Houses Most Overvalued in Australia and Hong Kong, Most Undervalued in Japan

Mar 15, 2011Edward Harrison

house-in-hands-150Perhaps a tiny bit of good news for Japan as it heads down the road of rebuilding after a massive tragedy: the next housing bubble is building elsewhere.

house-in-hands-150Perhaps a tiny bit of good news for Japan as it heads down the road of rebuilding after a massive tragedy: the next housing bubble is building elsewhere.

A few weeks ago, The Economist put out its quarterly gauge of house price values. Australia just beat out Hong Kong as the most overpriced market in the developed world, with an overvaluation of 56%. Japan was by far the most undervalued market, with an undervaluation of 35%. The only other housing markets that were undervalued, according to The Economist, were Germany (12%) and the U.S. (7%). (This was well before the earthquake and tsunami in Japan, so it is hard to say what impact those events will have on house prices.)

This same report was a good one to look at regarding the housing bubble as it was popping. In June of 2005, The Economist published an article called "In come the waves" that was quite prescient:

Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000. What if the housing boom now turns to bust?

According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries' combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stock market bubble in the late 1990s (an increase over five years of 80% of GDP) or America's stock market bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.

-as quoted at Credit Writedowns, June 2008 in Naysayers, the housing bubble was obvious (with Economist 2005 chart for comparison)

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What is The Economist saying now? It's pointing to Hong Kong first and foremost:

[W]hatever those 31,000 agents say, Hong Kong homes are not a good deal, according to our latest global house-price index (see chart). In theory, the price of a home should reflect the value of the services it provides. People who choose to rent their homes buy those services on a monthly basis. Home prices should therefore reflect the rents that tenants pay. Our index calculates the ratio of prices to rents in 20 economies. In Hong Kong, that ratio is now almost 54% above its long-run average -- and it is still rising.

People in Hong Kong often blame buyers from mainland China for pushing up prices. Ironically, mainlanders often blame buyers from Hong Kong for their own property frenzy. At a recent conference at Tsinghua University in Beijing, students complained that their parents had scrimped and saved to send them to university in the city, but now upon graduation they could barely afford to live there.

Prices in China are not that high relative to rents: our index suggests that homes are overvalued by less than 13%. But this is based on the government's 70-cities index, which showed prices rising by only 6.4% in the year to December. That figure seemed implausibly low to many of China's stretched homebuyers, and the Chinese government appears to share their scepticism.

Of the bubble markets where the bubble has popped, the U.S. seems to have corrected the most. Notice that Spain still has massively overvalued house prices according to this measure. Ireland and Britain is also well above the median. Here's the chart:

economist-house-prices-graph

Edward Harrison blogs at Credit Writedowns, where this piece originally appeared.

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James K. Galbraith Testifies on Sensible Tax Reform

Mar 8, 2011

Galbraith demystified tax policy in testimony. Will Congress listen?

Statement by James K. Galbraith, Lloyd M. Bentsen, Jr. Chair in Government/Business Relations and Professor of Government, The University of Texas at Austin, and Senior Scholar, Levy Economics Institute, before the Senate Finance Committee, March 8, 2011, hearing on Principles of Efficient Tax Reform.

Galbraith demystified tax policy in testimony. Will Congress listen?

Statement by James K. Galbraith, Lloyd M. Bentsen, Jr. Chair in Government/Business Relations and Professor of Government, The University of Texas at Austin, and Senior Scholar, Levy Economics Institute, before the Senate Finance Committee, March 8, 2011, hearing on Principles of Efficient Tax Reform.

"Chairman Baucus, Senator Hatch, Members of the Committee, it is an honor for me to appear before you this morning, to discuss the fundamental principles of an efficient tax reform.

1. Taxes and Deficits. Let me begin by noting that the realized budget deficit is an economic outcome, not a policy choice. So long as the economy faces high unemployment, there is no fiscal formula -- no combination of tax increases and spending cuts -- that can make it go away.

Our present very large budget deficits arise for two reasons. First, because of the collapse of private credit, the decline of employment and activity, and therefore the fall of tax revenues in the slump and recession. This is a problem we share with the whole world, as the International Monetary Fund's staff has recently shown. Second, in the (almost unique) case of the United States, part of our budget deficit is due to the global role of the dollar and the use by the rest of the world of Treasury bonds as a reserve asset. That they do so -- "exorbitant privilege" -- is greatly to our advantage.

Neither of these forces can be controlled by cutting spending or raising taxes. One can reduce projected deficits -- for future years -- by raising future tax rates or cutting programmed spending for those years. But this is an artificial and unreliable exercise. The actual realized deficits in the future will depend on economic performance at that time, and it is economic performance that actually matters, not the deficit or the public debt. Thus tax reform -- and spending policy as well, in my view -- should properly focus on economic performance and not on deficits.

