aid for education. He argued that the country’s wealth would increase by educating the public and should be borne by the taxpayer. He was immensely successful in the task. Mann ultimately became president of Antioch College in 1853, six years prior to his death.
The fundamentals for universal public education were established and accepted on both a private and state level. However, it took nearly three quarters of a century, in 1935, for direct federal government loans to be debated. First, government student lending began on the state level when Indiana initiated the waiver of fees to students who successfully competed in statewide tests.
By 1944, the Serviceman’s Readjustment Act (commonly known as the G.I. Bill) was passed. It was the first legislation to provide direct aid for students on the federal level. The bill was amended and expanded following the Korean and Vietnam conflicts. Now called the Montgomery G.I. bill, it forms a crucial benefit to men and women voluntarily joining the military services.
The next half century saw a rapid rise in various federal, or federally-guaranteed, student loans and grants. Loans are to be repaid at subsidized low interest rates, while grants are outright gifts, requiring certain criteria and qualifications.
Some examples include:
- National Defense Education Act was launched after Russia orbited Sputnik I in 1958. It was centered on science, mathematics and language. The federal program is now called the Federal Perkins Loan program for low-income students with ten years to repay at five percent interest.
- The Health Professions Educational Assistance Act 1963 for medical and health program students was later broadened to add scholarships in addition to loans.
- The most significant and sizeable is the Federal Stafford Loan Program. It was initially passed by Congress in 1965 as the Guaranteed Student Loan Program. The program used private banks and other lenders, guaranteed by the federal government.
- Outright grants, such as the 1965 Educational Opportunity Grant Program and the 1972 Basic Educational Opportunity Grant, now known as the Pell Grant, consist of outright gifts to students in low income brackets. Eligibility is based strictly on need.
Later yet, government educational funding started to be offered to middle and upper income families such as the 1978 Middle Assistance Act and the 1981 PLUS loans.
Finally, loan consolidations and the William D. Ford Direct Student Loan Program of 1993 expanded loans available directly from participating schools.
As the population increased, and students availed themselves of the increasing variety of grants and loans, so did defaults on student loans.
A report published in October 2007 by Education Sector, an independent non-profit, non-partisan think tank, shows that student loan default rates were approximately five percent. Twenty percent, the largest percentage of those defaulting, owed $15,000 or more after attaining a four-year undergraduate degree.
According to the report,
Black students who graduated in 1992–93 school year had an overall default rate that was over five times higher than white students and over nine times higher than Asian students. … Hispanic students’ overall default rate was over twice that of white students and four times higher than Asian students. (www.educationsector.com)
The current financial crisis offers some serious food for thought.
Most significant is that, unlike mortgages, student loans have no underlying asset value. While defaults on mortgages have the backing of real estate – no matter if it has depreciated in market value – student loans are unsecured. Recourse to recover default payments may exist through attachment of wages and other measures, including tracking of an individual through IRS records, but has no tangible value except the student’s future earning power.
Despite the high-risk exposure, private firms in the student loan industry, such as SML Corporation, generally known as “Sallie Mae,” realized some $18.5 billion in derivatives sales in 2007. According to Bloomberg.com on October 22, Sallie Mae lost $185.5 million for the third quarter, compared to $344 million year-to-date. The company increased contingencies for bad student loans by some 31%. It also had extraordinary legal expenses in connection to a failed sale of the company to a third party. The stock declined from a high of $48.24 to close at $4.50 October 22, year-to-year.
According to Bloomberg, SLM “is partly insulated from the crisis because the company’s loan portfolio is 82 percent government guaranteed. The U.S. Department of Education is offering funding for those loans through July 2010.”
SLM Corporation owns or manages some 10 million student loans in addition to its ancillary businesses of college savings accounts and collection agencies. It was originally formed in 1972 as a “government-sponsored entity” similar to Fannie Mae and Freddie Mac. It became a totally independent company in 2004.
The question remains: if SLM Corporation’s management underestimates its potential student loan defaults and overestimates its cash and asset positions, will the federal government be in yet another “bailout” mode?
The history of government’s historic and stated position regarding education is clear. It remains for legislators to determine how best to reduce or eliminate student loan defaults. Don’t let the fear of college debt keep you from getting your degree. See the affordable degree options available at Belhaven College.
Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.
Why, oh why, did the biggest financial crisis since the Great Depression have to hit during a presidential election year?
The ‘Fear Index’, also known as the VIX (or, officially, the Chicago Board Options Exchange Volatility Index) is a financial tool that measures market swings or volatility. The higher the VIX goes, the scarier the market looks, and the more panicky investors feel. Until very recently, few people had heard of the VIX and even fewer cared about it, but ever since the credit crunch took hold a few weeks back, the VIX has been a staple number on nightly cable news channels. On October 17, it hit 70.3, the highest fear rating ever recorded since the VIX was first introduced in 1993.
I don’t know about you, but I don’t really need a VIX rating to convince me that people are scared. Insiders and investment specialists do have a practical use for an exact day-by-day volatility measurement. People like me, however, who write for economics blogs and read the financial sections of the major newspapers for sport, tend to get a general sense of the mood of the country simply by watching how many people in our own communities are completely melting down at any given moment.
Here’s a basic formula I’ve devised that any nonprofessional can use to measure financial fear:
1) Take the number of personal friends and family members who have lost at least 30% of their 401(k), and 2) divide that by the number of emotional outbursts about the economy that you have personally fallen victim to on the day you are measuring, then 3) multiply that final figure by the chocolate available in your household by 10:00 p.m. on any given weeknight, and 4) eat all the chocolate before someone else in your house gets to it.
Perform that equation and I guarantee you will discover that Americans are pretty scared right now.
Sadly, fear is a big stick that can be useful in political campaigns, especially with only days left until November 4th. Think you might need some help with that adjustable rate mortgage pretty darn quick? Socialist! What, do you think the government is supposed to wipe your chin and put you to bed! On the other hand, do you think you deserve the tax breaks you got under George W. Bush for finally, after 50 plus years, making it to a 50% income bracket? Fat cat! What are you, some kind of AIG executive or something? I’ll bet you eat homeless people for breakfast, you scoundrel!
The rhetoric surrounding the already significant economic mess is off the charts emotionally right now, and I submit it does not help the current situation one bit. What can we make of the term ’socialist’ in an environment in which the U.S. Treasury has just admitted it is considering nationalizing the banks? Which is more ’socialist’: a nationalized banking system, or a universal healthcare system? Don’t taxes by definition always redistribute wealth (unless we’re talking about a flat tax, which we aren’t)?
On a related note, if people who earn over $250,000 are actually about to be financially eviscerated by Barack Obama’s plan to rescind the Bush tax cuts, how is it that Cindy McCain paid just 20% of her 2007 income ($2 million of a total income of $10 million) but my household got stuck paying 27% on a microscopic fraction of that amount? OK, I know that question isn’t entirely logical, but it does beg a related question: Are taxes really the central issue here? Or do we just need access to much, much better accountants?
The economic political waters are about as muddy as they can get right now, and that’s useful because confusion and rhetoric throws people back on their own fears and emotional prejudices instead of their capacity for rational analysis of the issues at hand.
I’ll be frank: I have no clue what is going to happen next.
There, I said it.
You know, there are people in the world who spend years and years in Zen meditation practice just to someday, hopefully, somehow, train their minds to live completely in the present moment. Here in America, we’ve suddenly been given that gift free of charge by means of a financial meltdown. If we want, we can choose to simply admit that we are at a completely unrecognized moment in historical time, that no one is certain how this is all going shake out, and then we can just wing it, as it were.
That’s what will ultimately end up happening anyway.
In Zen meditation, when practitioners get caught up in projecting what might or might not happen and in thinking so fast it starts to make a soft whirring noise inside their own heads, the Zen master will often come up behind that practitioner and whap him or her upside the head with a big stick to snap that person out of it. Right now I see an excess of stick wielding Zen masters and a shortage of humble practitioners. If one more Zen master starts in on my own head, seriously, I’m going to…
Well, I’m going to do exactly what I’m currently doing: baking lots of chocolate things and eating them while I still can.
Here’s the scoop (as I understand it): We are either in for the hardest, longest recession in U.S. history or a mild downturn of one to two years followed by complete recovery. We are either about to become a socialist nation with requisite neo-WPA posters in every heavily-taxed home, or else we’re about to give the obscenely wealthy all the rest of our money and stuff, whatever little we have left, even our cats. These dueling outcomes will destroy us by fire or ice, but the important thing for us to understand is that, either way, we will indeed be destroyed.
