Americans Can't Afford a Tax on Mortgage Relief

May 3, 2012Bruce Judson

house-in-hands-150Failure to renew legislation that prevents mortgage debt relief from being counted as taxable income could destroy the fragile recovery.

house-in-hands-150Failure to renew legislation that prevents mortgage debt relief from being counted as taxable income could destroy the fragile recovery.

The economic crisis began with the housing crisis, and it will only end when the housing crisis also ends. Unfortunately, the evidence of the past five years suggests that the Obama administration and Congress have never actually understood this connection. Despite massive numbers of foreclosures, the loss of almost $7 trillion in housing wealth (over one-half the nation’s home equity), and even unprecedented pleas from the Chairman of the Federal Reserve, there has been a shocking paucity of innovation or even policy activity in the housing arena.

Now there is a a very real chance that Congress will destroy the limited policies the Obama administration does have in place, prevent additional efforts, and further widen the gap between the haves and have-nots in America. Moreover, the net effect of this congressional failure could be to further undermine the weak housing market and risk sending the nation into another economic tailspin.

The administration’s signature housing policy effort is now aimed at mortgage principal reductions. This effort is at the core of the multi-state robo-mortgage settlement and central to the administration’s criticism of Edward DeMarco, the acting director of the Federal Housing Finance Agency. From the perspective of many analysts, myself included, the administration is finally on the right track, but its efforts are far too minimal to make a meaningful difference. Indeed, the nation’s total negative equity (the amount of mortgage debt owed which exceeds the value of the underlying properties) is presently in the range of $700 billion, and it's likely to increase.

Nonetheless, the administration’s principal reduction efforts are a step in the right direction. These efforts open the door for the far larger, far more creative efforts that will ultimately be needed to prevent millions of upcoming foreclosures and possibly massive walk-aways from the estimated 23 percent (and increasing) of all mortgage holders -- 11 million families -- who are underwater.

Here’s the issue: As a general rule, any debt forgiveness is income. This means that if a home buyer borrows to buy a house and the bank forgives a portion of the loan, whether in a short sale, through debt reduction (i.e. the settlement), or even foreclosure in states that allow banks to officially choose not to seek recourse, a taxable event has occurred. The income earned is the difference between the original mortgage borrowed and the amount ultimately repaid to the bank.

For example: A family borrows $300,000 for a mortgage. The home declines in value and the bank agrees to a short sale (where the sale price is for less than the amount of the homeowner’s mortgage debt) and receives a total pay-off of $200,000. The $100,000 difference between the amount borrowed and the amount ultimately paid back is the amount of the loan the bank has forgiven. This $100,000 is a type of principal reduction and generally subject to ordinary income taxes.

However, at the start of the housing crisis in 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007, which exempts precisely this phantom income from federal taxation. The term of the law was extended in 2008. But the current law expires at the end of 2012, and it is by no means clear that it will be extended. Moreover, the seeming lack of public discussion about the need to extend it is shocking.

(There is a complex array of qualifying circumstances and exemptions surrounding this tax issue, including the laws of the individual state involved, the solvency of the homeowner, whether the homeowner is in bankruptcy, whether the sale involves a primary residence, refinancing associated with the property, and a variety of other factors related to qualifying for the federal exemption. In particular, short sales in nonrecourse states (which include California) are not considered debt forgiven and therefore, if no other income-generating activities apply, do not trigger federal taxes. But this post does not address the many nuances involved in these issues.)

it’s virtually impossible to imagine that struggling families who are selling underwater homes at a large loss (and have already lost a large chunk of their life savings as the value of their home equity, including their down-payment, was vaporized in the housing crisis) will go forward with short sales. The vast majority of homeowners will not be able to afford the resulting tax debt. So one consequence of a failure to extend this law is likely to be an immediate end to the vast majority of short sales, which have been increasing rapidly. Short sales constituted an estimated 24 percent of all January 2012 home sales and surpassed the estimated 20 percent of all January sales comprised of foreclosed homes.

For the same reasons, all efforts at principal reduction will be stopped cold at the end of this year. Homeowners who are struggling to meet their monthly obligations are unlikely to be able to accept sizeable principle reductions that will create large income tax obligations that they can't afford. This means Obama's debt principal reduction initiative will never get off the ground.

Congressional opponents of renewing this legislation are assuming a lack of potentially severe consequences. It’s impossible to predict what might happen, but the downside risks are unquestionably high. It raises the real risk of directly leading housing prices to decline further or even plummet for a variety of reasons. Efforts at principal reduction could come to a stop as the public loses confidence in a housing recovery, the end of short sales could have a strong negative impact on the housing market, or underwater homeowners fearing tax consequences could decide to walk away from their homes, leading to a massive increase in the inventory of newly empty homes that banks must ultimately resell.

None of this may happen, but the risks are real and unacceptable. A substantial drop in housing prices will almost certainly harm or destroy the already tepid pace of our economic recovery. Congress and the Obama administration are playing with fire. Sometimes those who do so remain unscathed, but sometimes they get burned.

Congressional inaction also fails the pro-capitalism test. As an economic system, capitalism is intended to build the overall wealth of a society. To properly function, capitalism requires an equal playing field, absolute accountability for business decisions, and rules ensuring that markets function fairly. As I have repeatedly argued, the many failures of lawmakers and administration officials to hold the financial services sector to a capitalist model has created a financial sector that is anti-capitalist and wealth-destroying. The current predicament of homeowners who might rely on this lifeline is a direct result of this failure. To now penalize the weakest link in the chain is a further demonstration that we have created an economic system that is not fair capitalism, where everyone lives up to their responsibilities and is accountable for their actions.

Capitalism only works when the citizenry believes it leads to fair outcomes. Our nation has already reached dangerous levels of anger. The lack of trust in our institutions is pervasive, and Americans who have always been regarded as optimists have turned cynical and lost hope. By taxing struggling families on phantom income, Congress will reinforce the belief that our economy is blatantly unfair and further wear away the remaining thread of our painfully frayed social fabric.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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For Capitalism to Survive, Crime Must Not Pay

Apr 12, 2012Bruce Judson

money-justice-scalesUnequal enforcement of the law will distort and destroy any capitalist society, and we may be witnessing just such a downward spiral in the financial sector.

money-justice-scalesUnequal enforcement of the law will distort and destroy any capitalist society, and we may be witnessing just such a downward spiral in the financial sector.

Capitalism is not an abstract idea. It is an economic system with a distinct set of underlying principles that must exist in order for the system to work. One of these principles is equal justice. In its absence, parties will stop entering into transactions that create overall wealth for our society. Justice must be blind so that both parties — whether weak or powerful — can assume that an agreement between them will be equally enforced by the courts.

There is a second, perhaps even more fundamental, reason that equal justice is essential for capitalism to work. When unequal justice prevails, the party that does not need to follow the law has a distinct competitive advantage. A corporation that knowingly breaks the law will find ways to profit through illegal means that are not available to competitors. As a consequence, the competitive playing field is biased toward the company that does not need to follow the rules.

The net result of unequal justice is likely to be the destruction of the overall wealth of our society. I don’t mean the wealth of individuals; I mean the total wealth of goods and services that are the benefits of healthy competition. To the extent that unequal justice prevails, entities that are exempt from the laws will, in all likelihood, be more profitable than law abiding competitors. Then they use their profits to further weaken competitors by using their illegal profits to further build their businesses at the expense of competitors. All of this business building activity is based on a foundation of sand, and ultimately the entire industry — or even the larger economy — becomes distorted. The “rogue” company gains power, changes markets, and destroys direct and indirect competitors because it is playing by different rules.

