By G.L.C., on October 6th, 2008
The Federal takeover of Fannie Mae and Freddie Mac has not put an end to the woes of these two companies. The two companies have now received subpoenas from federal prosecutors in New York seeking information on the companies’ accounting, disclosure, and corporate governance. The two companies have also received requests from the Securities and Exchange Commission that they preserve documents.
The investigation focuses on activities starting in 2007. The bookkeeping practices of the two companies have always been questioned by critics. In fact, a Fortune magazine story said new accounting procedures at Fannie Mae masked potential losses on bad loans.
Accounting irregularities are nothing new to Fannie Mae and Freddie Mac. Both have had to restate earnings in past years following discoveries by federal regulators of irregularities on the companies’ books. Few years back, both companies were forced to restate billions of dollars in earnings after federal regulators discovered accounting irregularities at both companies. The scandal led to the replacement of the companies’ top executives. Freddie’s former chief executive, Gregory Parseghian, was ousted in December 2003. Fannie Mae CEO Franklin Raines and Chief Financial Officer Timothy Howard were swept out of office a year later.
Fannie Mae has also paid a record $400 million to the SEC in 2006 to settle charges that senior executives fraudulently used “cookie jar” reserves and other accounting gimmicks to hide $10.3 billion in losses from 2002 to 2004 to maximize bonuses.
Freddie Mac paid $125 million in fines in 2003, while earnings between 2000 and 2002 were restated after it discovered derivative-related errors after replacing one of its former auditors, Arthur Andersen. At the time, regulators charged that the company manipulated its accounting to push about $5 billion in earnings to future quarters.
The two companies have been in the conservatorship of their regulator, the Federal Housing Agency, since the government seized them. There is increasing pressure on the administration to hold accountable the companies and top executives. Both companies have said that they will cooperate fully with the prosecutors. The Federal Housing Finance Agency, which controls the companies, said that it will work with the companies to assure a smooth and efficient process and will work with the government agencies as they undertake their inquiries.
The Federal Bureau of Investigation is already looking at potential fraud by these two companies and insurer American International Group, Inc. The inquiries will focus on the financial institutions and the individuals who ran them. A number of members of Congress, including several on the Senate Judiciary Committee, have urged the FBI to be more aggressive in pursuing possible criminal charges against major players in the crisis. If the top executives of these companies were cooking the books, manipulating, doing things they were not supposed to do, then every American taxpayer would want them held responsible.
By Evelyn Black, on October 1st, 2008
When I was a kid (I’m 55 now), I looked forward to holiday dinners because that was when my parents and my grandparents held their traditional “Was FDR a scoundrel or a savior?” debate. My grandparents, who worked for public utilities and, thus, survived the Great Depression with conservative opinions intact, argued for FDR the scoundrel. My father, who worked for a public utility company on the blue collar side and was a union steward, argued for FDR the savior.
The FDR argument was a traditional debate in our household even though the issue itself was a historical one, and though I already knew what every single participant was going to say, I looked forward to it because it was so exciting to see people I loved all vehemently disagreeing without really hurting each other. That’s the democracy I saw as a kid and the one that I miss today; a democracy that encouraged informed debate and tolerated strongly divergent views.
Watching the wrangling in Washington over the current banking crisis reminded me of that debate. The holidays are approaching, lots of Americans are scraping for turkey money, and, in an effort to maintain calm, the press is trying hard to replace the “D” word (Depression! Run for your lives!) with the more awkward but also more calming phrase “possible severe recession.” Once again we are witnessing an autumnal debate about the role of government in business and financial markets. Once again we are witnessing the spectacle of a televised tag team match between Emergency Socialism and Unfettered Capitalism.
Was FDR a scoundrel or a hero?
I don’t know. I do know that our current economic situation is similar in some ways to the one our grandparents (or in many cases, great-grandparents) survived. The stock market collapse that kicked off the Great Depression in 1929 came at the end of a bubble that included high-rolling, unfettered speculation and wildly indulgent personal lifestyles. The Dust Bowl disaster of the 1930s is parallel in some ways to our current climate change and energy crisis, with the displacement and disenfranchisement of huge numbers of people due to Katrina and now Hurricane Ike, and the promise that these kinds of monster storms will most likely become the norm, not the exception.