On the broader question of deficits, I am attaching for your record a brief statement by Trustees, Directors and Fellows of Economists for Peace and Security, a professional association. It affirms that the US government is not broke, that budget deficits are normal, and that our pressing priorities are related to economic performance. The statement is signed by distinguished economists including Kenneth Arrow, Andrew Brimmer, Robert J. Gordon, and Alan Blinder.

2. Tax Incentives. When economists address tax policy, they often speak of "distortions." The implied claim is that distortions are bad, and should be removed from the tax code as a matter of principle. You will not hear this language from me. To economists, the phrase "tax distortion" generally implies comparison is to a system with a "lump-sum head-tax" -- a poll tax -- because that is the only kind of tax that cannot be reduced by changing behavior. Yet the poll tax is the most regressive and pernicious tax available. In the real world, practically every other tax is plainly superior to that one.

Tax incentives are therefore an inescapable fact of life. The proper question is: which incentives work best, for which worthy objectives? And how best to reconcile the incentives in the tax code with the other function of taxation, namely the regulation of demand? Let me begin with an example.

In the years 1981 through 1984, I served first as Executive Director of the Joint Economic Committee under Chairman Henry Reuss, and then as Deputy Director under Vice Chairman Lee Hamilton. The Senate Democratic Members were Senators Bentsen, Proxmire, Kennedy and Sarbanes. In 1984, in the Joint Economic Report, we endorsed the Bradley-Kemp Tax Reform Bill. That bill later evolved into the famous Tax Reform Act of 1986.

The concept of the Tax Reform Act was to promote simplicity and fairness, without changing the overall burden or incidence, by broad income class, of the income tax. The method was to reduce or eliminate many exemptions and deductions, mainly taken by wealthy people, and then to tax the expanded Adjusted Gross Income at a lower marginal rate. The effect was to redistribute tax burdens mainly within upper-income groups, to the benefit of those who had relatively simple earned incomes (a category that had at one time included Bradley, Kemp, and also President Reagan), and to the detriment of many whose incomes were related to tax-favored activity.

President Reagan deserves full credit for adopting the Bradley-Kemp principles, which he did on the recommendation of his Treasury Department after a year of study, intended to delay consideration of the issue past the 1984 election. During that year, the Treasury tax policy office had conducted among other things an analysis of the Value-Added Tax, and had rejected that alternative for reasons that remain, in my view, valid today. Bradley-Kemp achieved an important improvement in tax fairness.

The Tax Reform Act saved the income tax. But in retrospect it had at least two problematic effects.

The first effect -- and here I speak broadly of the movement toward lower top marginal tax rates from 1978 through 1986 -- was on corporate executive pay. It is probably not accidental that the years after lower marginal income tax rates took hold -- along with lower rates on capital gains -- saw the CEO pay explosion.

Why? In part, because lower marginal rates reduced the cost to companies of raising post-tax executive pay (just as the high marginal rates had deterred big pay packages in the first place). The new rules made it irresistible for those who controlled CEO pay to reward themselves in this way. Crudely put, companies quit building skyscrapers and their chiefs built themselves mansions instead. Many ills of American corporate governance can be traced to this new age of executive self-dealing.

Second, as a political compromise, the TRA disallowed deduction of consumer interest payments except for mortgages. This led to an inexorable rise in the use of homes as collateral for loans that supported consumer, student, vacation and health-care-related spending, and therefore to the depletion of home equity as an element in the financial security of the middle class. As the process unfolded over time, it helped produce the systematic abuse of mortgage lending that became pandemic in the middle years of the last decade and that produced the financial crisis.

On the whole, there is no reason to believe that the TRA improved economic performance. The aftermath of tax reform saw the market crash of 1987 and then the recession of 1989-91, from which the economy recovered only very slowly. There were no significant increases in private savings as a share in income, nor in work effort. Thus, I do not believe that the Tax Reform Act of 1986 should be viewed today as the single ideal for the tax code going forward. In particular, a new tax reform should not make a virtue of low marginal rates. If higher taxes are needed, one of the best ways would be to impose a new rate or rates on the highest incomes. And tax reform should not aim indiscriminately at existing tax preferences for middle class Americans, some of which serve their purposes well.

For example, the Reagan years invented and the late Clinton years saw major expansion of the Earned Income Tax Credit. The EITC stabilizes the incomes of workers in the lowest-paid and hardest jobs, and protects them from unstable employment. It is invisible to employers; therefore it is likely to have little effect on the proffered wage. It is a well-designed and effective program; there is no reason to cut it just to reduce "tax distortions," and also none to cut it for "deficit-reduction."

Equally, the home mortgage interest deduction worked for many decades to promote home ownership in stable communities and neighborhoods. It became pathological only when it became the vehicle for all forms of lending, and when mortgage originators took advantage of the law to create massively abusive and fraudulent mortgage instruments, including exploding ARMS, NINJA loans, liars' loans, no-doc loans, and the rest. The appropriate solution is not to eliminate the tax preference for a standard 15-to-30 year self-amortizing mortgage with a substantial required down payment. It would be more sensible to write the law so that only that type of plain-vanilla, fully-documented mortgage received tax-deductible status.

