Saturday, October 4, 2008

Marsha Blackburn and the Bailout

I received a form letter from Marsha Blackburn, my representative from the 7th Congressional District in Tennessee, in response to an email concerning her no vote on the bailout bill, where I called her a female Herbert Hoover for voting no on the bailout package.  Marsha explained her no vote on the bailout by blaming poor blacks and Wall Street for causing the mortgage crisis.  Marsha did not use those words exactly but her meaning was the same. There was a law passed in 1977 with bipartisan support that was intended to prevent redlining by banks, meaning discrimination in the grant of home loans to blacks.  

It was called the Community Reinvestment Act (CRA) and Marsha blames that act for the credit crisis and possible upcoming depression or severe recession.  So did Ann Coulter who claims that this law enacted over 20 years ago  substituted a mortgage applicant's ability to make payments with "nontraditional measures of credit-worthiness, such as having a good jump shot or having a missing child named 'Caylee';" the result, Coulter continues, is that "middle-class taxpayers are going to be forced to bail out the Democrats' two most important constituent groups: rich Wall Street bankers and welfare recipients."  

A similar sentiment was expressed by Rush Limbaugh: "The dirty little secret is, folks, that nobody wants to talk about what got us into this problem: loaning money to minorities and poor people who could not pay it back. This was Marxist social engineering. This was affirmative action via mortgage."

This is Marsha's version  of Coulter's opinion as expressed in her letter to me that is not as explicit as Coulter but the meaning is the same:     

"The Community Reinvestment Act of 1977 compelled banks to grant mortgages to low income households - some who could not afford the homes they bought.  In the 90's that Act was strengthened and expanded.  Fannie Mae and Freddie Mac got into the game in the 90's by backing or originating more and more risky mortgages and forming them into mortgage backed securities.  As a government backed entities, Fannie and Freddie implied security and support for loans and products that did not exist.  Wall Street greed took the crisis the rest of the way.     

I believe that the Federal Government never should have intervened in the mortgage market as they did in 1977.  Both parties initiated, propagated, and fostered that intervention.  The system that made constituents happy looked good on the federal books, but it was a bad idea.  It didn't help that federal regulators were either asleep at the switch or ignored by Congress.  Now the chickens have come home to roost.   

The time has come to dismantle the Community Reinvestment Act and privatize or eliminate Fannie Mae and Freddie Mac. Fannie and Freddie execs and their buddies on Wall Street need to be strictly investigated and held accountable.  If normal partisan bickering is allowed to return to this issue, none of this will get done and our economy will continue to spiral.  I, for one, will make this my first priority when Congress returns next year."  

No support is cited for Marsha's claim that low income individuals seeking home ownership were the cause of the current economic crisis.  In Fannie Mae's last 10-Q filed with the SEC, Fannie states that it was the higher loan category, ALT-A, where they suffered the biggest losses and these were from people with good credit scores but who were self employed and could not document income like an employee could do with W-2s.  

ALT-A loans had the name "liars loans" and were actually referred to as such by people in the industry when the loans were being made in the 2004 to 2007 period,  with a wink and a nod.  This is a quote from the 10-Q filing: "Increases in our default and initial charge-off severity rates are both driven primarily by losses on our Alt-A loans in markets most affected by the steep home price declines. 

The deterioration in the credit performance of our higher risk loans is especially pronounced in our Alt-A mortgage book, with particular pressure on loans with layered risk, such as loans with subordinate financing and interest-only payment terms. As of June 30, 2008, our Alt-A mortgage loans represented approximately 11% of our total single-family mortgage credit book of business, and accounted for 49% of our credit losses for the second quarter of 2008."  These are not sub-prime loans. 

Most of the deterioration in credit quality occurred in states where there had been parabolic increases in home prices for several years prior to 2006, including California and Florida, followed by steep declines in values starting in 2007. 

As stated in the 10-Q, "certain states, such as California, Florida, Nevada and Arizona, which have experienced home price declines of 24% or more since their 2006 peaks." were one of the primary sources of the credit problems. These four states represented 27% of Fannie's " single-family conventional mortgage credit book of business as of June 30, 2008 but 42% of its credit losses for the first six months of 2008. What caused the bubble in real estate, the CRA as claimed by Marsha and her soul mate Ann Coulter?

Contrary to Marsha's desire to blame the poor, primarily poor blacks,  the current credit crisis has a more complex origin.

After the Nasdaq meltdown and the bear market of 2000 to 2002, the Federal Reserve lowered the federal funds rate to close to 1% and kept it at that low level from November 2002 to the summer of 2004. This is close to free money and it found a home in real estate, causing the start of the same kind of bubble that had just burst in the stock market. This was the fuel for the real estate bubble.

