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  • A Really Big Short Still Awaits

    Posted by Kevin Villani on September 24th, 2016 (All posts by )

    When testifying in 2010 before the Financial Crisis Inquiry Commission into the financial crash, then Federal Reserve Board Chairman Ben Bernanke recommended only one reference, Lords of Finance: The Bankers Who Broke the World (2009), presumably for the narrative that insufficient money printing in the aftermath of the Great War lead to the next one. Right idea, wrong narrative!

    The US homeownership rate peaked at a rate well above the current level almost a half century ago mostly funded by a system of private mutual savings banks and savings and loans. The historical justification for federal “secondary market” agencies was political expediency – exemption from now obsolete federal, state and local laws and regulations inhibiting a national banking and mortgage market. Now government-run enterprises account for about 90% of all mortgages, with the Fed their primary funding mechanism, what the Economist recently labeled a de facto nationalization.

    The Historical Evolution

    How did the private US housing finance system repeatedly go bankrupt? To quote Hemingway: Gradually, then suddenly. The two competing political narratives of the cause of financial market crises remain at the extremes – either a private market or public political failure – with diametrically opposite policy prescriptions. The politician-exonerating market failure narrative has not surprisingly dominated policy, with past compromises contributing to the systemic financial system failure, the global recession of 2008 and subsequent nationalization.

    The Great Depression stressed the S&L system, but the industry’s vigorous opposition to both federal deposit insurance and the Fannie Mae secondary market proved prescient as the federally chartered savings and loan industry eventually succumbed by 1980 to the federal deposit insurer’s perverse politically imposed mandate of funding fixed rate mortgages with short term deposits and competition from the government sponsored enterprises.

    The S&Ls were largely replaced by the commercial banks. To make banks competitive with Fannie and Freddie, politicians and regulators allowed virtually the same extreme leverage, in return for a comparable low-income lending mandate – CRA requirements leading to a market dominating $4 trillion in commitments to community groups to whom the Clinton Administration had granted virtual veto power over new branch and merger authority.

    The Financial Crisis of 2008 and the aftermath

    The Big Short by Michael Lewis and more recent movie portrayed not just banker greed but the extreme frustration of those shorting the US mortgage market stymied by a housing price bubble many times greater than any in recorded US history that refused to burst. The reasons: 1. the Fed kept rates low and money plentiful, and 2. whereas banks would have run out of funding capacity, the ability of Fannie and Freddie to continuously borrow at the Treasury’s cost of funds regardless of risk and their HUD Mission Regulator requirement to maintain a 50% market share kept the bubble inflating to systemic proportions.

    The Obama Administration fully embraced the alternative private market failure narrative in Fed policy, regulation and legislation:

    • To partially ameliorate the effects on the real economy of disruption to the global payments mechanism the Fed had to bail out the banking system. QE1/2/3/4 and ZIRP (zero rates), now NIRP, did this by re-inflating the house price bubble, postponing defaults while allowing banks risk-free profits. The Fed – and taxpayers – would lose more than the entire S&L industry did should rates rise by a comparable amount if it marked its balance sheet to market.
    • Regulators had to appear to punish the banks. In response to paying hundreds of billions of dollars in what the Economist labeled “extortion” – some of which ironically went to populist political action groups – and the subsequent oppressive regulatory regime, U.S. commercial banks are exiting the US mortgage market in spite of ongoing profits enabled by extreme leverage.
    • One legislative centerpiece, the Dodd Frank Act passed in July 2010 in direct response to the financial crisis, doubled down on political control of financial markets without addressing the future of Fannie and Freddie. The other, Obamacare, enacted four months earlier, was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available.

    The Long Term Consequences

    Bernanke’s focus on choosing the narrative was useful, but the political choice of the market failure narrative appears to reflect convenience rather than conviction. The direct taxpayer costs of implicit or explicit public insurance and guarantees come with both a whimper – tax savings amounting to tens of billions annually due to the deductibility of interest costs – and a bang – future taxpayer bailouts generally delivered off-budget.

    Fannie and Freddie conservatorship deftly avoided debt consolidation while dividends reduced reported federal deficits. The student loan market has also been de facto nationalized, with potential unbudgeted losses totaling hundreds of billions. Obamacare was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available, but under-budgeted health insurance subsidies predictable caused massive losses and health insurers are now withdrawing from the market.