The above scenario is not simply a hypothetical example. It is exactly what happened at Worldcom. As the company succeeded because of its then-unknown illegal activities, it grew, managed to take over MCI (one of the true innovators in the industry), and weakened competitors who could not match its profitability. Ultimately the whole edifice collapsed, causing massive wealth destruction in the telecommunications industry and the economy as a whole.

In the WorldCom example, appropriate legal enforcement and prosecution did not occur until the accounting fraud and other crimes were detected. Thus, while it is more an example of undetected accounting fraud than unequal justice, the results are illustrative. In a society with unequal justice, the appropriate laws are never enforced, so entities acting outside the law continue to grow more profitable and powerful (as compared to everyone operating according to the rules). Moreover, the profits from illegal activities can be used to subsidize competition across the spectrum of business activities of companies acting outside the law — which further enforces the competitive advantage, and possible hegemony, of entities operating on a different playing field.

Now, here’s why the above discussion is so important if we hope to return our economy to the dynamo of wealth creation for the entire society that is, in part, what made America a great nation. As economic inequality increases, two sets of laws implicitly develop: one set for powerful members of society and another set for the weaker. These two sets of laws are often defined by a single question: who is prosecuted for crimes and who is not. When powerful members of society can break the law without fear of prosecution, they will inevitably exploit this competitive advantage by engaging in profitable (but illegal) activity. At the same time, the weaker members of society can’t compete; they are shackled by the need to follow the laws of the land. Meanwhile, everyone loses as the profits of companies violating the law distort the competitive playing field and the activities of everyone in it and divert societal activity from the creation of real wealth.

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In effect, equal enforcement of the law is not simply important for democracy or to ensure that economic activity takes place, it is fundamental to ensuring that capitalism works. Without equal enforcement of the law, the economy operates with participants who are competitively advantaged and disadvantaged. The rogue firms are in effect receiving a giant government subsidy: the freedom to engage in profitable activities that are prohibited to lesser entities. This becomes a self-reinforcing cycle (like the growth of WorldCom from a regional phone carrier to a national giant that included MCI), so that inequality becomes ever greater. Ultimately, we all lose as our entire economy is distorted, valuable entities are crushed or never get off the ground because they can’t compete on a playing field that is not level, and most likely wealth is destroyed.

The central question for the nation right now is whether we are, in fact, in the middle of the dire and dangerous cycle described above. Washington insiders have reportedthat the Justice Department is explicitly choosing not to prosecute seemingly illegal bank activities. Indeed, in my previous column I noted that the audits released by the Office of the Inspector General of the Department of Housing and Urban Development detailed activities by senior banking officials associated with the robo-mortgage scandal that seem to constitute clear evidence of multiple federal felonies, and most likely violated state laws as well. Yet no one has been indicted.

In an entirely different sector of financial services, the venerable American Banker just completed a three-part series on past credit card debt collection practices. Many of these activities are now under investigation by the Office of the Comptroller of the Currency. But if the past is prologue, it’s unlikely that any criminal indictments will result, no matter what these investigations uncover.

Indeed, as has been repeatedly documented, when illegal activity is detected, the SEC settles with the banks in civil lawsuits for sums that, while appearing to be large, are a pittance compared to the profits of the institutions involved. While these same activities would in many cases constitute criminal violations, no prosecutions have occurred. The bankers who operate our largest financial institutions can rightfully assume that they are above the laws that constrain everyone else.

The evidence that crime does, in fact, pay is perfectly clear. Before the 1990s, the total profits of the financial services sector rarely accounted for more than 20 percentof the total corporate profits of the nation’s economy. By 2005, they averaged aboutone-third of all corporate profits. After sinking as a result of the crash, they rebounded dramatically. By early 2011, the sector once again accounted for about 30 percent of total corporate profits. As The Wall Street Journal noted, “That’s an amazing share given that the sector accounts for less than 10 percent of the value added in the economy.”

Finance serves a valuable function. Its principal role is to ensure that capital is most efficiently allocated in a society. However, financial services are also an intermediate good. They grease the wheels, through capital allocation, so that real goods and services that people consume or experience can be created. Yet, as the Journal noted, the sector’s profits are far in excess of the value the sector adds to the overall economy. At the same time, recent academic research has suggested that the financial sector has become less efficient over time, with the gains from information technology cancelled out by increases in trading activity (whose social value is certainly open to question).

This will ultimately lead us in a downward spiral: A few large powerful entities and people operate above the law, inequality is extreme, citizens have lost faith in their political systems, real societal wealth is not created, and political instability becomes a potential reality. John Adams held that “We are a nation of laws, not men” for a valid reason. Now, we need those charged with enforcing our laws to do their job.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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A Seven Day Plan to Finally Hold Wall Street Accountable

Mar 19, 2012Bruce Judson

money-justice-scalesNew evidence points to illegal behavior. Prosecution is the only way to keep that behavior from continuing.

It's now a near certainty that Wall Street executives committed felonies.

money-justice-scalesNew evidence points to illegal behavior. Prosecution is the only way to keep that behavior from continuing.

It's now a near certainty that Wall Street executives committed felonies.

The recently released audits of robo-mortgage activities by the Office of the Inspector General of the Department of Housing and Urban Development (HUD) details shocking behavior at the five banks constituting the Federal Housing Administration's largest mortgage servicers. At Wells Fargo, management quashed a midlevel manager's study of the foreclosure process as negative results began to emerge, and it gave an individual whose last job had been in a pizza restaurant the title of "vice-president of loan documentation" to facilitate robo-mortgage signing. Bank of America evaluated employees on the volume of foreclosure affidavits produced. JP Morgan Chase gave individuals titles such as "vice-president of Chase Home" where "the titles were given by Chase for the sole purpose of allowing individuals to sign documents and came with no other duties or authority." Citigroup and Ally similarly engaged in seemingly illegal practices.

Under federal law, the knowing filing of a false affidavit with the court is a felony offense of perjury, punishable by a prison term of up to five years. An individual violates laws against perjury whether he or she personally appears in court and swears to a false statement or provides the court with a false affidavit. Individual states have their own perjury laws, which were undoubtedly violated as well. The HUD report also suggests that individual banks may be guilty of obstruction of justice and the criminal violation of the False Claims Act for filing insurance claims without following HUD requirements.

Since the start of the financial crisis, federal and state officials have been struggling to change Wall Street behavior. To date, every effort has failed miserably, and the weak enforcement provisions of the robo-mortgage settlement are unlikely to meaningfully change this dynamic. Government officials have also relied, with a very few exceptions, entirely on civil enforcement when criminal laws appear to have been egregiously violated.

The greatest moral hazard now confronting the nation is what appears to be increasingly brazen criminal activity by financial industry executives. With each decision not to prosecute, Wall Street executives justifiably conclude that they are immune to the rules. As a result, it appears that Wall Street criminal activity is increasing in frequency and severity, as opposed to the reverse. The activities surrounding the collapse of MF Global are one example.