No wonder people are scared!
I submit we may soon be looking at C) None of the above.
In the meantime, keep your stick to yourself, would you please?
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More than 20 countries have set up sovereign wealth funds while a dozen more have expressed interest in establishing them. Many of these sovereign wealth funds are picking up stakes in U.S. companies, which is raising concerns about the need for regulating them. Up until the $700 billion bailout, which effectively is a U.S. Treasury-directed fund, the United States did not have a sovereign wealth fund.
This fund is the world’s largest, beating the $600 billion sovereign wealth fund of the oil-rich emirate of Abu Dhabi in the United Arab Emirates.
The fund has many characteristics of sovereign wealth funds. It endorses the latest trend – the most powerful financial entities are not risk-happy investment banks but state-sponsored investment entities that are more cautious.
So far, the United States government has stayed away from investing in the markets. The fund presumes that the government must play a crucial role in deciding how best to deploy a nation’s investment capital.
Critics have long argued that sovereign funds be allowed the privilege of holding positions in public companies when the U.S. government did not do so. When the fund was approved by Congress, it took the sting out of this argument. But there is a difference between this fund and sovereign wealth funds. Sovereign wealth funds invest surplus funds, and in many cases they are doing so abroad for the purpose of financial diversification. The money for this fund has to be borrowed by the Treasury: $700 billion. It will only be investing in the United States. It will make no investments abroad.
The mandate to the fund is clear - avoid further financial collapse by extending a lifeline to U.S. institutions hobbled by their exposure to toxic mortgage assets. This is similar to the goal of sovereign wealth funds – advancing national economic goals. The only difference is that sovereign wealth funds openly state that their goals are political. This fund on the other hand seeks the best prices for the assets it buys.
There are some who feel that the fund does not resemble a sovereign wealth fund, but some sovereign wealth funds are beginning to look like the fund. The present credit crisis is not restricted to the U.S. alone. It is having a worldwide impact. There is tremendous pressure of many of the sovereign wealth funds to come to the rescue of home markets that have wobbled in recent months.
The U.S. Treasury fund’s mandate will run out after two years. But the government might have other ideas if, at the end of two years, it has more than $1 trillion in assets - it has the benefit of starting to buy at what may well be the rock bottom. It could become a permanent fund, and its mandate could be broadened to allow it to invest abroad. It would then become a full-fledged sovereign wealth fund.
In an op-ed piece of October 17’s New York Times world-famous entrepreneur and financier Warren Buffet urged American investors to return to the stock market and bet on the long term future success of the United States. “Buy American,” Buffett’s headline reads. “I am.”
The essay was a vote of confidence from a successful guy at a time when America badly needs a vote of confidence from somewhere, anywhere, for anything.
But is Buffett’s advice valid?
The gist of Buffett’s analysis is that when markets tumble, the best time to buy stocks has historically been before recessionary effects hit the broader economy. As Buffett explains it,
During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.
Or, if you need a more shorthand rule of thumb: “Be fearful when others are greedy, and be greedy when others are fearful.”
It’s hard not to like Warren Buffett, a guy who admitted openly on a recent televised interview that 1) his clerical staff pays higher income taxes than he does, and 2) that’s not right. No, he’s not out pestering the IRS to accept additional taxes from him as a mea culpa, but he does go out of his way to encourage Americans, to back American businesses, and to responsibly critique U.S. government policies, all the while managing to still enrich Warren Buffett in the process.
If there’s such a thing as an Everyman CEO, Buffett is the guy.
Still, many analysts see hard times ahead for the U.S. for many decades, not just many years. While it’s true that ‘buy low, sell high’ is still a decent way to conduct yourself in regard to the stock market, it’s also true (and Buffett admits it in the NYT essay) that the U.S. could be in for a prolonged decline before we see a Renaissance. What that means is that unless you are young and careful with what you purchase, this might not be a great time to jump into the stock market: Not because America will never come back–of course it will come back eventually–but because you may or may not be around when it does, and you may or may not pick the company that will thrive in whatever nation America is about to become.