Like working Americans during the Great Depression, working Americans today are witnessing a rapid increase in costs concurrent with wage stagnation. Unemployment, while nowhere near Depression era levels of 25%, is rising rapidly and will rise even more rapidly should the current credit crunch continue. Just as in the aftermath of the stock market crash of 1929, we have a Hoover-like presidential candidate and an FDR-like candidate, acting out their respective roles in the holiday FDR debate on the national stage.
But there are real differences between our current situation and the one FDR seized by the horns in the ’30s.
The first difference is that American industry was still strong in the 1930s, and gearing this industrial base up for WWII arguably helped FDR turn the country around. Now, not only is U.S. infrastructure shot, our industrial base is gone, too, shipped overseas by multinational corporations in the wake of NAFTA for better profit margins.
A second difference is a loss of skills in the general populace. While my grandmother loved to regale me with stories about how she walked six miles for a 20 pound sack of government-issued potatoes once a week and fed her family of six on that and not much else, today’s consumer would be hard pressed to know what to do with a potato if there wasn’t a Wendy’s nearby. While we can relearn these skills (and many are doing just that: agricultural markets are “ripe for picking,” so to speak, and purchase of vegetable seed skyrocketed this year), in the short term, we have lost a lot of self-reliance and capability as individuals.
But maybe the most striking difference between that time and this one is the lack of a unifying political vision. My parents and grandparents argued about FDR at the Thanksgiving dinner table in part because FDR, scoundrel or hero, was able to bring everyone together for the common good, at least for awhile. Today, we have political machines that are still feeding the culture war in America, drawing a line between red and blue and even underhandedly pitching to white – something we all hoped we were past but clearly are not.
Who has the 21st century New Deal for America?
Hank Paulson doesn’t. But between the stock market’s meltdown after the House rejected Paulson’s bailout plan on Monday and tonight’s Senate vote on their version of a financial rescue package, we are finally hurting bad enough to come together to fix the mess wrought by 25 years of free market capitalism. Even then, freeing up U.S. credit markets will not in and of itself stop the free-fall in home values and home sales. It will do nothing to bring back the tax bases of our major cities. It will not encourage energy independence or investment in U.S. industry and infrastructure, and it will not address the problem of declining wages and rising costs.
Finally, helping Wall Street get its credit markets back on track will not bring together a populace split down the middle over issues of religion and personal lifestyle. It will not stop the feckless political pandering that has brought us to this sorry state.
I think we do need a New Deal, a vision of where America wants to go and who America wants to be on the world stage. Until that emerges, we will be seen only in terms of what we once were, and our suffering will continue. Debt cannot be a nation’s only commodity if that nation intends to prosper.
The parallels to our time and the time of the Great Depression are there alright.
But we haven’t seen anything, yet.
By G.L.C., on September 30th, 2008
In the late 1970s, the total compensation of chief executives in large American corporations was 35 times that of the average American worker. In 1993, Congress limited the tax deductibility of executive salaries to $1 million unless it could be demonstrated that the extra pay was linked to performance incentives. This contributed to the practice in later years of very generous grants of stock options, which helped drive executive pay to new heights. According to an estimate by the liberal research organization the Economic Policy Institute, in 2007, an executive’s salary was 275 times that of the average worker.
Wall Street executives, with their eight figure earnings, are at the top of the corporate pay range. Wall Street firms have a bonus system which rewards short-term trading profits. It acts as an incentive for executives to expand their highly profitable businesses in exotic securities and ignore the risks. The present financial crisis is a direct result of the compensation practices at these Wall Street firms, which encouraged executives to maximize profits and ignore risks. The salary levels at some Wall Street firms are appalling, given their performance. After news of the bailout plan spread on September 19, experts felt that it was only reasonable to impose limits on the salaries of executives of firms that would participate in the bailout. It was they who made those risky bets on behalf of their firms.
As Congress and the Bush administration (represented by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke) deliberated the bailout plan before it was rejected by the House on Monday, lawmakers felt that executives should not be allowed to walk away enriched, especially since many have contributed to the present crisis by taking too many risks. There were calls to impose some limits or approval authority on salaries of executives whose firms seek help.