So what can be done about it? We can change the behavior in the financial service industry for a full generation in just seven days. This plan may seem to be tongue and cheek, but it hearkens back to a similar action in the era of the Great Depression. In the final months of Herbert Hoover's presidency, the Senate Banking Committee began an investigation into the causes of the Great Crash of 1929, and a young prosecutor named Ferdinand Pecora was appointed as Chief Counsel. Subsequently, the Roosevelt administration conveyed to Pecora that "the prosecution of an outstanding violator of the banking law would be the most salutary action that could be taken at this time. The feeling is that if the people become convinced that the big violators are to be punished, it will be helpful in restoring confidence." Ultimately, this investigation, which came to be known as the Pecora Commission, led to the indictment of one of America's most prominent financiers; demonstrated widespread self-dealing in the financial sector; and, as noted by historian Alan Brinkley, generated "broad popular support" for Roosevelt's reform agenda, including the creation of the SEC and the Glass-Steagall Act.

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My seven day plan is based on a simple premise: When criminal laws are egregiously violated, the guilty parties should face appropriate punishment. Here's the plan:

Day One: Read the HUD Inspector General's reports and the public records of past mortgage foreclosure cases from across the nation.

Day Two: Meet with the team at the Office of the Inspector General at HUD that prepared the audits. Obtain the names of all the bank officials, lawyers, and notaries whose behavior, as cited in the audit reports or otherwise known to the investigators, represent clear and unquestionable criminal violations. Add to this list other individuals who have similarly demonstrated or testified to behavior unquestionably constituting criminal acts, as indicated by the public records of the mortgage foreclosure cases reviewed in day one.

Day Three: Indict all of the individuals on the list compiled on day two.

Day Four: Indict banks and financial institutions on criminal charges where criminal behavior by employees (as demonstrated by day three indictments) appears to be endemic. The Justice Department guidelines for prosecuting firms include: (1) the pervasiveness of such activity, (2) the compliance procedures in place, (3) attempts by the corporation to end bad behavior, and (4) cooperation with federal investigators. In 2008, the Justice Department adopted a policy of accepting "deferred prosecutions," involving agreements to change corporate behavior without damaging innocent third parties through prosecution.

Corporations receive the benefits of "legal persons," as demonstrated by Citizens United. But they must also bear the responsibilities of these privileges. A reading of the HUD reports, and other public records, suggests several banks should clearly be prosecuted.

Day 5: Discuss plea bargains with indicted lower-level officials in return for cooperating in investigations of higher-level officials.

Day 6: Consider plea bargains with indicted banks, which require the removal of all remaining officers and directors who were serving when egregious criminal activity occurred, as well as senior officials who were in a position to exercise appropriate supervisory responsibility but chose to look the other way.

Day 7: Indict any senior Wall Street officials implicated by new cooperative testimony resulting from activities on day five. Adopt and announce a policy that future criminal violations will be prosecuted in a similar fashion.

What is particularly disturbing is that a look at the evidence already in the public domain (much less what investigators already know) shows that none of the actions discussed above are entirely absurd. The purpose of prosecution not simply punishment. It acts to deter further illegal activity and to restore public confidence in our system of governance. The nation desperately needs both of these benefits today.

Moreover, these ongoing, almost certainly criminal activities are ultimately dangerous threats to our economy, the success of capitalism, and our democracy. In his column on MF Global, Joe Nocera noted that "customers need to be able to trust" the laws protecting their money. "Otherwise, the markets can't function."

Today, as in the era of FDR, we must send a message to the financial community that illegal behavior will not be tolerated. By prosecuting blatant felonies now, we will deter future misbehavior and begin the process of recreating a fair society where equal justice prevails.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Are Bankers Capitalists?

Mar 1, 2012Bruce Judson

wall-street-150Jamie Dimon says banks are more successful than media companies, but which industry is actually following capitalist principles?

wall-street-150Jamie Dimon says banks are more successful than media companies, but which industry is actually following capitalist principles?

The phrase "Wall Street" is evocative in American culture. For generations, it has referred to the showcase of American capitalism: our financial services system that ensured the efficient use of funds by channeling capital to its most productive use. Indeed, the governing ethos in America is that Wall Street is the heart and soul of our capitalist economy.

As I have written before, capitalism involves four basic principles: absolute responsibility for anything and everything that happens to your company (i.e. total accountability), equal justice under the law, compensation based on the real value created for society, and competition, which involves failure and what is often called creative destruction.

The CEO of JPMorgan Chase, Jamie Dimon, has repeatedly touted the success of his efforts and disparaged critics. Earlier this week he compared compensation in the banking industry to the struggling media world, suggesting that the banking industry was far more successful. In speaking to journalists, according to Bloomberg, he noted, "Worse than that, you don't even make any money... [while] we make a lot of money."

Mr. Dimon is right. He and his colleagues are successful. But the real question is this: What are they successful at? By almost any criteria, the banks operate under rules that are so far from capitalism as to be unrecognizable. Let's take Mr. Dimon's comparison of the media industry and the banking industry further.

Both industries have been affected by unforeseen events. The Internet has undermined the viability of innumerable media businesses, leading to bankruptcies, changing business models, and intense competition for advertiser and subscriber dollars. In the face of these changes, industry participants have been forced to adapt or die. The forces of creative destruction, which are central to capitalism, have operated with an unforgiving ferocity. Formerly dominant entities have been forced to declare bankruptcy, while new media competitors and business models emerge on a seemingly daily basis.

In contrast, the banks argued that TARP was warranted because the economic tsunami of 2008 was unforeseeable. One of the essential functions of a financial institution is to manage risk. The majority of our large institutions failed entirely in this central responsibility as the economic crisis struck. In effect, many of our leading financial services firms were (and often continue to be) led by such poor businesspeople that if the principles of capitalism were enforced they would be out of business. My friends who are media entrepreneurs in Silicon Valley actually laugh when they hear the "we should not be responsible because this was not foreseeable" claims from the bankers. Every entrepreneur knows that they must make payroll each week or they are bankrupt.

At the same time, no one in Washington seriously believes the too big to fail legislation in Dodd-Frank will ever work. Inevitably, as in the case of AIG, counter-parties will declare that they will suffer irreparable harm if one of our leading banks is allowed to fail. I have come to call this "the Washington wink." You ask a federal official if too big to fail legislation will work, they dutifully say of course it will. However, the "of course" is inevitably accompanied by a knowing wink.

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In another divergence, the government has not subsidized media businesses. The banks may be showing profits, but they are on government life support. These so-called zombie banks can borrow from the Federal Reserve at almost no cost, and a long list of government initiatives have served as additional "stealth" bailouts of the banks. In the absence of this government support, would the banking industry still be successful? If media companies could borrow funds at almost no costs, I suspect their balance sheets and profits would be dramatically enhanced.

Capitalism is built on the idea that compensation and profits reflect the relative contribution an individual or firm makes to the total wealth of a society. Real societal wealth is anything that can be consumed or experienced. Profits are an accounting proxy meant to measure wealth. As I have written before, this proxy has failed miserably with regard to the banking industry. Given the loss of real societal wealth that accompanied the economic crisis as a result of poor bank management, the employment crisis, and the ongoing support the industry needs from the government, there is only one possible conclusion: at this moment the financial services industry is far more of a destroyer of real wealth than a wealth creator.

Meanwhile, media companies don't profit by repeatedly breaking the law. The lack of enforcement against Wall Street undermines our democracy and capitalism, and is effectively another form of stealth government support for the industry. As noted here, JP Morgan Chase (like several of the large banks) is in the middle of a host of potential scandals. In a true capitalist economy, the government would enforce the law to prevent repetitive malfeasance. The executives leading a firm that repeatedly violated the law would be held accountable by the firm's board for failure to exercise this basic responsibility to society.