Because the America that existed up until this month? That nation is effectively gone now.
What we are witnessing right now is for all intents and purposes the decline of an empire. How far will we fall? The most positive estimates have the U.S. going through a severe recession with a continued drop in housing prices, rising unemployment, and frequent government intervention through 2010 at least and possibly longer. Those are the optimists.
Pessimistic forecasts invoke Mad Max movies and survivalist nightmares.
I think the truth will, as usual, be somewhere in the middle, with the downturn being more severe than predicted in the press but less apocalyptic than predicted by the conspiracy theorists. Will some people find ways to get rich during these difficult times? Yes. Some people always do. The Chinese sign for crisis is also the sign for opportunity (whether it really is or not!) and so on and so forth.
But will most of us prosper?
Most of us will be lucky to hang on to what we have, and any little bit of money left over will probably not be spent on stocks. Not for a long time.
What that means is that, while the stock market may be close to bottoming out at this point (who can say?), and while certain stocks might be worth buying right now for that reason (which stocks, even Buffett isn’t saying), the ability of most people to buy anything is going to go away for a long, long time, starting this Christmas if not sooner.
We are likely to see a stock market bottom, whenever it comes, followed by years of flat-lined market activity. Gains will be modest and unpredictable. Old standbys will go the way of the dinosaur and some surprising start-ups will briefly appear like shooting stars. Good guessers with lots of cash will be rewarded, but most people will just hang on until whomever we are going to be as a nation emerges clearly out of the 2008 smoke and carnage.
Many have made a credible case that the housing bubble was really an extension of the tech bubble and that, by replacing one bubble with another, we only forestalled and worsened the effects of an economic crisis that has been building for decades, not years. Manufacturing is no longer the foundation upon which the American middle class builds its wealth and security. We have been hemorrhaging manufacturing jobs, and a lingering distaste among many for the abuses of the labor movement that led to the disappearance of Jimmy Hoffa and the coronation of Ronald Reagan continues to keep us from doing what we need to do to shore up wages and opportunities. It’s fine to have beliefs, economic or otherwise, but here’s a fact that flies in the face of fiscal dogmatism: People can’t spend money they don’t have.
Not anymore they can’t, anyway. Not with credit markets frozen and jobs disappearing into the October mist like so many spectral visitors from America Past. With Christmas approaching, retail chains where I live are laying off employees.
Anyway you slice it, our “consumer culture” seems to be DOA. A victim of fiscal cardiac arrest.
So what does America do now? We don’t make things. We’ve lost the tech battle to China and India. We’ve tapped out our oil. Our young people are uneducated and unwell. And the final death rattle of a declining culture–rampant consumerism–is about to become a morality tale told to children around the wood stoves of the future by grandparents who lived through The Crash of 2008.
I appreciate Buffett’s encouragement, his faith in American business, and his willingness to step forward as a cheerleader right now. But I submit that the crisis we are facing is not so much a financial or economic one as it is an identity crisis, the biggest identity crisis we have faced as a nation since the Civil War.
Who are we and who do want to become?
The answers to these critical questions will determine our future prosperity.
Let’s hope and pray we get them right.
A recent article splashed across the front page of the mid-size mid-western city where I live tells a surprisingly unfamiliar story about how ordinary people have pocketed hundreds of thousands of dollars by investing in subprime real estate. Though the current financial crisis has brought about intense discussion about the moral hazard of borrowing beyond one’s means, as well as the irresponsible underwriting that went hand in hand with the subprime borrowing fever, much less attention has been paid to the phenomenon of mortgage fraud.
We know mortgage fraud mushroomed during the boom times of subprime loans. Yet it continues to hover just off the main radar screen, remaining conveniently just outside of public awareness. What exactly is mortgage fraud anyway?
In the case recounted in my local paper, two men–let’s call them Mr. Smith and Mr. Jones–decided to go into the real estate development business by buying up properties in depressed neighborhoods, ‘flipping’ (that is, renovating) the houses they bought, and then selling the houses or renting them out and thereby making a profit on their investment.
So far, that doesn’t seem like a bad idea, especially when credit is readily available and the houses in question are close to a university or a major manufacturing center, or are part of a boom market like some areas in Florida or California. We’ve all watched TV shows on the Learning Channel and on the Discovery Network that chronicle the adventures and misadventures of these flipping entrepreneurs, and many of us have vicariously enjoyed their journeys while eating Cheetos and keeping our own hands soft and clean.
