Thursday, December 30, 2010

Foreclosure of mortgaged homes

Randall Wray questions the banks who are foreclosing on defaulted properties because of illegal record keeing a failure to file with local clerks:
"In plain simple language, the banks are royally screwed. They cannot foreclose on the properties. Holders of the "mortgage-backed" securities can turn them back to the banks because they are actually unsecured debt. In previous pieces I have also explained why MERS's recommended practice also violates US tax code -- so back taxes are owed. And we know that the mortgages stuffed into the securities did not meet the "reps" of the PSAs.

So, in short, banks have got to take the whole lot of toxic waste securities back. Trillions of dollars worth. The banks are toast. There is no cooking of the books that will turn this blackened toast back to bread."
see Huffington Post Dec. 30,2010

Tuesday, December 28, 2010

Causes of the Financial Crisis

The end of the year, and more than two years into the Great Recession is a good time to summarize the
Causes of Financial Crisis
The too-big-to-fail banks are blaming the financial crisis and the subsequent Great Recession on greedy home buyers who bought and mortgaged houses they could not afford. The accusation is very convenient because it holds the banks and financial organizations blameless and suggests no need for legislative reform. This is disingenuous. Who offered house buyers non-traditional liar loans with low starter rates that would balloon in a few years? Profits on the difference between home mortgage rates and the lender’s cost of money were too plebian for the high flyers of the financial sector. So the commercial and investment banks packaged mortgages into bonds and resold them to other banks, governments and pensions funds around the world. The market for these derivative bonds was marked by use of absurd levels of leverage, as high as 30 to one. This market was not regulated as are stocks. This allowed unheard of levels of profit as long as the price continued upwards. But, as any finance student knows it creates gigantic losses if the music stops. The losses could be several times larger than the capital reserves of the financial organizations.
The bond rating firms (e.g. Warren Buffet’s Moody’s and Standard and Poor’s) cooperated (co-conspired?) to anoint these bonds with ratings making them suitable for pensions funds, etc. The bond raters reasoned (if we can call it that) that real estate values had increased steadily for years with little volatility. Low volatility meant low risk to them.
If the rating firms had bothered to look at the individual mortgages contained in the bonds, they would have seen that a large number of them were taken out by people with poor credit who could only survive in an environment of rapidly and continuous escalation of housing prices.
The incentives for the players were all wrong and this explains why a lot of smart, calculating people went wrong. The mortgage brokers did not hold the mortgages and were paid on volume and not quality. The investment banks such as Goldman and Lehman did not expect to hold the mortgages either, but rather resell them as packages of derivatives whose value depended on a steady stream of payments by the home buyers. Firms such as Goldman resold the derivatives to Iceland, USB, etc. Everyone wanted in on the golden goose as firms like GE and GM, who formerly made real goods, switched to earning a big share of their profit on leveraged financial contracts. Fannie Mae and Freddy Mac, originally government chartered to support home mortgages, were now private, seeking big returns like all the rest. Paulson of the US Treasury was forced to nationalize them in 2007 or there would be no one to buy home mortgages.
For those it kept, Goldman (and Merrill Lynch, Bear Sterns, CityGroup, etc.) bought insurance against lower prices from AIG, called Credit Default Swaps. Goldman assumed they were fully hedged and safe, but gave no thought to what would happen if everyone headed for the exit at the same time. AIG itself was beguiled by the promise of returns much larger than its conventional insurance business earned.
When Goldman experienced falling prices, it and others went to AIG to recover its looming losses. The Government’s highest purpose during the crisis was to rescue the banks, under the guise that otherwise credit markets would freeze. It had 700 billion to buy troubled assets of banks. The government did nothing for the mortgaged home buyers who were dying as house prices fell and interest rates increased after the sucker rates expired. The unpaid balance on their mortgages soon exceeded the market value of the house. Many walked away leaving empty houses behind. In spite of the trillions government spent, it is no wonder that the prevailing public opinion said it didn’t work as they observed persistent unemployment.
Granted that in 2007 the President , Treasury and Federal Reserve officials were making decisions in an unprecedented financial crisis, nevertheless their failure to insist that the banks and their shareholders take some of the loss and write off some of the amount home buyers owed in inexcusable.
When the big picture is grasped, it is clear that the problem was not greedy home buyers, but super greedy avaricious, (yes, immoral) brokers, banks, and bond raters. The system was rotten and needs fixing, including a return to the Glass-Steagall rules passed in the Great Depression prohibiting combining commercial banks and investment banks. This would prevent the losses in bond trading from destroying the commercial banks. The fix still has not fully happened because the big players are willing to expose the system to cataclysmic failure for their own short-term profit.
This experience is an example of how smart individuals within a faulty system produce an aggregate result few desire. It cries out for institutional change.