Presidential candidates Barrak Obama and John McCain have both called for limits on the salaries of such executives. There is a fear among many, including lawmakers, that Wall Street’s tarnished titans might walk away with tens of millions of dollars a year while taxpayers pick up the tab.
A Senate draft document calls for a ban on incentive payments that the Treasury deems “inappropriate or excessive” and a “claw-back” provision requiring an executive to give up pay or severance benefits if the firm’s financial results are later shown to be overstated. Other proposals call for a ban on severance payments and allowing large shareholders, with a stake of 3% or more, to propose alternative slates of board directors. This would be an effort to tackle excessive pay practices by opening up and strengthening corporate governance.
Opponents of the proposals say that pay restrictions will discourage hard work and innovation. It would have an overall impact on the financial sector and the economy. Some feel that it would be best to stretch out payments for several years, encouraging executives to pursue the long-term health and stability of the firms they head. However, the salaries are bound to fall. With consolidation, more people would be competing for fewer jobs, leading to lower salaries.
By Evelyn Black, on September 29th, 2008
“OK, everyone, stay calm. Hand over the $700 billion right now, and no one gets hurt. Make a wrong move, and the whole economy goes down! Make it quick, or you can all kiss your retirements good-bye!”
Dialog from an old-fashioned “stick-em-up” Western? No, actually, this drama was playing out in real-time Congress last week as Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and President George W. Bush promoted a $700 billion financial bailout plan to Congress and, I might add, a mob of very angry constituents. The drama ended today with the House of Representatives voting to reject the plan.
Paulson’s bailout plan has forced Main Street and Wall Street into a really ugly confrontation, and if you think I’m overstating this, read the comment sections attached to the New York Times editorials. Those comments are running at around a thousand or more each day. Wading through them, I found not one that said anything remotely resembling, “Thanks Hank! What a great idea! Thank goodness we have a smart guy like you in charge at a terrible scary time like this!”
Before rejecting it, Congress had managed to negotiate some governmental oversight to be added to the plan (the original bailout deal specified no oversight allowed and complete immunity from prosecution) and also negotiated the addition of some provisions for helping homeowners in foreclosure refinance and stay in their homes. Still at issue were CEO salaries and consequences for banks and lending institutions that avail themselves of the Paulson plan to buy up the worst junk on their books: mostly dubious and impossible-to-value mortgage-backed securities, credit default swaps, and other weird, overly creative investment vehicles that threaten to bring the U.S. economy to a catastrophic halt.
What was emerging, as Paulson’s request sunk in, was an incredible amount of public outrage. Initially, the request was for Congress to push the bailout plan through in a day, if not sooner, or suffer dire consequences. It didn’t take long for the American public to start calling their representatives nonstop to let them know that they would, personally, rather suffer dire consequences than hand over $700 billion in taxpayer money to a Wall Street investment banker on the strength of two words: “Trust me.”
Putting dire warnings and assurances of fiduciary responsibility aside, there was no guarantee that this plan (which was literally cobbled together overnight) would work. Comparisons have been made between Paulson’s plan, or, as NYT columnist and Princeton economist Paul Krugman calls it, the “Cash for Trash” plan, and the Resolution Trust Corporation of 1989. The RTC took home mortgages seized during the savings and loan crisis of the late 1980s and sold the homes attached to those mortgages, eventually recouping some of the money lost in the S&L failures. The markets stabilized, and the RTC was widely credited for helping to get the economy back on track.
The original RTC took in $225 billion worth of bad assets and sold them for $140 billion over time, reducing the actual taxpayer cost of that bailout to around $85 billion. But the Paulson plan was widely expected to top $1 trillion for the initial purchases, and there is a big difference between the assets seized then, which were backed by real property, and the assets clogging the books today, which are so complex and poorly constructed that decoding what backs them and where that property might be has become a nightmare in its own right.
No one knows the actual value of these assets, or if they even are assets, and whether they will ever have any resale value. If they are purchased too cheaply, banks will have to declare large losses and may fail anyway. If they are purchased at too great a cost, it amounts to handing over taxpayer money to the very institutions that created the problems in the first place.