Since the start of the economic crisis, the financial services industry has grown even more concentrated. It's hard not to regard our largest financial services institutions as effective monopolies. Yet, to my knowledge, no investigation of antitrust issues related to the industry is underway. This is yet another stealth government subsidy. By contrast, in an earlier article I wrote about the misguided Justice Department investigation of e-book pricing, another area that is already suffering badly.

Yes, Mr. Dimon, you are a success. However, I would suggest that the success you so proudly proclaim reflects the loss of two of our nation's most important values. The first is the failure of individuals and leaders to simply take responsibility for their actions and the actions of their companies. The second is that Wall Street, which should be the heart of American capitalism, has instead become the heart of a dysfunctional system that is destroying the nation's wealth.

No, bankers are not capitalists. At every turn, they demonstrate that the last thing they want is the return of real capitalism to America.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Why Inequality Matters: 3 Ways the Mortgage Crisis Has Undermined Our Legal System

Feb 17, 2012Bruce Judson

money-justice-scalesBanks are demonstrating that if you have enough money and influence, you're not expected to follow the same laws as everyone else.

money-justice-scalesBanks are demonstrating that if you have enough money and influence, you're not expected to follow the same laws as everyone else.

For several years, I have been writing that extreme economic inequality is among the most destructive forces in a society. As inequality grows, it undermines the effective functioning of the economy, the basic tenets of capitalism, and the foundations of democracy.

Unfortunately, the housing crisis and now the housing settlement increasingly look like an example of how these mechanisms work.

One of the central characteristics of highly unequal societies is that two sets of laws develop: One set for the rich and powerful and one set for everyone else. The more unequal societies become, the more easily they accept the unacceptable, and with each unrebuked violation, the powerful actors at the top of the society gain an ever greater sense of entitlement and an ever greater sense that the laws that govern everyone else don’t apply to them. As a result, their behavior becomes increasingly egregious.

I would suggest that the robo-mortgage scandal is a strong indicator that this type of unequal justice is now becoming ever more commonplace in America. Past bank abuses are typically discussed without a sense of outrage. They have, in effect, become a recognized practice of deception with no consequences. Here are three prominent examples from the past few years:

First, the robo-mortgage scandal was discovered. As powerful members of society, the banks effectively decided what laws they wanted to follow and disregarded others. The banks claimed that their violations were technical and harmed no one. Nonetheless, the activities of the banks constituted massive fraud, perjury, and conspiracy. Bank officials have testified in court that they filed as many as 10,000 false affidavits a month. These are effectively undeniable admissions of law-breaking on a massive scale.

It’s a federal crime, punishable by up of five years of imprisonment, to knowingly file a false affidavit with the court. From the perspective of the law, you are guilty of the same perjury when you falsely testify in court or when you submit a false affidavit. In most states, filing false affidavits with the court similarly constitutes a felony offense of perjury.

If an individual citizen perpetrated this kind of massive perjury, he or she would be prosecuted. For illegal activities to take place on this type of massive scale, other serious crimes, such as conspiracy, are undoubtedly committed as well.

This week an audit of San Francisco mortgage practices, the first systematic audit in the nation, revealed that an astounding 82 percent of the cases analyzed involved suspicious activity by the foreclosing institution and concluded that a large portion of these activities probably involved felony violations of California perjury laws.

Second, when Martha Coakley, the attorney general of Massachusetts filed a civil suit related to the robo-mortgage scandal against several financial institutions, she was demonized by the financial services industry and appropriately recognized for her bravery by housing advocates seeking to end abusive bank practices.

What is noteworthy, however, is that Coakley filed a civil suit. This was a lenient effort as she undoubtedly had the ability to build a compelling criminal case against the banks (as institutions) and the bank officers who knowingly created the robo-mortgage scheme.

Third, the national housing settlement, involving the federal and state governments, was announced last week. A central concern associated with the settlement is how it will be enforced. The banks have a long and well-documented history of agreeing to settlements that will change their behavior and then failing to live up to these binding agreements. Moreover, penalties for failure to comply with these settlements are rarely, if ever, assessed.

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In her New York Times feature story, "The Deal is Done, but Hold the Applause," Gretchen Morgenson wrote about this behavior, and how it relates to the current settlement:

But perhaps the largest question looming over this settlement is how it will be policed. Recent history is littered with agreements that required banks to take specific steps to make amends. All too often, the banks have skated away from their promises.

Morgenson then recounts a series of instances where the banks failed to comply with past settlements, including this quote from a former judge involved in these processes and her conclusion:

"It's astounding that in such a huge percentage of cases the lenders are not complying," said Philip A. Olsen, a former Nevada Supreme Court settlement conference judge. "The banks have learned that they can thumb their noses at the program and it won't cost them anything."

So you have to wonder whether banks will thumb their noses at last week's settlement, too. That makes policing compliance crucial.

The full details of the settlement have not been released, but unfortunately, the most recent disclosures suggest that this enforcement power and large penalties per violation are wishful thinking. An executive summary of the provisions of the settlement can be found here. It states, among other things: "If banks fail to remedy violations, they are subject to civil penalties of up to $5 million from the court.”

While the full details may suggest otherwise, the process as described here seems to be a far cry from substantial penalties for each failure of compliance. Why does the monitor need to provide the banks with a chance to remedy violations of the settlement? The banks certainly know what they are supposed to be doing. It is a clear indication that the banks will be able to act without a sense of urgency.

In addition, have the banks agreed that they will not contest the monitor’s request of penalties to the court? If not, then, as I have noted previously, a court fight over each penalty can ensue -- with the possibility that the entire monitoring process is a charade.

I hope that I am wrong, but the above analysis certainly suggests that, in Morgenson’s words, banks will have the opportunity to “thumb their noses at last week’s settlement” without incurring serious penalties.

The stakes here are enormous. They extend beyond the housing market to the nature of American society itself. The banks’ blatant malfeasance with regard to the robo-mortgage scandal and other foreclosure-related activities has been a clear example of unequal enforcement of the laws.

Sustainable capitalism requires that all participants in a contract or bargain believe their interests will be enforced equally by the courts: Capitalism requires that Lady Justice wear a blindfold. When powerful players are permitted to alter established rules at will, capitalism ultimately collapses. Contracts and the idea of a fair bargain become meaningless as less powerful parties to an agreement know their rights will not be enforced. Over time, citizens lose faith in government and their own ability to thrive in what becomes a corrupt economy. This uncertainty leads the small businesses, which are so often cited as important to our economy, to shy away from new activities that might put them at the risk of unequal treatment.

President Obama has declared economic inequality to be “the defining issue of our generation.” I agree, but I am terrified that the most recent news related to the housing settlement is not the definition the president intends.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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The Mortgage Settlement's Missing Piece: Will Banks Now Follow The Law?

Feb 10, 2012Bruce Judson

home-foreclosure-documentIf the ability for independent monitors to impose fines for failing to follow the law is eviscerated, we'll be back where we started -- or worse.

home-foreclosure-documentIf the ability for independent monitors to impose fines for failing to follow the law is eviscerated, we'll be back where we started -- or worse.

The country's banks agreed to change their behavior as part of the robo-mortgage settlement announced earlier this week. The announcement, however, leaves open a central question: Does the settlement include new, pre-defined penalties for banks that fail to uphold their new promises? Since a change in bank behavior is a vital piece of the settlement, the absence of an answer is highly disconcerting.