The seminal event in the train wreck that would start to occur in 2007 happened in 2004 and it has nothing to do with the CRA, Fannie or Freddie. 

In 2004, the Securities and Exchange Commission voted 5-0 (3 Democrats and 2 Republicans) to eliminate the rule that limited investment banks to keep leverage at 12 to 1 or less. US SEC Clears New Net-Capital Rules For Brokerages - 04/28/2004  That means these firms had to keep at least 1 dollar in equity for every 12 borrowed prior to 2004. The change in this limitation of leverage was due to the belief that Wall Street was capable of regulating itself, a traditional Republican theme but this decision was made with the support of Clinton Democrats at the SEC.  

Within a relatively short period of time, the investment banks had dramatically increased their leverage, with Lehman moving to 30 to 1, Merrill Lynch near 40 to 1,  and Bear Stearns at 33 to 1. With that kind of leverage, a 3% loss of capital can wipe out the firms entire equity. If you give anyone that much rope and allow greed to run rampant, it will only be a question of time before the investment firms would hang themselves. 

These firms used their excessive leverage to lead the way in marketing an ever expanding volume of sub-prime loans, syndicating them to investors worldwide and often combining sub-prime, ALT- A and prime mortgages into the same pools, slicing and dicing them into tranches to be sold to different kinds of investors. These loans were acquired from independent mortgage companies, now bankrupt.  All of this bypassed the CRA, Fannie and Freddie. Only 1/4 of the sub-prime loans were originated by banks and thrifts operating under CRA. When the music stopped last year, the investment firms had to eat their own cooking, holding billions of dollars of toxic assets that could no longer be sold. Without the SEC rule change, I doubt any of this would have happened. 

       The other problem was that the rating agencies were not regulated in an effective way by the SEC .  Both Moodys and Standard & Poor's gave AAA ratings to Collateralized Debt Obligations that contained sub-prime and ALT-A loans that could not have been sold without the AAA rating.  Many of these AAA rated pools are now in default or rated at junk levels.   Then, you have the problems of  selling inappropriate mortgages to unsophisticated consumers, inflated appraisals, and outright fraud.  So the origins of the current crisis are far more complex than Marsha or Ann Coulter would have us believe.  The rating agencies facilitated the mortgage meltdown and the current economic crisis. Without their cooperation, it could not have happened in my opinion.

       Lastly, Fannie and Freddie were allowed to lever themselves up with excessive debt that created the same problem for them as bad assets did for Bear Stearns and Lehman Brothers.

      Whatever the cause, none of these reasons have anything to do with what had to be done now to save the world economies. Over 1 trillion has already been lost by banks and needless to say that money is no longer available to lend.  Perhaps another trillion or more is tied up in bad mortgage paper that can not be sold or even valued due to the irresponsible way that Wall Street created it. The most significant credit crunch since the Great Depression is already underway.

      The first lesson of financial crisis history, when the credit markets quit working properly as now, is for the government to step in to prevent a financial collapse.  Eliminating capital gains taxes for 2 years, as suggested by Marsha, as the solution to a credit crunch is only an invitation to disaster.  To have any chance of a recovery in 2009, the credit system must purge itself of the bad paper so that the surviving institutions can start lending after being recapitalized and the system re-liquified with good money.  The model that Marsha wants to follow is the one use by Japan starting in the 1980s that allowed the bad loans to fester on their banks balance sheets for almost two decades, which led to two decades of anemic growth and a stock market that has declined from almost 40,000 in the 1980s  to 10,000 now.

    Marsha also complains about using taxpayer money.  The 700 billion is not taxpayer money.  It will be borrowed money, primarily from foreign investors which is how the United States supports itself already, running close to a 500 billion budget deficit in the current fiscal year. The interest on the 700 billion will also be borrowed.  The American taxpayer is just a bystander and it is not our money in any sense of the word.  The interest on the five year treasury note is currently about 2.6%.  By borrowing at that rate, a very large arbitrage is created between the yield of the mortgage securities purchased at depressed prices and the low yield paid for the borrowed money.  With some recovery in the housing market during the next five years plus the arbitrage spread, it would not be hard to envision a profit being made as Warren Buffett claimed. 

    Another alternative favored by Marsha, other than a workable plan, was to sell insurance to protect the owners of these mortgage securities that had already gone bad.  That is exactly what brought down AIG, selling insurance or credit default swaps on mortgages.  

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