Acknowledging the difficulty in valuing and purchasing these junky securities, Paulson’s solution was to hire investment analysts from the private sector to broker the deals and to protect the brokers and the buyers under a cloak of immunity from scrutiny and prosecution. The appeal of such an approach for Wall Street is obvious. On September 19, stocks rebounded insanely, causing even sympathetic investors (the few that remained) to recoil in disgust. But what was the appeal to taxpayers?
The appeal was, “This will stop The Great Depression II from happening.”
Whether it will or won’t, Congress has killed the chance to find out. For now.
By Evelyn Black, on September 26th, 2008
If you watch the news at all these days (and a case could definitely be made for avoiding this habit), then you already know that the United States imports way more cheap stuff from China than it sends over there for sale to the Chinese people. That big difference between the huge amount we import and the tiny amount we export is called the trade deficit, and you’ve almost certainly been hearing for eight years now about how it keeps going up and how that isn’t such a great thing.
What you may not realize, however, is that the recent federal bailout of the mortgage giants Fannie Mae and Freddie Mac stems in part from the strange and delicate trade relationship the U.S. has forged with China; a relationship that consists of lots of imported Chinese goods that Americans buy up with money that is essentially loaned to the U.S. by, you guessed it, the Chinese.
The Chinese do not issue loans directly to the U.S. the way that a bank would issue a loan to an individual. What the Chinese government does instead is buy up U.S. debt, mostly in the form of mortgage-backed securities. The recent tax rebate stimulus package designed to get shoppers out and spending money again to shore up the flagging U.S. economy came largely from this kind of investment by the Chinese in the debt held by American financial institutions.
While it may seem circular and confusing to think of the Chinese actually loaning the U.S. the money to buy Chinese products, the fact is that right now the U.S. government is heavily dependent on this kind of Chinese investment just for the continuation of its day-to-day business. In other words, without Chinese money being poured into the U.S. in the form of securities purchases, our government would experience such a budgetary shortfall, it would have to shut down.
The linchpin in this arrangement, obviously, is U.S. housing values. If the value of the properties backing the mortgage debt purchased by the Chinese remains stable or increases steadily, everything continues to hum along normally (or at least normally on the surface of it). The Chinese have an asset they see as increasing in value (that is, American mortgage-backed debt securities), and the U.S. government has the money it needs for its day-to-day operations. The Chinese make money off of their exports to the U.S. and off of their investments in U.S. housing-backed debt, and U.S. citizens continue to consume the cheap Chinese goods we have grown accustomed to buying.
That’s the U.S. consumer economy in a nutshell, and if it sounds a bit Orwellian, bizarre, and unbalanced, that’s because it is. Nevertheless, that’s how we roll these days, or did, until the housing bubble burst and the values of the properties actually backing all this mortgage debt began to drop precipitously. At first it was only subprime debt that went bad, but that spread to what is known in the mortgage industry as Alt-A debt (which is a notch above subprime and once considered quite a safe risk).
Now even homeowners who are in no danger of defaulting on their mortgages are seeing dramatic drops in their property values due to a badly inflated housing market and the subsequent bursting of that bubble. And as if that isn’t all bad enough, the problem is rapidly spreading to other kinds of U.S. debt: credit cards, car loans, home equity lines, and small business lines of credit.
To put it in just a few words: the actual assets backing U.S. debt are now depreciating instead of appreciating in value, leaving the Chinese holding substantial investments in the U.S. that are looking less and less profitable. The Chinese have been friendly to the U.S. because they are making lots of money from the relationship. With the bursting of the housing bubble, not so much. They have been growing more and more nervous about this fact.
What does that have to do with Fannie and Freddie?
Fannie Mae and Freddie Mac back most of the mortgage debt in the United States, but because they have always had a quasi-governmental status, they have not kept the kind of prudent reserves on hand that a private financial institution would be required to keep to mitigate such losses. As it became more and more clear over the course of the past year or so that Fannie and Freddie didn’t have adequate financial reserves to back the debt they held, the Federal Reserve and the Treasury Department began to talk about a bailout.
It’s a bad thing that housing values are plummeting in the U.S., but it has to happen because they were so wildly inflated during the boom years. That hard correction would be painful for the U.S. no matter what, and we are certainly feeling the pain already in the form of a major economic turndown that looks like it will last at least through the better part of 2009. But what would be even more catastrophic than the pain we are already feeling in our collective national pocketbook would be a decision by the Chinese to pull back on their investment in us. Such a move would literally throw us into a financial meltdown that would make the Depression era look pretty cheerful by comparison.