When the deal was announced, the Associated Press reported, "The conditions will be overseen by Joseph A Smith Jr., North Carolina's banking commissioner. Lenders that violate the deal could face $1 million penalties per violation and up to $5 million for repeat violators." The initial impression on reading this report is that there are real teeth to it. It sounds like the banks are agreeing to pay $1 million dollars each time they fail to perform as promised.

However, the actual press release from the Department of Justice announcing the deal reads (emphasis added):

Compliance with the agreement will be overseen by an independent monitor, Joseph A. Smith Jr. Smith has served as the North Carolina Commissioner of Banks since 2002... The monitor will oversee implementation of the servicing standards required by the agreement; impose penalties of up to $1 million per violation (or up to $5 million for certain repeat violations); and publish regular public reports that identify any quarter in which a servicer fell short of the standards imposed in the settlement.

There are two open questions. First, what does "up to" mean? Does the independent monitor have discretion over the size of each penalty? This could effectively make the million dollar figures announced by the Justice Department meaningless. Banks have argued that the tens of thousands of robo-mortgage signatures and well-documented servicing errors were all technical violations that harmed no one. Undoubtedly, they will argue that any single violation was a meaningless error.

This provision would have real meaning if we applied the same standard our nation has applied in other areas: a zero tolerance rule. What would happen if each bank knew that any violation would result in a minimum fine of $1 million? I suspect bank behavior would change significantly.

Second, can banks contest these fines? Have the banks agreed that they will pay any fines assessed by the independent monitor? If not, then once again the provisions have the potential to be meaningless. The monitor will assess fines for violations and the banks will challenge the fines through whatever venues, the courts or otherwise, have been established by the settlement. The judgment and ability of the independent monitor to set fines will have been eviscerated.

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Efforts to determine answers to these and related questions have seemingly been rebuffed. The Huffington Post reported on its efforts to understand the details of the enforcement provisions of the settlement:

Details of how the states will make sure banks follow the deal's guidelines haven't yet been released... The announcement on Thursday did not include any new information on bank penalties. A call to the Smith's office was not immediately returned. A HUD spokesman did not immediately return an e-mailed request for comment.

There appears to be near universal agreement that this settlement will do little for homeowners who have been the victims of past bad bank behavior. But there may be real value in the deal if it successfully changes bank behavior going forward. The New York Times quoted the Attorney General of North Carolina as saying, "This agreement is more important for the foreclosures we're hoping to prevent."

At the same time, The New York Times wrote, "Advocates for homeowners facing foreclosure expressed cautious optimism," but indicated that these same advocates believe rigorous enforcement is essential for the program to work:

"We're hopeful," said Joseph Sant, a lawyer at Staten Island Legal Services' homeowner defense project. "But we had a lot of programs that are good on paper. What will make the difference is that it's vigorously enforced."

The stakes here are enormous. They extend beyond the housing market to the nature of American society itself. The banks' blatant malfeasance with regard to the robo-mortgage scandal and other foreclosure-related activities has been a clear example of unequal justice. The banks have knowingly and repeatedly violated laws (such as providing tens of thousands of false affidavits to the courts) that would have landed an ordinary citizen in jail.

At the same time, successful capitalism itself depends on the enforcement of rules and contracts in a fair bargain. When powerful players are permitted to alter pre-established rules at will, capitalism ultimately collapses. Contracts and the idea of a fair bargain become meaningless as less powerful parties to an agreement know their rights will not be enforced. Over time, citizens lose faith in government and their own ability to thrive in what becomes a corrupt economy.

If the settlement enforcement provisions turn out to lack substance, these forces will be reinforced rather than counteracted. We must wait for the details. Like homeowner defense advocates, I am cautiously optimistic -- but terrified that ultimately I will be disappointed.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Seven Questions Begging to Be Answered Before a Foreclosure Settlement is Reached

Feb 2, 2012Bruce Judson

foreclosure-gavel-150Why the secrecy? Why the haste? Rushing into an ill-advised settlement with the banks may undo one of our last chances to avert another economic catastrophe.

foreclosure-gavel-150Why the secrecy? Why the haste? Rushing into an ill-advised settlement with the banks may undo one of our last chances to avert another economic catastrophe.

Tomorrow is the deadline for state attorneys general to sign on to a joint federal and multi-state $25 billion settlement of the robo-mortgage scandal. The settlement will involve Ally Financial Inc. (formerly GMAC), Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co., and Wells Fargo & Co. The details of the proposed settlement have not been released. However, one thing is clear: This settlement puts the nation at further risk of another systematic financial crisis and runs counter to any notion that the actions of the Obama administration will reflect the president's newly energized populist rhetoric.

As a nation, we need to ask several questions. As a participatory democracy, we also have the right to the answers before any settlement is inked:

1. In his State of the Union Address, President Obama announced a new financial crimes taskforce, yet the administration is rushing to finalize this settlement before the taskforce begins its work. Why?

2. What is the public interest in releasing banks that have openly admitted they broke the law in tens of thousands of separate instances from liability?

3. The bank narrative has been that the robo-mortgage scandal reflected procedural issues of no consequence (despite the fact that they constituted fraud, perjury, conspiracy, and a knowing effort to mislead the court). Recently, a new narrative has emerged that suggests these activities were actually the back-end of even greater malfeasance involving tax evasion and the banks' failure to comply with basic rules in securitizing mortgages. If we are a nation where justice is blind, should we not investigate the full truth before we give the offending financial institutions another free pass?

4. Why are the terms of this settlement secret? Prosecutorial negotiations are normally secret in order to prevent the disclosure of evidence that might or might not be relevant to a later trial if the negotiations collapse. This concern does not apply here.

5. This settlement has far more of the characteristics of legislation than of prosecutorial activities. The offending banks have destroyed the wealth, livelihood, and dreams of millions of Americans. Shouldn't the public at least have two weeks to view the proposed terms of the settlement and make their views known to their state's attorney general? And at a time when trust in government is at historic lows, isn't secrecy for this type of activity the wrong way to build the much-needed confidence of the American people?

6. The press also has a constitutionally guaranteed role in our system of governance. In these unusual circumstances, isn't this precisely the type of situation where the nation would benefit from careful scrutiny of the intended settlement by the press?

7. Officials have indicated that the settlement will require banks to write down the principal on homeowner loans. Unfortunately, a portion of the $25 billion allocated for this purpose is far too little, spread across a large number of homeowners, for any write-downs to make an effective difference. So either these statements are effectively meaningless, or the settlement is based on promises of future activities by banks. To date, the nation has witnessed repeated and egregious failures by the banks to live up to promises of future behavior, with no subsequent penalties for such failures. For any release from liabilities to be effective, shouldn't it be contingent on the banks actually delivering on these promises?

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Since the start of the economic crisis, none of the administration's housing policies have succeeded. Each policy initiative has been fatally flawed. As a consequence, there's no reason to believe that the policy pursued in the current settlement will aid, rather than hurt, the housing market. Meanwhile, the secrecy surrounding this policy initiative makes its potential positive contribution to the crisis even more suspect.

A month ago, I wrote that we were a nation in denial with regard to housing prices and the impact of ongoing foreclosures. Despite a favorable rent to buy ratio, ultra-low interest rates and an "all time low cost of owning a home," housing prices are continuing downward. There is a simple explanation. With foreclosures and the so-called shadow inventory of homes, our housing supply will overshadow demand for many years to come.