What we don’t see, however, are the house flippers who never flip, never sell, and then default on the loans.
Here’s how it works:
Mr. Smith buys a home in a slum neighborhood for $20,000. He hires an appraiser to value the home at $80,000. The appraiser is committing a crime at this point–the house is not worth $80,000 in anyone’s imagination–but the appraiser and Mr. Smith know each other and are working together to defraud the mortgage industry. Mr. Jones comes along and offers to buy the house (which is actually worth $20,000 or slightly less but is now appraised at $80,000) for $100,000. Mr. Jones is a ’straw buyer’. He doesn’t really want to own the house; he is working with Mr. Smith and the fraudulent appraiser.
Mr. Jones approaches an out-of-state mortgage broker who, not knowing or caring too much about the value of local real estate, is only too happy to make Jones a loan of $80,000 or even $100,000. When Mr. Jones explains he will be improving and then reselling this hot property, the broker envisions repeat business and repeat commissions when Jones buys and flips his other houses.
Mr. Jones then repeats this same process with a dozen or more other properties, all in league with Mr. Smith and his fake appraiser. They pocket the profit on the homes ($60,000 or $80,000 on just the first one alone) and then Mr. Jones proceeds to default on every single mortgage, sticking the out-of-state company who wrote the first mortgage with a $100,000 debt on a nearly worthless house.
Although FBI tables show that mortgage fraud has increased dramatically in recent years, the cases that are actually investigated are really just the tip of a very large iceberg. The FBI doesn’t have anything close to the staff it needs to launch a thorough and comprehensive investigation into this kind of scam because of the sheer volume of cases since 2006 alone.
In my own town, with our own local Mr. Smith and Mr. Jones, neither man has ever been formally charged with anything and neither have paid anything to the mortgage companies that made them the loans. The FBI will neither confirm nor deny whether the two of them are under investigation for fraud. These two men, under their own initiative, have purchased, sold, and defaulted on over 60 homes in the worst neighborhood in this city over the past two years for a net profit of over $1.5 million for Mr. Smith and over $750,000 for Mr. Jones. Their defaults account for more foreclosures in that specific neighborhood than all the other individual foreclosure cases combined.
Both Mr. Smith and Mr. Jones now claim to be disabled and speak to the press only through their spouses, who both insist no wrongdoing has occurred. None of the homes were ever rented or improved. All of them are currently vacant and in a state of serious disrepair. Mr. Jones never took out a single building permit. He claims that he planned to do the work himself but health issues intervened.
Is it possible that these two men are just a couple of enterprising fellows who fell down a flight of stairs at the same rather convenient time? I guess so. Is it likely?
What do you think?
A new and particularly nasty wrinkle on this scheme is called foreclosure fraud. While many different scenarios can be set up, by far the most common involves a ‘foreclosure rescue’ agency that approaches (or is approached by) a longtime homeowner behind on his or her house payments. You’ve probably seen signs posted around your town that say, “We Buy Houses!” Many of these agencies are set up to defraud people in danger of foreclosure. If you try to track them down or investigate them, all you will find is a list of post office boxes and vague nonspecific names attached to no specific person.
Here’s how it works: The foreclosure rescue agency offers to buy the house from the mortgage company about to foreclose on the property and then rent it to the homeowner for a set period of time, during which the homeowner hopes to improve his or her financial situation. At the end of that mutually agreed-upon period (typically two or three years), the foreclosure rescue agency promises to then resell the property to the homeowner on terms they can actually afford. The rescue agency claims to make their money on fees and appreciation, the people get to stay in their house, and everybody is happy.
Except, what really happens is that the minute the homeowners sign the house over to the ‘foreclosure rescue’ folks, the rescue agency runs right out to the easiest lender on the farthest block, cashes out the equity in the home, then disappears off the face of the earth, leaving the homeowner still about to foreclose and owing more in some cases than the house is even worth.
Foreclosure fraud is off the charts in recent years and is growing so fast no one is quite sure how many people have been hit. If you are in danger of foreclosure, read up on some of the most common schemes before you agree to talk about your situation with anyone except your original lender.
