By Claus Vistesen, on October 27th, 2009
Sorry for the hiatus, but I am preparing a large note on the ECB, whether it is conducting QE or not, what QE at the ECB is, and finally what the prospects of an exit strategy is. This has taken most of my time the last week. I will be posting this report shortly. Meanwhile, I will leave you with the following fresh report from the FT about the earnings derived from the ECB’s open market operations (emphasis is mine) which is naturally, although not directly, related to my analysis;
The European Central Bank has made up to €1bn in extra profits from crisis-related emergency lending, but its caution on unconventional policy measures has curbed potential earnings, analysts estimate. Extra liquidity pumped into the eurozone banking system since the collapse of Lehman Brothers last year has probably generated an extra €900m ($1.5bn, £780m) in profits so far, according to calculations by Goldman Sachs.
Some €300m of the total has been generated since June, when the ECB provided €442bn in one-year loans in its biggest liquidity providing operation. The extra profits are on top of the sums that the ECB normally makes on its market operations. Although the interest rate currently charged by the ECB – 1 per cent – was the lowest in its 11-year history, revenues “remain juicy because of the quantity of liquidity that banks keep hoarding”, said Natacha Valla, European economist at Goldman Sachs in Paris.
From last October the ECB has been meeting, in full, eurozone banks’ demand for liquidity. Ms Valla argued, however, that by sticking largely to using policy instruments already in its armoury the ECB had forgone potentially far higher margins.
Profits on the ECB’s programme to buy €60bn in covered bonds – low risk assets issued by banks and backed by public sector loans and mortgages – could be dwarfed by those on schemes launched by other central banks, which have involved higher risk. The Financial Times reported last month that the US Federal Reserve had made a $14bn profit on its crisis loan programmes, with its purchases of commercial paper among its most lucrative operations.
Instead, the ECB has created arbitrage opportunities for eurozone banks, which have used liquidity provided by the central bank to buy large amounts of government bonds, including from some of the smaller eurozone countries and riskier assets. These, in turn, can be used as collateral to raise fresh funds from the ECB. Eurozone banks’ holdings of euro-denominated government bonds have increased by more than €200bn since last year.
By Bron Suchecki, on August 11th, 2009
Amusing read from Unqualified Reservations (UR) blog. Introduction comments:
Here at UR, “economics” is not the study of how real economies work. It is the study of how economies should work – in other words, of how sound economies work. Sound economies, as we’ll see, are also stable economies.
Since there are no economies on the planet which are even remotely sound, nor is there any prospect of any such thing appearing, this discipline cannot conceivably be empirical, quantitative, or worst of all predictive.
Readers familiar with Austrian economics will find much to skim, especially at the start, but should also watch out for nontrivial differences in the origin of money and the structure of the loan market.
By Stephan Zimmermann, on October 27th, 2008
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.
By Evelyn Black, on October 20th, 2008
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.
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.
By Evelyn Black, on August 11th, 2008
According to a New York Times business editorial published on August 5th, when the Federal Reserve recently asked for comments on its proposed rules on abusive credit card practices, it received over 56,000 responses. Most of the responses were from credit card customers who were enraged over practices such as arbitrary interest rate hikes based on factors other than the customer’s payment history, moving up due dates and shortening payment periods, and all manner of exorbitant fees.
The NYT editorial urged the passage of a consumer’s rights bill sponsored by House Financial Services Committee Representative Carol Mahoney, a Democrat from New York. Her bill would prevent credit card companies from arbitrarily raising interest rates on a balance incurred under an old rate and would stop the practice of “universal default,” now common in the business, which allows credit card companies to hike rates on a card if that customer pays a completely unrelated bill to another company late.
The bill is a good start, but of course banks are fighting it ferociously, despite its fairly modest restraints. This resistance by the industry to any oversight or regulation raises the question of whether practices which used to be considered usurious or unethical have become “normal.” Has the financial services industry mainstreamed abusive lending to the point that banking has completely lost whatever moral compass it might once have possessed?
I think the answer is clearly yes. Of course it has. But there are always reasons, and some of them require systemic changes that will not be accomplished without bloodshed.
At the top of the list of factors that motivate abusive lending (besides greed, which you can really only say so much about before you’re out of things to say about it) is the trend towards larger and larger corporations and the selling of debt. In the not-so-olden days, if you wanted a credit card, you went down to your local bank or credit union, where they actually knew you, and you applied. If you had a good history with the bank and a steady job, they would issue you a card with a low limit and a decent interest rate. They’d handle the underwriting and the billing themselves. If you screwed up, you could go down there and talk to a person.
Today, Bank of America, Citigroup, and Chase issue most of the credit cards in the U.S., and they are huge. The banks that they have not yet swallowed up are not small either. Huge financial institutions can take huge credit risks and absorb the damage in the form of fees, increased interest, and the sale of bad debts. Because of this, underwriting standards have become much more lax and usurious fees and rates have developed to offset the risk.
Another factor influencing abusive lending is the outrageous salaries now payed to CEOs and the unrealistic expectations of stockholders who pay them. A CEO should answer to stockholders and customers, not just stockholders. People who buy stock have come to expect ridiculous returns on their investments, and the CEOs they employ are judged and paid according to whether or not they deliver those ridiculous returns. So long as this corporate culture prevails in the financial industry, regulations will be skirted and customers will be fleeced. The money has to come from somewhere, and it’s been trickling upward for some time now.
A third factor influencing abusive lending practices has been the government practice of encouraging spending in the absence of money. I know that sounds stupid. It is stupid. But we hear it all the time. We’re bombarded with, “Are consumers consuming? How much are consumers consuming? What if consumers stop consuming? This is a consumer economy! Consume! Buy stuff! Buy more stuff!”
Most Americans got tax rebate incentives this year in an effort to get them to buy stuff. Many people saved the money, put it in their gas tanks, or fueled up for winter heat in the dead of July, foiling the hopes of economic stimulus through conspicuous consumption.
Last but not least, lower incomes and rising costs encourage abusive lending practices. When people don’t make enough money to meet their basic needs, they will accept terrible lending terms to get by, especially if these terms are easy to get. In effect, Americans have been doing just that with credit cards for the past year, especially since the subprime mortgage crisis hit and many home equity lines dried up as a source of ready cash.
Our healthcare system has become so completely unattached to any kind of sane fee structure that people  who spend a day or two in the hospital and who have health insurance can suddenly be deluged with bills from all over, leaving them thousands of dollars in debt before the problem is even successfully treated. All of these bills come with the words “Due in full on receipt.” Put them on a credit card and suddenly you can add as much as 30% interest to that debt. It doesn’t take very many emergencies to sink an ordinary family.
So credit card reform is overdue, yes it certainly is. But the larger issue is, why aren’t we focusing on the underlying problems that lead people to lean so hard on abusive unsecured lending?
If we are to have a consumer economy, it strikes me that what we need first and foremost is a pool of people who make enough money to cover their basic needs with a bit of surplus left over to spend on consumer goods. That means good jobs, a healthcare system that works for everyone with a sane billing system and fees ordinary people can afford, and lenders who take their fiduciary responsibility seriously and don’t promise outrageous returns to stockholders or run up billions with risky schemes while chasing an impossible profit expectation.
Regulation and reform can solve part of this. But without jobs, healthcare, affordable housing and food, and a market that works for everyone, not just the rich, we will just get more of the same old wolves in fluffly new clothing.
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