With 29 percent of homeowners already underwater, this creates a massive risk for the economy. Some analysts predict that home prices will drop another 10 to 20 percent, which will put many borrowers deeply underwater. With additional price declines, underwater homeowners may start to simply walk away in droves. This will create havoc for our economy, the mortgage securities markets, and it will destroy solvency of the banks as they are forced to write-down their portfolios. The nation will be plunged into another economic crisis.

Unfortunately, all indications over the past several weeks are that this risk is continuing to grow. Indeed, the most recent reports on housing prices showed larger than expected declines in November. This reflected the third month in a row of declines. "The trend is down and there are few, if any, signs in the numbers that a turning point is close at hand," said David M. Blitzer, chairman of the S&P's home price index committee.

In his State of the Union speech, President Obama stressed assistance for "responsible homeowners." Yet the current definition of a responsible homeowner is someone with a job. (Although yesterday the president did say, "We're working to make sure people don't lose their homes just because they lost their job." ) So, at least for the moment, continued unemployment woes will keep this vicious cycle going.

Here's how this relates to the proposed settlement: All of the activities covered by the settlement took place after the crisis began. They were not unforeseen effects of once-in-a-lifetime systematic risk. They reflected willful, knowing, and egregious malfeasance and disrespect for the rule of law. There is no question that laws were broken on a massive scale with potentially enormous civil liabilities and with criminal offenses. The essence of capitalism is responsibility and accountability. The settlement ignores both.

I suspect that the existing testimony of bank officials in open court, which are effectively admissions of guilt, provides sufficient evidence to lead to state and federal suits that would make the banks insolvent. This means that, because of the banks' malfeasance and greed, the nation has the leverage to bargain for a massive write-down of mortgages -- thereby preventing an economic catastrophe. I am not advocating this option, nor am I saying it is good policy. But I do believe it would be a scandal to limit whatever leverage we have to save our economy by once again permitting gross malfeasance.

In late May, my eldest daughter will graduate from college and join the labor force. Will there be jobs for her and her classmates? Will she come of age in a decade of limited employment opportunities, the collapse of the middle class, and unequal justice while a privileged few live lives of abundance because they have corrupted our democracy? As someone who reveres our system of justice, what is the advice I should give her about working hard and playing by the rules? There is still a chance that we can turn all of this around. But rushing to settle with law-breaking banks is certainly not the way to solve the issue of inequality -- which President Obama called the defining issue of our time. It is also the antithesis of capitalism, which is based on adherence to law, a fair bargain, and accountability.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Ensuring a Robust Marketplace of Ideas: Antitrust Policy in the Digital Age

Jan 19, 2012Bruce Judson

internet-idea-150Will antitrust laws of the past century threaten the capitalist incentives that encourage important ideas in ours?

internet-idea-150Will antitrust laws of the past century threaten the capitalist incentives that encourage important ideas in ours?

In early December, the Justice Department confirmed that it was investigating the pricing of e-books and the related activities of major publishers and online retailers, such as Amazon.com and Apple. As a print and digital author, participant in the publishing industry, and graduate of the Yale Law School, this naturally caught my eye. It also led me to start thinking about the assumptions that underlie existing antitrust laws.

Democracy is the basis of our form of government. Capitalism is the basis of our economic system. They are distinct systems, and (at least in theory) it's possible to have one without the other. But will the antitrust rules developed to foster capitalism in the previous century inadvertently weaken our democracy in this century? In addition, do pre-digital era antitrust doctrines hinder the development of a fair, robust capitalism in our age? The current Justice Department investigation is a case study for examining these issues.

Lengthy, reasoned arguments (i.e. books) have historically played a central role in the marketplace of ideas. Important books have changed the way we look at our society, altered our political beliefs, changed foreign policy, and moved the nation in myriad ways. In the digital era, we benefit from many new forms of disseminating information, such as blogs and online news sources, all of which add to the marketplace of ideas. Nonetheless, none of these new sources of information has replaced the essential nature of a book (in physical or digital form): a lengthy effort, researched and written over a long period of time, which reflects the author's most thoughtful analysis and reflections on the subject in question.

The research and creation of many significant, important works are funded by advances from book companies. The book company grants the money up front on the basis of a proposal, which allows the author to pursue the project while earning a living. Hypothetically, if publishers stopped offering advances, many important works would never be created. Authors (who are not always academics or paid foundation researchers with a guaranteed salary) simply could not afford to undertake the work. This capitalist, for-profit motive plays an important role in funding important contributions to the marketplace of ideas.

Today, the book industry is struggling to adapt to the digital transformation. At its core, digital information has a tough time establishing value in the eyes of the consumer. If the book industry declines, some authors will undoubtedly self-publish, and it's possible new financing vehicles, for the equivalent of today's advances, will evolve. In essence, a weaker book industry means our society loses a source of funding for important, time-consuming, and extensive research and analysis.

The Justice Department has not revealed the precise nature of the investigation. But it's my understanding that when the Kindle was first released, Amazon.com priced e-books at less than the wholesale cost it was paying publishers. In effect, to boost Kindle sales and the idea of e-reading in general, Amazon was often taking a loss on sales.

A long-held tenant of antitrust law is that vertical price fixing (an agreement between the manufacturer and the retailer to sell a product at a specific price) is often illegal. These restrictions are why manufacturers offer products with a "manufacturer's suggested retail price" ("the MSRP"). The manufacturer is not permitted to formally agree with retailers on the prices consumers pay for products. The retailer is free to set the price offered to consumers, thereby enabling discounts from the MSRP. (Note: In recent years, the Supreme Court has adopted a more flexible approach to the issue or vertical price fixing, adopting a "rule of reason" test, but it remains a central area of antitrust policy.) In addition, competitors cannot work together to restrain price competition in some way (horizontal price fixing).

As the e-book business started to develop, publishers were concerned that Amazon's pricing approach was devaluing their products and (I assume) threatening to destroy hardcover sales at bookstores. In response, publishers developed what is known in the industry as "the agency model." Under this model, the publisher sets the price the consumer pays. In this model the digital retailer is not buying the product at a wholesale price, but acting as a sort of sales agent for the publisher. As the sales agent, the retailer receives a commission on each sale. In effect, digital book purchases become like insurance policy purchases, with Amazon and Apple as the brokers. From the perspective of antitrust law, the actual seller is the publisher, which sells through an agent and no agreement in restraint of trade exists. My assumption is that the Justice Department is investigating whether this agency pricing model violates restrictions on vertical price fixing and whether the way it was deployed by multiple publishers reflects some form of horizontal price fixing.

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It's easy to have a knee-jerk negative reaction to the higher e-book prices that publishers have set under the agency model. But here's where this all gets interesting. As the (now barely existent) music industry and suffering newspaper industry have learned, it's incredibly hard to establish value for digital content. This reflects the competitive marketplace that may make content available for free, consumer perceptions of what they should pay for digital goods, the availability of other revenues streams (such as advertising), and a host of other factors.

One undeniable effect is that the Internet inherently drives the value of digital goods down. Instant price comparisons, easy access to lower-priced alternative options for digital information and entertainment, and illegal file sharing all contribute to this phenomenon. Traditional publishers also face challenges in making the digital transition. Importantly, a host of new competitors that help authors create digital books have arisen, and authors can also publish on their own. So the competitive dynamic for digital books, with far easier access to low-priced and free alternatives as well as all kinds of new types of publishers and distribution models, is very different than the dynamic that existed when vertical pricing restrictions were first developed.