As we listen to the most recent attempts to bail out and/or stabilize the U.S. economy, we have also been hammered by lots of campaign rhetoric meant to push our emotional hot buttons by assigning blame for the current mess to individuals we might already mistrust or dislike: certain ethnic groups, minorities, members of certain financial occupations, Wall Street bankers, mortgage brokers, Democrats or Republicans, and so forth. What we are witnessing is a veritable frenzy of blaming, and it gets to be contagious. For some reason, it feels reassuring in times of crisis to find a scapegoat, to blame somebody, anybody, for what is happening. Blame, when properly or improperly placed, always creates the illusion of control. We think that if we find the right person or persons to blame, we can then proceed to hold them accountable and then fix the problem at hand.
While the need to assign blame is completely understandable, especially in an election year, it unfortunately obscures the sheer volume of criminal activity that took place at every level of commerce during the height of the housing bubble. Even at the most basic level–the level of buying a single house–an underpaid local reporter was able to uncover millions of dollars of what was, for all intents and practical purposes, most likely out and out fraud. And that’s just in one small mid-western city. All the poor people on that entire side of town didn’t cause as much damage as those two guys and their fast thinking. And that’s at the very lowest, most transparent level of the whole mess. Now multiply that scenario by every city in the U.S., and square with every level of finance and speculation, and you’ve got the mother of all criminal messes.
So far, few people are going to jail for any of this. But maybe at some point a few should.
At the very least, it’s food for thought.
For at least a year now, ordinary people in the United States (people the press has been referring to as “Main Street”) have known that the economy was starting to slow down at the same time that prices were rising uncomfortably fast.
Now, some economists are finally starting to admit that, yes, the U.S. probably went into recession somewhere around January of 2008. U.S. economic growth is expected to go officially negative by the end of this year, and this negative growth pattern is expected to continue and worsen throughout most of 2009, if not longer, driven by job losses, a continued drop in factory orders, and falling home prices that still have a long way to fall before the housing market stabilizes.
On October 3, the U.S. Labor Department announced that 159,000 jobs were lost in September, much higher than the expected loss of 100,000 jobs. Orders for durable manufactured goods declined by 4%, almost double the 2.5% figure expected by analysts. Even the service sector flat-lined in September, hovering just barely above the 50 point threshold that signals economic growth.
Although the House of Representatives finally did pass the $700 billion credit market rescue package on October 3rd, by the time the bill was at last on its way to the White House for the President Bush’s signature, that same credit crisis had already pushed the State of California into a $7 billion budget shortfall, with the real possibility of not being able to meet payroll this month, and the State of New York into a shortfall of $1.6 billion, expected to worsen next year. California may have to turn to the Federal Reserve to borrow if credit isn’t available by the end of October or else face a total shut down of state government.
It is not at all unusual for economists to declare a recession in retrospect or for consumers to feel the recessionary effects before the experts do. This is partly because economists have varying criteria for labeling an economic slowdown recessionary (two consecutive quarters of negative growth is just one rule-of-thumb) and partly because it takes awhile to accumulate enough data to analyze and declare a trend. So often the effects of a recession are felt long before it is formally announced.
However, this time the economic trouble feels like it runs much deeper; and the unease accompanying the acknowledgment of this trouble feels closer to panic. While caution is almost certainly wise at times like these (Why create panic if taking care with words can restore calm?), it is also true that, at every step of this current economic crisis, experts have erred on the side of minimizing the depth of the turn-down. With each new catastrophe, someone important was out in front of cameras declaring that the housing market was bottoming out and the economy was about to turn around. Each catastrophe was expected to be the last. Until the next catastrophe. The phrase “a river in Egypt” springs to mind.
Eventually, the public quit believing the experts. Soon the public ignored the experts entirely, believing instead that positive spin was all that was really available from such persons: the hard truth was to be found instead in the price of milk, the number of overdrafts in a personal checking account, a declining 401(k) balance marked with a red double-digit loss percentage. Let the experts spin until they puked: the truth is that when the money is gone a week before payday arrives, you don’t need an expert to explain that times are getting tough.