So, while it may or may not be true that Fannie and Freddie “are too big to be allowed to fail,” what is unquestionably true is that the U.S. government is too big to be allowed to fail, and fail it would without a steady influx of Chinese money.
All of this is more food for thought that I can possibly digest in a single sitting. If you pay close attention to the expressions on the faces of Bernanke and Paulson, you may well detect a hint of dyspepsia there, too.
The day is saved. Again. For now.
And yet once again, in the smoking (and indigestible) aftermath, a familiar and phrase rears its ugly head:
“What next?”
By J.D. Seagraves, on September 19th, 2008
On Monday, the Dow Jones Industrial Average – the bluest of Wall Street’s blue chips – lost 4.4% in a single day. Fannie Mae and Freddie Mac have been “seized” by the government. Oil continues to drop while gas prices rise. Inflation runs high while jobless claims continue to soar and gold falters. What a strange economic cocktail! Let’s look at the issues one by one:
First, “Black Monday.” It was prompted by the announcement that investment-banking giant Lehman Brothers would be filing for bankruptcy protection. This, after a weekend spent trying to negotiate a government bailout. For once, the government blinked. A week earlier, the markets soared on the news that the feds had “seized” control of the mortgage industry through Fannie Mae and Freddie Mac. Smart traders who hadn’t already taken the hint knew that those gains were illusory.
Now how is it that oil can continue to fall while gas prices have been on the rise? Two words: Hurricane Ike. It threatened refining capacity, which has nothing to do with the price of crude oil but everything to do with your pain at the pump. The real question is why does oil keep falling? That’s actually a troubling sign given the inflation being felt elsewhere in the economy. And the answer is: demand is softening…even in the face of monetary expansion. That does not bode well.
Is there really any question why consumer prices continue to rise? It can’t be blamed on OPEC (oil is dropping), or greedy corporations (profits are down), or labor unions (they hardly exist anymore), or the greatest scapegoat of them all, illegal immigrants (they’re moving back to Mexico!). No, instead, we’re finally confronted with the reality that the Federal Reserve creates “price inflation” (higher prices) through monetary inflation (creating new money). Just this past Tuesday, they unleashed another $70 billion into the economy. Think that won’t find its way into the price of your milk? Think again.
That jobless claims continue to rise shouldn’t confuse anyone unless they’ve had an economics class recently. Just three years ago, when I was taking introductory Micro- and Macroeconomics courses, my professors still taught the widely discredited Phillips Curve – the Keynesian idea that there’s a “trade-off” between inflation and unemployment (i.e., if you have high inflation you should have low unemployment and vice versa). Of course, this was objectively destroyed by the 70’s stagflation, and we’re headed there again.
But how is it that gold, presumably a measure of the dollar’s value, is falling even as dollar-denominated consumer prices rise? Well, as I stated earlier, it’s because gold was overbought – with Fed-created fiat money – and became its own bubble. As the Fed continues to inflate, though, look for gold to rise.
By G.L.C., on September 18th, 2008
The present financial crisis has resulted in an increase in the number of lawsuits filed in the country. The mortgage meltdown is forcing financial institutions to leave the negotiating table and turn to the courts to resolve subprime-related disputes with their partners. In the past, large financial institutions often shied away from suing each other, preferring to work out problems quietly because they did not want to jeopardize future business relationships. Now, if the cases filed in the courts are any indication, then these companies are dropping their reluctance to sue each other.
HSH Nordbank AG is suing UBS AG in a New York state court over losses HSH sustained on a $500 million portfolio of collateralized debt obligations linked to the U.S. mortgage market. M&T Bank Corp sued Deutsche Bank AG and others in June to recover more than $82 million it said it lost by investing in collateralized debt that had been billed as nearly risk free. Another lawsuit involved Barclays PLC and the now defunct Bear Stearns over the high-profile collapse of two mortgage-linked hedge funds.
The severity of the subprime losses means that more such corporate disputes are likely to land in court. The stakes involved are so high, and many experts are not surprised about the increase in the number of lawsuits.