There is a second, more fundamental issue at work here. The digital world makes the bundling (whether explicit or implicit) of intellectual property far easier than the physical world. Companies can make their profit in one place and break even or lose money on other products to support this activity. The problem is that this kind of activity destroys the perceived value among consumers of the bundled products. Amazon, for example, may be making money on the Kindle and not the e-books, but still profit in the long run.

The basic point here is that in the digital world it's possible to imagine instances where it's profitable for retailers to destroy the perceived consumer value of e-books and the associated hard copy titles.

Our society is best served by a robust e-book industry. As e-book prices declines, fewer and fewer authors are able to make a living expressing their ideas, whether they are political, socially insightful, or a form of entertainment.

With so much new competition emerging, and so many unknowns for the publishing industry itself, my strong bias is not to stretch interpretations of antitrust laws developed for a different era-and to allow the industry to do what it feels is best for its long-term survival. If the violations of the laws are clear-cut, then perhaps the Justice Department should seek to have the laws changed before beginning an enforcement action. If no violations are clear cut, then the Justice Department should have the wisdom to leave well enough alone. The worst possible outcome would be for the Department to attempt to extend the doctrines of the antitrust laws to cover the agency model, working from the mistaken belief that this would benefit our society.

Here are two takeaways:

First, the creation of information in our society has always been recognized as playing a central role in building a healthy democracy, with the attendant benefits of the best aspects of capitalism. This recognition is embodied in the first amendment. As we move to a digital era, there is increasingly less ability for information creators to profitably fund the creation of "expensive" information (i.e. books requiring extensive research and interviews, investigative journalism, and the like). Our democracy, and ultimately the operations of a robust, fair capitalist system -- based on the best possible information -- are poorer for this loss. To the extent that any of our existing laws inadvertently destroy the remaining infrastructure that profitably supports the creation of such information, they must be reexamined.

Second, the ability for retailers to make money on one product (such as the Kindle or the iPad), while cutting prices on digital products, is something new to our era. We need to stop and think about how the distribution of products that spread ideas may be affected by antitrust laws. We must ensure that our laws are not furthering the destruction of a robust marketplace for ideas.

Full Disclosure: I have published books with several publishing houses and worked as a paid consultant to several book and magazine companies.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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The Foreclosure Crisis: A Government in Denial

Jan 9, 2012Bruce Judson

mortgage-crisis-150The Federal Reserve sent a warning shot that housing is the greatest threat to the economy. The government should take note.

mortgage-crisis-150The Federal Reserve sent a warning shot that housing is the greatest threat to the economy. The government should take note.

As we start the New Year, the executive branch and Congress continue to pretend the gravest risk to our economy and social stability does not exist: the ongoing foreclosure crisis. The financial crisis began with the housing crisis and it will not end until we resolve housing. Government policymakers who seemingly ignore this basic fact are leading the nation to another potential catastrophe.

This past week, a number of important events occurred in Washington, including important recess appointments by President Obama. However, the most noteworthy event did not make front page news: the Federal Reserve's (apparently) unsolicited memo to the committees of Congress that oversee financial services warning of the dangers the current housing market poses for the economy.

This represents an extraordinary action and underscores both the seriousness of the continuing crisis and the absence of meaningful discussion of the problem in Washington. Bernanke's memo reviewed federal actions to date and effectively concluded that they were unlikely to solve this national tragedy. The memo concluded, in part:

The challenges faced by the U.S. housing market today reflect, in part...a persistent excess supply of homes on the market; and losses arising from an often costly and inefficient foreclosure process (and from problems in the current servicing model more generally)... Absent any policies to help bridge this gap, the adjustment process will take longer...pushing house prices lower and thereby prolonging the downward pressure on the wealth of current homeowners and the resultant drag on the economy at large.

This memo is notable for several reasons. First, it's important to remember that when the Fed speaks, it does so in sober, limited terms. So an unprompted Fed warning suggesting "a persistent excess of supply" and a "resultant drag on the economy" is comparable to the Secretary of Homeland Security holding a press conference to warn of the risk of an imminent national emergency. Second, an unprompted memo from Bernanke to the House means that he is so deeply worried he felt the need to speak out in as strong a voice as his position permits. Third, the Fed rarely speaks on issues unrelated to its direct activities. Indeed, The Wall Street Journal subsequently wrote, "For an institution that jealously guards its independence, the Federal Reserve is wading into treacherous political waters."

Finally, co-ordinated speeches by three top Fed officials further indicate the depth of the Fed's concerns. On Friday, the presidents of the New York and Boston Fed banks and Betsy Duke, a Fed Governor, all gave speeches detailing the need for aggressive action to spur a housing recovery. For example, William Dudley, President of the New York Fed, told a group, "The ongoing weakness in housing has made it more difficult to achieve a vigorous economic recovery."

There are a multitude of other indicators that our current treatment of the housing sector will at minimum prevent an economic recovery and at worst have disastrous consequences for the stability of the financial sector as well as the health of the middle class. (For the record, my analysis leans toward the latter of these two viewpoints.) These include the reportedly poor health of our financial institutions (zombie banks), the administration's seeming efforts to cover this fact up, and the inevitable failure of federal homeowner assistance programs that rely on the cooperation of financial institutions whose profit incentives are in the reverse direction.

Consumer spending represents 70 percent of the nation's economy and is central to any economic recovery. To achieve sufficient aggregate demand (i.e. total spending on goods and services), this will require spending by middle-income individuals in addition to what we now call the 1%. The Fed report suggests that the housing crisis makes such a recovery unlikely.

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The report found that, in the aggregate, more than $7 trillion in home equity -- more than half of the aggregate home equity that existed in early 2006 -- has now been lost, noting, "This substantial blow to household wealth has significantly weakened household spending and consumer confidence." Moreover, "Middle-income households, as a group, have been particularly hard hit hit because home equity is a larger share of their wealth in the aggregate than it is for low-income households (who are less likely to be homeowners) or upper-income households (who own other forms of wealth such as financial assets and businesses)." These households have seen their home equity decline by an estimated 66 percent.

Moreover, the fear of a continuing loss of wealth (which is a cushion against job loss or other economic emergencies), the fear of job loss itself, the negative effects of underwater homes, lack of forbearance for unemployment (a point the Fed particularly emphasizes), and consumers struggling to meet mortgage payments in a far more difficult environment are all dragging the economy down.

There is also a far worse possibility. Today, an estimated 29 percent of all homes with mortgages are underwater. In addition, at least one respected analyst estimates that a total of 14 million homes will be foreclosed on from 2007 to the end of the crisis. This represents a hard-to-imagine one in every four mortgages. With foreclosures increasing, there is now such a looming imbalance of supply and demand that, as the Fed notes, further decreases in home prices are likely. Some believe home price reductions of another 20 percent are likely. This would, in all likelihood, have disastrous consequences on at least three fronts -- and ripple effects that are impossible to predict.

First, so many homeowners would be so far underwater that massive walkaways would be likely. The negative impact on consumer spending of such price declines would almost certainly lead to a vicious cycle of more job losses, leading to further walkaways by struggling consumers.

Second, the mortgage securities market would be in chaos. Nonperforming loans would lead to the forced recognition that bank capital (based on the value of mortgages in bank portfolios) is weak or insufficient.