    Monetary policies caused household savings to stagnate as returns to retirement savings evaporated. Defined obligation public pension funds were all rendered technically insolvent when funding is valued at current market returns rather than the assumed rate as much as ten times that. The failure of the economy to grow per capita was explained as the “new normal”. But politicians made no attempt to reflect the implied technically insolvency of public pensions or Social Security and Medicare.

    Private firms fail, but private markets rarely do. Public protection and regulation makes firms “too big to fail” until markets fail systemically. The current and projected future public debt bubble is unsustainable, and financial markets will eventually ignore the accounting deceptions and pop it. The relative weakness of other sovereign debt is delaying the inevitably, making The Really Big Short a good title for a Michael Lewis’s sequel. Politicians and central bankers will again say “nobody saw this coming”. What then?

    ====
    Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath. This article was originally published at FFE.org

     

    21 Responses to “A Really Big Short Still Awaits”

    1. Mike K Says:

      I was watching the movie “The Big Short” the other night. I read the book plus I read “Lords of Finance” when it came out.

      I like Nicole Gelinas’ book, After the Fall, for a concise summary of the 2008 collapse.

      The next big short will be far worse. I am now reading “Currency Wars.

      I have a gold money clip that has a gold quarter eagle mounted on it. It was worth $2.50 in 1906. I paid about $400 for it. That tells a story.

      I feel so sorry for my kids who will live through this after I have gone on. A little less sorry for the three who voted for Obama and will vote for Hillary, but still sorry for all of them.

    2. David Foster Says:

      There are at least 2 forms that such popping could take….(1) rising fear about unsustainable obligations causes sharp decline in the prices of government securities because of credit risk, or (2) governments act to inflate their way out of the problem…also causing decline in prices of government securities, but probably a different set of economy-wide impacts than with case (1).

      Kevin, which of these do you see as most likely?

    3. PenGun Says:

      A part of what’s happening is the destruction of interest rates. Interest benefits savers, and those not inclined towards investment. Investment benefits mightily, from very low interest rates.

      The, well it used to be 19 institutions, can go to the fed’s discount window and borrow vast amounts at .25%. They will not let this golden egg go easily. ;)

      Because of this it will take a serious earthquake to change the game.

    4. David Foster Says:

      “Investment benefits mightily, from very low interest rates”

      PAST investment benefits from low interest rates; current investment, does not. Low interest rates in the present, by increasing asset values, reduce the opportunities for return on investments made today.

    5. Mike K Says:

      “reduce the opportunities for return on investments made today.”

      Except gold. The “Currency Wars” book predicts government seizure of gold as occurred in 1933.

      So, in addition to gold, I am stocking up on guns and ammo. Guns are an excellent investment these days and have been since the 1970s.

      I just wish I had bought Ruger and S&W stock when Obama was elected.

    6. newrouter Says:

      > can go to the fed’s discount window and borrow vast amounts at .25%. They will not let this golden egg go easily. ;)<

      1st Art V. COS 1 topic: transfer the ability to raise the Fed. debt limit from Congress/Senate/President(280 people) to 3/4 of State legislatures

    7. MSimon Says:

      I just read somewhere that the Fed (or some gvmt body) has suggested lowering lending standards to keep the construction industry viable

      What could possibly go wrong?

    8. MSimon Says:

      This site suggests helicopter money to compensate for the continuing deflation technology is causing. And the helicopter money should go to individuals vs what is happening now – it goes to the banks and big borrowers.

      Deflation is what happens to the cost of housing when houses can be 3D printed. The cost of a house is currently about 50% labor. What happens when that is reduced to 5%?

      And of course we have seen electronics continually deflating for 50 years. Machines do most of the work of making products. The electronics are now cheap enough that they are affecting the whole economy.

      http://atom.singularity2050.com/

    9. PenGun Says:

      “Low interest rates in the present, by increasing asset values, reduce the opportunities for return on investments made today.”

      Indeed, but at the rates available, borrowing to invest becomes a powerful tool.

    10. Grurray Says:

      With rates very low to negative there isn’t much incentive for banks to lend while the Fed also pays them interest on their excess reserves. The result is malinvestment in risky assets like junk bonds or government funeed boondoggles.