The increase in litigation is not restricted to litigation between financial institutions. A study by Navigant Consulting found that the volume of private lawsuits in the U.S. stemming from the current financial crisis has already surpassed levels seen in the aftermath of the savings and loan debacle two decades ago when 559 lawsuits were filed over six years. From January 2007 to the end of June of this year, 607 civil cases were filed in federal courts. These cases related to the meltdown in the subprime mortgage market. More than half of the lawsuits were filed in the first six months of this year.
As the present crisis gets more serious, the litigation will also increase. The result of the study is scary – it shows only the lawsuits filed in federal courts and doesn’t reflect the number of lawsuit filed in the states.
As the present crisis deepens, we are likely to see an increasing number of bank failures resulting in another wave of lawsuits. Eleven banks have already been seized by regulators.
A study by Stanford Law School and Cornerstone Research found the number of class action lawsuits filed against Wall Street firms surged in the last year, fueled by the meltdown in the subprime mortgage market. There was a 43% jump in the number of securities fraud class action lawsuits last year. Forty-seven Wall Street firms sued in 2007, more than four times the number sued in 2006. New York City’s retirement and pension funds for city workers filed lawsuits against mortgage lender Countrywide Financial Corp., claiming the lender misrepresented the risk of its mortgage-backed securities.
An increase in volatility in the market, like the one that is now taking place as a result of the subprime mortgage problems, is directly correlated to an increase in the number of lawsuits filed. If economic conditions were to decline in the future, then a strong resurgence of lawsuits would likely follow.
By Evelyn Black, on September 17th, 2008
OK, I know Lehman Brothers just tanked, Fannie and Freddie have been seized, and AIG has been taken over by the Fed, but can we put all that aside for just a few minutes and talk about me for a change, please? I have liquidity problems of my own, and that being the case, I only have so much patience for Wall Street melodrama anyway anymore. It’s getting exhausting. I mean, seriously, what are are you and I going to do about it right this minute? Won’t things still be totally, terminally screwed up tomorrow? Am I right? Of course I am. So let’s take a little “me” break today for a change of pace.
Here’s what’s going on this month in Evelyn’s life:
Last Friday, I got a letter from the escrow department of my mortgage company letting me know that the dying, rust-belt city where I still own a small house in a bad neighborhood (because I couldn’t sell it after I moved to another state to take a job) has decided to hike my property taxes by $610 a year, thus causing a shortfall in my escrow account. I now have a choice. I can send the mortgage company $610 today, or I can pay an extra $50 each month on the house payment for the next twelve months.
The city, which is in northern Indiana, was once a major manufacturing center but has been decimated in recent years by the fall of the U.S. steel and auto industries. The government there is now in serious financial trouble. The tax base has eroded, companies have moved overseas, businesses are failing, unemployment is off the charts, and now, thousands of people are losing their homes to foreclosure.
Because the situation is so dire, and because the city has already cut essential services to the bone and still can’t generate the revenue needed to maintain normal operations (not public services, just day-to-day government operations), the city has seized on an opportunity and is hiking property taxes in the poorest neighborhoods so that the owners will be forced into foreclosure and the city can then sell the property back to the mortgage companies for pennies on the dollar (plus the cost of the back tax bill).
That strategy is indeed generating a small but steady stream of revenue for my old home town. It is also creating boarded up, bombed-out slum neighborhoods full of squatters, crack addicts, and meth labs, just like inner Detroit or the neighborhoods in Flint, Michigan. My dying city is literally eating itself to stay alive, and appeals by concerned citizens to turn the trend around fall on deaf ears. When there is nothing else to eat, we eat each other. Just shouting, “Stop it!” isn’t effective in such situations, no matter how passionate the shout may be.
“Scrapping” (the practice of pulling scrap copper and steel out of abandoned homes and buildings) has become a huge cottage industry here, and though such break-ins are illegal and the trade is dangerous, it continues to grow. A few months back, two homeless men were killed by other scrappers who wanted their haul. They stole the stolen scrap from the men, killed them, and stuffed them down a manhole. Such is life in the post-industrial Midwest in 2008.
On the block where my little house is located, fully half of the buildings are vacant and boarded up. I had my house on the market for a year and a half, asking only what was left on the mortgage and offering to pay all closing costs, everything negotiable. Not one person ever viewed the house, much less made an offer. The house has a new roof, a new furnace, new siding, and new appliances, and I couldn’t get anyone to even view it, much less make an offer, and this at a negotiable asking price of $39,000.