Third, it is almost impossible to imagine foreclosures on the massive scale anticipated without dire social consequences or even some form of social unrest. As Peggy Noonan has observed, the real meaning of Occupy Wall Street is that this is just the beginning of the protests we are likely to see. "OWS is an expression of American discontent, and others will follow," she predicts. Protests and social unrest are particularly likely if people feel they are unfairly losing their homes to support irresponsible, law-breaking institutions that have successfully disregarded the fundamental rules of capitalism and good citizenship. Mechanisms to avoid this possibility are one of the central issues I address in my forthcoming book, Making Capitalism Work for the 99%: A Manifesto.

What is shocking is the almost total lack of attention the administration has paid to suffering homeowners. It's hard for me (and apparently Chairman Bernanke) to understand how the administration can possibly hope to revitalize the economy without seriously addressing the overhang of consumer housing debt. Moreover, the failure to address the risk this poses for a broader economic catastrophe borders on the inexcusable.

If President Obama is serious about saving the middle class and reducing income inequality, the administration needs to be far more aggressive in developing policies to keep homeowners as homeowners. As I have written before, this was one of FDR's central goals in the New Deal. Detailed proposals for addressing this extraordinary risk do exist. However, they will require a determined effort. There are solutions, but they are not simple.

What is most important right now is that we recognize we are in a lifeboat that will not reach land. We need to focus on implementing a meaningful solution to the problem. A clock is ticking and Washington needs to acknowledge that a witching hour is approaching.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Are the .01% Capitalists?

Dec 22, 2011Bruce Judson

money-question-150The super-rich might not be so outraged by accusations that they haven't earned their money fairly if they didn't know it was true.

money-question-150The super-rich might not be so outraged by accusations that they haven't earned their money fairly if they didn't know it was true.

Thanks to the Occupy movement, the extreme inequality in America has become a focus of the national dialogue. Recently, several of the super-rich have stepped forward to defend their place in society. Leon Cooperman, the billionaire founder of  Omega Advisors, a hedge fund sponsor and previously a senior official at Goldman Sachs, wrote a much publicized letter to President Obama, while Bloomberg News reported that Jamie Dimon, the CEO of JPMorgan Chase & Co, used a question at an investor conference as an opportunity to say that "Acting like everyone who's been successful is bad and because you're rich you're bad, I don't understand it."

For me, the question is not why there seems to be an outpouring of criticism and anger at the rich but whether it's justified. My answer is straightforward: Many of today's super-rich, particularly in the financial sector, have achieved their wealth in ways that are fundamentally anti-capitalist. As a consequence, people are justifiably wondering whether we have an economy that operates on the principles of capitalism or of oligarchy.

A central tenet of capitalism is that those who create the greatest wealth for society should receive the highest compensation. This is the ideal that has for generations motivated Americans and led to the admiration, indeed often veneration, of the rich. These wealthiest members of our society are seen as the people that have helped make us all somewhat better off.  As a result, they deserve their rewards.

What the Occupy movement and others are questioning is whether making us all better off is, in fact, what has made people "rich" and "successful" (Mr. Dimon's words) in the current era. Are the rich and successful the creators of wealth and jobs for all of us, or are they the predators and moochers (Ayn Rand's term in Atlas Shrugged), the reverse Robin Hoods who succeed by finding ways to redistribute wealth upwards?

To me, it's also notable that the most virulent complaints of the 1% seem to come from those in the financial sector. As I talk with wealthy Internet titans, I hear almost universal praise for our societal focus on income inequality. In essence, the complaints emanating from our financial titans have the ring of Shakespeare's famous phrase in Hamlet, "the lady doth protest too much, methinks."

Let's examine the ways in which many of today's highest income Americans, originating in the financial sector, are reverse Robin Hoods rather than wealth creators:

First, as I have written in earlier articles, the financial sector now operates outside all of the disciplines that are inherent in capitalism, from accountability for terrible business decisions to the enforcement of fair bargains to retribution for malfeasance. On the contrary, Bloomberg News recently disclosed massive secret Federal Reserve support for failing banks. This has led to an emerging consensus that the financial sector is socially useless or acutally destroys our overall societal wealth. Nobel Laureate Paul Krugman wrote in his New York Times column that:

[A]fter the debacle of the past two years, there's broad agreement -- I'm tempted to say, agreement on the part of almost everyone not on the financial industry's payroll -- with Mr. Turner's assertion that a lot of what Wall Street and the City [London's stock exchange] do is "socially useless."

In addition, it seems almost undeniable that, in the absence of the excessive anti-capitalist activities of the financial sector over the past decade, our entire society would now be wealthier. I wonder whether many of the "rich" and "successful" who have emerged in this arena would have achieved this wealth if they had been forced to compete on a level, fair playing field governed by the disciplines and rules of actual capitalism.

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Second, finance is an intermediary good. It is not an end in itself, but a means of greasing the wheels to make the economy run better. In a capitalist system the purpose of finance is to help limit risk (for example, by allowing a farmer to hedge against price drops in grain) or efficiently allocate investment capital in support of the long-term growth of new enterprises. According to AR Magazine, the top 25 hedge fund executives earned $22 billion in 2010. In addition, a recent report indicated that, despite the recession, Wall Street was on track for a record year in bonuses, while the financial sector now accounts for 29 percent of all U.S. corporate profits. Since the Census Bureau just reported one in every two Americans is poor or low income, this suggests some kind of massive disconnect between the operating purpose of the financial services sector and the wealth it is accumulating for itself versus the benefits is it creating for our larger economy.

Third, in a capitalist economy, all zero-sum activities which have a winner and loser with no growth in societal value,  are, at best worthless. Yet the majority of hedge funds, Wall Street traders, quants (the people who created sophisticated trading models), and issuers of so-called naked Credit Default Swaps all make money largely through zero-sum activities or high-speed trading (which now accounts for an estimated 75 percent of all equity trading in the U.S.), none of which are oriented toward creating value for society. This suggests, as David Cay Johnston pointed out in a recent column, that the entire business associated with so-called naked Credit Default Swaps is zero-sum gambling and should be illegal. At minimum, it has no value in a capitalist economy.

Moreover, the marginal societal benefits of hedge fund activities, if they exist, are almost certainly offset by the other costs they impose on our society. They create the potential for systematic risk to the overall economy, while hedge funds and other high-paying Wall Street activities also lead to the terrible allocation of talent in our nation. An important share of the nation's top talent is now gravitating to high-paying finance activities, engaged in determining new arbitrage strategies rather than creating the businesses that will create the next generation of jobs and real wealth the country so desperately needs.

In short, I would deem the billions of dollars in bonuses and earnings from hedge fund activity, several large lines of business, and high-speed trading on Wall Street to be antithetical to the capitalism that has helped to make America great. I recognize that I am undoubtedly painting with too broad a brush, but the fundamental point remains.

Finally, many of the rich are not playing by the same rules as the rest of Americans, and in our democracy people resent this basic unfairness. Hedge funds and private equity firms have used their political influence to ensure that the carried interest rule -- which allows a large portion of their earnings to be taxed at 15 percent as opposed to ordinary income rates -- remains in place.

So this brings me back to my original question: Are there a sizable number of the "rich" and "successful," particularly among the most notable members in the financial services sector, who don't meet even the most basic definitions of practicing capitalists?

If so, then perhaps the emerging dialogue over wealth in America is justified and represents an important examination of whether the country's economy has strayed from a core value in the capitalist ideal. Is the vitriol we are now hearing really fear that soon crony capitalism, socialism for the rich, and corporatism will no longer guide national policy?

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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