Note: Some such as Steve Eisman saw the train wreck coming and figured out how to short newly invented CDOs and made billions. Brooksley Born, chair of the Commodity Futures Trading Commission, tried to write rules for regulating derivatives, but was told to desist by White House advisers Greenspan, Rubin, and Summers who, when the independent agency ingored them, persuaded Congress to prohibit any kind of regulation. They probably thought the profits of the financial sector, seemingly a large portion of economic growth, were too important to risk derailing. But, these profits were just paper. Casinos are not the stuff to build an economy on.

I wish all my readers a Happy New Year, though I fear the economy will not be happy.

Wednesday, December 15, 2010

Command & Control


Command and Control is a prejudicial concept. It implies a contrast with an alternative that is voluntary and free. However, all rights are made effective by legal commands to the non-rights holder to keep out of the way of the rights holder. Without coercion, no market.

A requirement to avoid downstream damage can be implemented by
1. A tort action by the downstream owners threatening an injunction, to sue for damages, (claim damages if infringed upon). This requires individuals to bring a court action and bear the costs thereof.
2. A regulation gives an opportunity to the downstream owner implemented by a public agency who bears the transaction cost of the prosecution and asks for a fine or injunction.

In the case where the rights holders are many with individually small damages, cost of court action may be prohibitive. Regulation with administrative implementation is equivalent to a class action suit for tort liability.

Usually the opportunity created by a regulation can’t be given up by selling the right. Though in some cases, the would-be actor without the right to act, may buy off the rights holders convincing them not to ask the government to prosecute.

The language of “command and control” assumes that there is a market alternative that is wholly voluntary. False! If the so-called “subsidy” is financed with a tax (common for HEC goods), it is hardly voluntary. There may be unwilling riders. This fact is not seen when payments for environmental services are paid for by foundations, NGOs and US AID. Coercion is inherent in HEC goods, no matter the institution, market or otherwise.

The concept of “environmental services” is prejudicial of rights. Much of the scholarship is thereby shifted to how much must be paid to obtain it. Alternatively, research might have focused on how legal alternatives give different opportunities to different interests. There is enough variation in rules out there to measure the effects of alternatives. Environmental interests are not homogeneous. Some, if owners, would sell if the price is right. But, since it is not possible for some to sell and some keep, the rules for deciding to sell are critical. The same issues arise in any cap and trade system. Estimating the supply curve for environmental services makes it sound like an economics question, but exploring the performance of alternative institutions that produce different prices is equally an economics question.

Get Real

Lots of people have not yet adjusted their expectations to today's realities of slow or no growth. This ranges from members of the Detroit Symphony Orchestra striking for higher pay while city services are being cut and the auto companies are not flush with charitable donations any more; Students asked to pay higher tuition in Great Britain, workers in France and Greece. Some have resorted to riots and destruction to insist on what they have come to believe is their right to more.
A bright spot is Michigan State University President Simon who refused a salary increase, in part because there was no money for faculty raises this year. Now if the basketball coach would follow suit, that would be news.

Taxes and Business

Republicans argue that we must give tax breaks to millionaires and business to create jobs. But, the fact is that American Corporations are sitting on $1.5 trillion in cash. Even if tax policy gives them more, they won't invest it when consumer demand and expectations are low! (Source: Harold Meyerson, New York Times, December 8, 2010)
We need fiscal stimulous, not tax breaks for the rich.

Friday, December 3, 2010

European Central Bank buys bonds of sovereign nations

The European Central Bank president, Jean-Claude Trichet, said he would keep giving banks unlimited liquidity well into next year but made no guarantee to step up the bond-buying to combat investor panic surrounding Portugal and Spain. The Guardian, Dec 3, 2010.

"The securities market programme (SMP) is ongoing, I repeat ... ongoing," he said after the ECB's monthly policy meeting left interest rates at 1%. "I won't comment on the observations of market participants."
The ECB started buying bonds through the SMP in May and has so far spent €67bn (£57bn), most of it during the first three weeks of the programme.
Analysts say that the ECB may well have to do so again soon if the eurozone debt crisis threatens to push Portugal and Spain to seek bailouts, as Ireland and Greece already have. "We continue to look for €100bn of purchases by the beginning of next year including Spanish securities," RBS economist Jacques Cailloux said in a note to investors.
It is not clear to me how the ECB pays for the bonds it buys. But, I suspect they make a loan just like a commercial bank would do (if they weren’t scared to finance sovereign nation debt in risk of default. That is, they just write numbers after a country’s name—they don’t borrow from the market first.

So has the banking system come round to my suggestion of zero-interest public debt? I think so, the only difference is that I have advocated that the public debt be used for stimulus type investments such as building public infrastructure. If the ECB can keep Ireland from going broke, it will certainly help public employment from tanking any more that it has. But, it won’t put the unemployed back to work, whose income would bolster consumer demand.
As one might suspect, the central bank is more interested in rescuing banks than in providing employment. Note that the central bank can do what it is doing without any legislative action. An expanded stimulus program, would need legislative authorization, and the western world’s legislatures seem more interested in adopting austerity programs (Ireland is an example) than in providing jobs. Of course, the austerity is likely to impact the relatively poor people rather than the relatively wealthy! So what else is new?