After a year, my real estate agent started to get testy. “People want nice kitchens and bathrooms. Why don’t you put some money into these two rooms and see if that helps?” I have no money to put into upgrading a house in a slum neighborhood in a dying city; I can barely pay my own bills where I am, and honestly, if no one is looking at the house, what difference would it make if I installed gold leaf appliances? A house two doors down is still for sale for $8900. Four years ago, when I bought this house, it was in a nice neighborhood. A new grade school was built right across the street in 2005. All that doesn’t matter.
So when my realtor asked me after a year and a half of not showing my house even one single time why didn’t I remodel the place, I said, “Why don’t you?”
That was the end of my realtor.
After flailing around for a couple more months once the realtor fled, I was finally able to rent the house to my daughter’s mother-in-law. She likes it there, and renting to her also means that our kids get to keep their privacy. But now, with the tax increase, I pay more on the mortgage than I take in for rent. I still take the homestead deduction because, if I don’t, the property taxes will shoot up to $4000 a year on a house I can’t sell at any price: not for the $37,000 I owe on it, not for $20,000, and not for $4000.
People tell me, “Walk away. Don’t waste another cent.” But I do still see some good coming out of renting it: one less bombed-out house in my town, a place where my daughter’s mother-in-law is happy, the knowledge that I am not directly contributing to the decay of a major urban center. So for now I will pay the extra $50 a month and pray for the best. But I know it can’t last.
Like a lot of Americans right now, I am always one disaster away from bankruptcy. So, apparently, is our entire financial system. That cheers me up a little bit (as in, at least it’s not personal), but it’s hard to maintain my good humor when I keep getting love letters from the city, the mortgage company, the insurance company, and God knows who else. I get depressed sometimes. And now the bank where I took the job (the one that landed me farther north with an unsold home in Indiana) is on a short list of four or five big regional banks most likely to tank in the near future, right behind WaMu.
So, OK, Wall Street is (once again) having a very, very bad week. That’s a problem. Pundits are all over the TV and radio explaining that this promises to be the worst financial disaster since the Great Depression, and that no easy fixes loom on the horizon. A hard correction is in process, they say, and it won’t be finished this year, next year, or maybe the year after that. (A few weeks ago, these same pundits were saying that it was way too early to call the current economic slowdown a recession.)
Here’s what bugs me today: while Wall Street is having its Very, Very Bad Week, Main Street is having a very, very bad yesterday, today, tomorrow, and what’s more, a fairly miserable foreseeable future. For every Bear Stearns that goes down, thousands of cities lose jobs, tax income, and infrastructure. For every Lehman Brothers that cashes in, millions of people like you and me lose homes, cars, and retirement benefits. For every AIG that goes bust by betting high on the wrong horse, another couple generations of kids can kiss college and all hope of progress goodbye.
So yes, I’m worried about Wall Street.
What I want to know is, when will Wall Street worry about me?
By G.L.C., on September 16th, 2008
It has finally happened: the federal takeover of Fannie Mae and Freddie Mac, which together own or guarantee almost half of the $12 trillion home mortgage debt. The takeover came after inspectors poring over the books of the two companies concluded that the accounting methods used by Freddie Mac had overstated the capital cushion of the company. The methods used to bolster the capital cushion have caused serious concerns among regulators. Freddie Mac’s portfolio has many securities backed by subprime loans, but the company has not written down the value of these loans to reflect the current market price. The two companies have also inflated their financial positions by relying on deferred tax assets – Fannie Mae’s worth increased by $36 billion and Freddie Mac’s by $28 billion. Without tax deferred assets, the value of both companies would fall below the regulatory requirements.
The takeover is being seen as necessary to help stabilize the mortgage industry in the short term. But it does not answer the all-important question of how best to finance home mortgages in the United States.
The lender’s retention of credit risk and maturity matched finding are two key characteristics of safe, efficient, fixed rate mortgage lending. In the mortgage market, these two characteristics are missing to a great extent. Lenders have used the securitization process to pass the risk to others. The transaction cost of securitization is high, particularly if the mortgages are refinanced at a lower interest rate. Maturity mismatching has been prevailing at most lenders, including Fannie Mae and Freddie Mac, since the early 1980s.