      People don’t realize what a disaster “reforms” like Dodd-Frank were. It further consolidated power with the big banks and Fed, while destroying small business. Prior to the recession about a hundred new banks a year would form. After Dodd-Frank there have been only three new banks total. New business startups overall are at a 40 year low, and so is the number of publicly traded companies.

      The government with its fiscal, monetary, and regulator policies is punishing entrepreneurs and small businesses and appears to be intent on killing them altogether.

    11. Mike K Says:

      I wonder if Trump and his administration can stop the runaway train without crashing the big banks.?

      I was convinced that Romney was the last chance for a soft landing in 2012. I still am.

      Dodd-Frank is part of it. That was as destructive as Fernand St Germain’s midnight intervention in the S&L industry that destroyed it.

      He also proposed an amendment to raise the FSLIC insurance on S & L accounts from $40,000 to $100,000 (at the time an average account balance was $6,000), bringing the proposal to the floor of the House of Representatives at midnight when only eleven other congressmen were present. It was voted for unanimously. This allowed for a flood of brokered CDs seeking higher interest to move around S & Ls and contributed to the debacle which will cost the taxpayer trillions of dollars and allowed hundreds of frauds to go unpunished.

      That single act is his biography. I wonder what it cost whoever paid him ?

      Dodd-Frank must have cost a fortune.

      Unwinding this seems impossible without a huge economic reaction. What will it be ?

    12. tyouth Says:

      I’ve thought for a long time that inflation/devaluation is the most simple, the most convenient (and maybe the least destructive) endgame for elitist decision makers (EDMs) and their functionaries. The U.S. continues to successfully kick the can down the road at present and will be able to as long as ex-U.S. EDMs see the U.S. ($) as providing a stability not to be found elsewhere.

    13. tyouth Says:

      I thought “The Big Short” accessible and excellent, by the way. Fairly faithful to Lewis’ work although it’s been awhile since I’ve read it. It may encourage me to re-read it.

    14. tyouth Says:

      MSimon: This site suggests helicopter money to compensate for the continuing deflation technology is causing. And the helicopter money should go to individuals vs what is happening now – it goes to the banks and big borrowers.

      MSimon, It seems that you’re ignoring 3-4%/yr ever increasing entitlements. It’s a wonder we’re not seeing high inflation; maybe the “over valued” stock market has sucked some or a lot of it up.

    15. tyouth Says:

      “The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
      This is the shabby secret of the welfare statist’s tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights”.

      – Alan Greenspan 1967

      Greenspan before becoming an EDM functionary, and (it seems) also after being an EDM fumctionary.

    16. Mike K Says:

      “Gold stands in the way of this insidious process. It stands as a protector of property rights”.

      I’m hoping that this will hold true for my little stash. Two of my kids have instructions on how to access my little store if and when I am unable to control it.

    17. Mike K Says:

      Interesting post at Powerline.

      Starting to look like the next president is going to face a recession. But maybe an American version of Brexit will “trump” all of this (heh—irony deliberate). Someone caught this nice juxtaposition of what the Certified Smart People said about Brexit:

      We can hope so.

    18. newrouter Says:

      >The government with its fiscal, monetary, and regulator policies is punishing entrepreneurs and small businesses and appears to be intent on killing them altogether.<

      yep. so take control of the federal gov't by:

      {1st Art V. COS 1 topic: transfer the ability to raise the Fed. debt limit from Congress/Senate/President(280 people) to 3/4 of State legislatures}

      2nd Art V COS: Term limit all federal employees

    19. newrouter Says:

      >2nd Art V COS: Term limit all federal employees<

      that would mean: john kerry, john mccain, hillary clinton, bernie sanders, louis lerner, most of the clinton foundation et al are gone

    20. Anonymous Says:

      They may not be gone, they may just trade places in musical chairs fashion. It does cause their costs of entry to increase as most of the benefits of incumbency are lost. With loss of incumbency advantage, entry by newcomers may increase. Competition is good for accountability.

      A real balanced budget amendment could significantly reduce the gains from corruption through bringing the costs back to the present. Any of these amendments will likely only be enacted by the initiative of the states. Never been done, but pressure is growing.

      Death6

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