By the time Henry Paulson and a seemingly exhausted, sincerely frightened Ben Bernanke went before Congress (was it really only a couple weeks ago?) with their request for $700 billion right now and a prohibition on any oversight or prosecution, it seemed obvious to all that Wall Street’s unending font of optimism had very suddenly run dry. Wall Street seemed to learn what Main Street had known all year in the space of only a few days. How can that be? Lots of people were asking themselves this same question, all at the same time.
All of which brings me to the current situation and the grotesque chasm that seems to have opened up overnight to separate the folks on Wall Street from the folks on Main Street and to separate Main Street from its supposedly representative democracy. To paraphrase the famous line from Cool Hand Luke, what we have here is not just “…a failure to communicate,” but rather a total breakdown in trust.
So what are we looking at here? A recession similar to the recession of the early 90’s with a light at the end of an admittedly dark tunnel? Or are we instead, as New York Times op-ed columnist and economist Paul Krugman says, truly on “The Edge of the Abyss”?
If you ask Wall Street that question today, you may or may not get an answer that spins. There comes a time when all that is left for anyone to do is breathe and pray and cross their fingers.
If you ask Main Street this question today, you will probably get an earful.
It won’t be pretty.
Neither will the year ahead. Or the one after that. Let’s hope our new leadership has a strong spine and a better plan. We’ll all be needing both.
On October 1, 90-year-old Addie Polk, distraught over her home’s impending foreclosure, shot herself twice in an attempted suicide.
Fortunately, Ms. Polk’s attempt was unsuccessful. Even better for her, Fannie Mae – which had taken possession of her mortgage after numerous missed payments – forgave Ms. Polk’s debt and signed the house over to her, free and clear.
What part of this story makes any sense? A woman shoots herself after falling behind on payments she agreed to make, and, as a reward, she gets a free house? Since when did Fannie Mae, now essentially a wholly owned subsidiary of the U.S. government, get into the Extreme Makeover: Home Edition business?
In 2004, Ms. Polk took out a 30-year mortgage for $45,620 at 6.375% interest. That same day, she also took out a line of credit for $11,380. Four years later, her inability to make her payments had reached the point of foreclosure. Police had made 30 attempts to evict her before the October 1 shooting incident.
Now, you can feel sorry for Ms. Polk all you want. But the fact of the matter is that she took money and agreed to pay it back, and she didn’t. Yes, the lenders may have “taken advantage of her” – only because they knew the government would step in and bail them out if Ms. Polk and others like her couldn’t pay – and yes, the Federal Reserve System creates money and credit out of thin air, which is “predatory” by its very nature. But these were the rules of the game when Ms. Polk took out her loans, and if she didn’t know them, she had no business playing.
What message does Fannie Mae’s forgiveness of this loan send to other people facing foreclosure? Attempt suicide, and if you’re lucky enough to survive, you get a free house? This story is a fitting microcosm for a corrupt system in which lenders are criticized for making loans to people who couldn’t repay them and then are rewarded with a $700 billion bailout as “punishment.”
Under a free market, interest rates would be set by savings and investment. No entity would have the power to create money and credit out of thin air and, as a result, no “predatory” lending could take place. When companies made bad loans, they’d suffer the consequences, and when people took secured loans they couldn’t repay, they’d lose the underlying properties.
The free market is self-correcting. But what we have in America is far from a free market. As one Republican congressman put it, we have “capitalism on the way up, and socialism on the way down.” In order to maximize utility and respect individual rights, we must return to a more laissez-faire form of capitalism where the people who take bad risks – both mortgagor and mortgagee – are made to bear the consequences of their actions.
Evelyn Black wrote a great blog on September 26 explaining the financial inter-connectedness of the U.S. and China. To sum it up, she says that the U.S. imports more from China than it exports to China. This difference, the trade deficit, is made up by the Chinese government’s investment in U.S. government debt. In other words, China trades the U.S. real goods in exchange for paper promises. Now, as the assets backing those paper promises (housing prices in the case of mortgage-backed securities, “full faith and credit” otherwise) are depreciating in value, China’s government is in a pickle. If it dumps its U.S. dollars and dollar-denominated debt instruments on the open market, the value of those assets will fall further and faster. But holding them as they depreciate isn’t an attractive option, either.
I’d like to expand on Evelyn’s article and answer these questions: Why the heck would China put itself in this predicament? Why trade real goods for paper promises? Why put so much faith in the value of the Federal Reserve Note (FRN) and in the ability of the United States’ central bank to maintain the value of dollar-denominated assets?