One answer to the question is to introduce covered bond financing for mortgages. These bonds are on balance sheet borrowings and secured by mortgages owned by the issuer of the bonds. The lender can safely hold on its balance sheet the fixed rate mortgage it has made.
Covered bonds are new to the United States. Only two lenders – Bank of America and Washington Mutual – issue them. But in Europe, they have been issued for over two centuries. Today there are approximately $3 trillion of these outstanding in Europe. Since these bonds are on balance sheet borrowings, it acts as an incentive for good lending decisions: the lender would be stuck with lending errors.
The authorities are now taking steps making covered bonds more popular. The United States Treasury has already issued a set of best practices for issuing covered bonds. New Jersey Rep. Scott Garrett introduced a legislation for providing statutory protection for investors of covered bonds similar to the protection enjoyed by investors of covered bonds in Europe.
Covered bonds have the potential to fund a significant portion of the $10 trillion outstanding in home mortgages today. With covered bonds, the lenders need not sell their fixed rate mortgages into a secondary mortgage market. Instead, they can safely keep their mortgages.
The federal takeover of Fannie Mae and Freddie Mac has only demonstrated that the present mortgage infrastructure is inefficient and extremely risky. The introduction of covered bonds in such a scenario is a welcome step in the right direction.
By G.L.C., on September 8th, 2008
There seems to be no end to the foreclosure crisis. In fact it is likely to get worse.
Option Adjustable Rate Mortgages (ARMs) allow homeowners to choose a low minimum monthly payment typically for five years. The low monthly payments often fall short of the interest due on the loan. The difference is added to the loan balance. After five years, the loan is recast, and the monthly payments are increased to ensure full repayment of the loan by maturity. Option ARMs were originally designed for self-employed people with fluctuating incomes and gained popularity with other workers during the peak of the real estate boom in 2004, when rapidly rising home values would have otherwise kept many buyers out of the market. It peaked in the first three quarters of 2006, exceeding 15 percent of the value of all first mortgage originations, according to data from the Mortgage Bankers Association.
According to a study released by Fitch Ratings, over the next two years, $96 billion of such mortgages sold with initial flexible payment options will switch to more stringent terms. The switch will hike the homeowner’s monthly payments by about 60%. This can result in more than double the number of homeowners falling behind on their mortgage payments on such mortgages issued between 2004 and 2007. Late payments and defaults on such mortgages are already as high as 24% in some areas. The potential average payment increase on recasting loans was 63% or $1053 extra due each month. Most of these mortgages will not reach the five year period until after 2010, but many of these mortgages have a limit on negative amortization generally between 110% and 125% of the original loan amount. And when the homeowner reached this limit, the mortgage may be recast much earlier.
The combined impact of payment shock, declining home prices, and restricted availability of mortgage credit may leave many homeowners with such mortgages unwilling or unable to continue making the monthly payments.
Optional ARMs have been a boon to many homeowners who otherwise would not have been able to own homes. But now it has become a ticking time bomb waiting to explode. Lack of legislation to regulate such mortgages is one of the reasons for the present state of affairs. But the sad part is that such mortgages would not have been possible without federal laws passed in the 1980s – the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the Alternative Mortgage Transactions Parity Act of 1982 (AMTPA).
DIDMCA abolished state usury caps that had limited the interest rates banks could charge on primary mortgages – and, in the process, gave banks more incentives to make home loans to folks with less-than-perfect credit. Before AMTPA, banks were barred from making anything but the conventional fixed-rate, amortizing mortgages. AMPTA lifted those restrictions, giving birth to all the new and exotic mortgages that have so many homeowners in trouble today, including optional ARMs. There were no substitute regulations to make sure these new mortgages didn’t turn out to be exploitative.
While it’s too late for some homeowners, efforts are being made by the Congress. An October 2007 report put out by the Senate and House’s Joint Economic Committee (which is chaired by Sen. Charles Schumer of New York) recommended that underwriting standards be tightened on adjustable-rate mortgages. The report suggests that the federal government should require lenders to determine that the borrower has the ability to repay a loan at the fully-indexed rate and assume fully amortized payments.
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