As a developing (nearly developed) country transitioning from socialist central planning to a market economy, China has relied on the U.S. dollar as a means of stabilizing its own domestic currency, the yuan. For a long time, the yuan was pegged directly to the dollar so that its value went up or down with the FRN. But the U.S. Congress viewed this as “currency manipulation” and threatened high tariffs against Chinese imports if the yuan weren’t revalued. In other words, Congress demanded that China make the U.S. dollar weaker vs. the yuan, which would diminish the trade deficit – at least on paper.
Ever since the end of World War II, when the international gold standard was abandoned, the U.S. dollar has served as the world’s reserve currency. It has been the most stable and widely accepted of the world’s fiat money. But years of monetary expansion have eroded the FRN’s value, and the policies of aggressive debasement of Alan Greenspan and Ben Bernanke have led us to the place we find ourselves today: with the dollar rapidly losing its status to the euro.
What prevents China from switching out of the dollar and into the euro? Again, it holds too many dollars and dollar-denominated assets to make the trade without severely throwing the relationship between the dollar and the euro out of whack. Many other governments are in a similar quandary. And the U.S.’s military dominance still holds sway, particularly over petroleum-exporting countries who are literally forbidden from accepting anything other than the U.S. dollar in exchange for barrels of oil. Just ask Saddam Hussein.
Evelyn said it best when she called the U.S. financial system “Orwellian, bizarre, and unbalanced.” Another word she could have used is “unsustainable.” How and when the system will come crashing down remains to be seen, but my bet is that it happens sooner than most of us are are expecting.
Several questions during the last few days pointed out the obvious: lost in the media coverage of the American financial crisis and the tail end of the presidential election seems to be the fact that there really is news beyond Wall Street and Main Street.
I could not agree more.
For example, how much attention has been paid to the fact that our closest neighbor, Canada, is having its 40th parliamentary election on October 14?
Neither the Liberal nor Conservative Party has a majority in the parliamentary system.
The economy, of course, is topmost on the agenda.
In the Toronto Star, the paper raised the question whether Canada is likely to experience similar problems in its housing boom. The upsurge in housing lasted for more than ten years, although it has somewhat cooled off even before the Bearn Stearns, Merrill Lynch, Lehman Brothers, and AIG debacles.
According to Jim Adair of Realty Times,
Tighter lending guidelines for developers and a lower level of investor participation have reinforced a more cautious approach among home builders. …Households, for their part, are not over leveraged. Home equity as a share of real estate assets has been steadily building this decade, as price appreciation outpaces the rise in mortgage obligations. Canadian households also have little direct exposure to sub-prime lending, which has accounted for only about five per cent of domestic mortgages in recent years, compared to over 20 per cent in the United States. (www.realitytimes.com)
Reflecting the fears and uncertainties of Wall Street, however, the Toronto stock exchange (TSX) on October 2 saw a fall of more than 800 points, following on the events of Monday, September 29.
Further adding to market malaise,
On October 1, 2008, the United States Securities and Exchange Commission issued Release No. 58703 announcing the extension of the temporary easing of restrictions on issuers repurchasing their securities. Issuers listed on a U.S. national securities exchange (U.S. Exchange) are temporarily exempt from the application of certain share repurchase rules under the Exchange Act Rule 10b-18. TSX has granted and is extending similar temporary relief to TSX listed issuers that are also listed on a U.S. Exchange. (www.tsx.com)
That SEC rule extension virtually encourages Canadian companies to repatriate subsidiaries with U.S. exposure.
Other key items on Canada’s election agenda include the environment, the arts, infrastructure, and the nation’s role in Afghanistan.
Unlike the United States with it two-party political system, Canada’ multi-party parliamentary structure assures that dissident or minority parties’ concerns are widely aired. The dual-language nation also airs its major parties in both French and English debates. Interestingly, while some 30% of Canadians didn’t plan to listen to either the Canadian or the American vice-presidential debates, more than 60% of those polled had planned to watch both. The debates were both aired on October 2.
Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. If you would like Stephan to answer your economics-related questions, read his post “Got an Economics Question?” and submit your questions in the comments area there.