3. Bad and good incentives: the payroll tax and the estate tax.

The payroll tax was increased sharply in 1983 and is the largest direct tax paid by most working people. It tails off, as a proportion of income, for upper-income Americans on account of the cap on earnings, and the fact that non-wage incomes are not subject to the tax. The high payroll tax rates on working people - yielding revenues which were for many years vastly higher than benefit payments under Social Security - were partly intended to shield Social Security benefits from pressures to cut them when the baby boomers began to retire. But they were also a way to shift the burden of taxes in general onto labor and away from non-labor income.

The payroll tax penalizes job creation. By extension it fosters the gray economy, welfare-dependency and crime. This was not a serious problem in (say) the late 1990s, when strong credit creation propelled us to full employment. It is a major problem today. That is why a payroll tax holiday, with the federal government holding the Social Security Trust Fund harmless, was a good idea when enacted last year. On the employee side payroll tax relief helps increase household disposable income; on the employer side it helps cash flow and to reduce the cost of job creation. There may be more efficient job-creation incentives -- the TJTC comes to mind -- but they are also harder to implement.

In the United States, uniquely among nations, about eight percent of all employment is in the non-profit sector. Why? In substantial part, because for over a century we have given wealthy citizens a strong tax incentive to make philanthropic gifts to universities, hospitals, churches, museums, foundations and other not-for-profit organizations, in advance of the grim reaper. This is partly responsible for our broadly excellent employment performance (compared to Europe) over many years. It is partly responsible for the greatness of our universities and hospitals, and for the vibrancy of our religious life. It integrates wealthy Americans back into their communities, helping to foster and strengthen our democracy. It fosters a broad decentralization of important public activities: for example, higher education policy decisions that in other countries are often vested in a single cabinet ministry, are here made by thousands of independent university administrations.

These benefits and advantages are threatened by the campaign against the estate tax, pushed heavily by one group of wealthy citizens, yet opposed by many other wealthy citizens. History and experience support the second group. There is a very strong incentive-based case for an estate tax with a high tax rate, a high level of exemption, and a one-hundred percent deduction for qualified philanthropic contributions.

4. Simplicity? A frequent stated concern of tax reformers is how best to simplify the code. One proposal before you would reduce the income tax for most filers and to replace it with a value-added tax. An appeal of this proposal is that it would eliminate many income tax returns. But of course, a large number of lower-income filers use the short form. This is not a complicated document, and to eliminate it does not seem to be a pressing priority in itself.

Yet, eliminating the federal income tax for low-income filers would make state government taxation much harder, since state income taxes are keyed to the federal tax. Meanwhile the proposed VAT would force a major restructuring of state sales taxes, which would have to convert to piggy-back on the VAT at variable rates, depending on the amount of income tax that would have to be replaced. This, in turn, would create new location incentives for business, to the disadvantage of high-tax states. These changes would create impressive challenges for states and localities already in the grip of fiscal crisis.

As a rule, let me urge you to work slowly. Any truly radical reform is likely to have far-reaching effects. They should be studied carefully, and by analysts with a wide range of views. Actions in this area should always be cautious and incremental, and claims of great gains over the existing system should always bear a heavy burden of proof. Things are often not so simple as they seem.

5. Growth? Tax reformers often promise that their proposals will favor economic growth. But there is little evidence that this has ever happened in the past. In principle, this should be no surprise. The long-run potential for economic growth depends on the growth rate of our population, the cost of natural resources, technological progress and the rate of business investment. It is very difficult for any tax reform to change these factors materially. Business investment can sometimes be stimulated by tax favors in the short-run, such as the investment tax credit. Sometimes, this is desirable policy. But a one-time increase in investment does not yield a long-term increase in the rate of growth.

Despite the tradition of hype that suffuses this topic, the most any tax law change can reasonably promise is modest improvement in economic conditions in the fairly short run. History also teaches that most of that effect comes from increasing purchasing power when it is too low - that is, from the Keynesian effect and not the supply-side effects. Tax law changes do not supply magic bullets for financial crises, nor for a period of slow technological innovation or rising costs of energy.

6. Should we tax capital, labor -- or rent? Is it a good idea to shift the tax burden from high-income to low-income Americans, in the guise of shifting the tax burden from capital to labor, in order to promote "saving and investment"? In particular, will this create new jobs? History say not: we have been shifting this burden for decades with no appreciable effect on savings, investment or jobs.

And there is also no shortage of capital in our economy. As the economist Mason Gaffney wrote in a paper delivered to the National Tax Association in 1978: "The key to making jobs is changing the use and form of capital we already have. Tax preferences for property income, in their present and proposed forms, bias investors against using capital to make jobs, doing more harm than good."

Economists from Smith to Ricardo to Mill understood that fixed investments, however useful, do not generate many permanent jobs. What creates jobs is the revolving capital that supports payrolls. A tax policy aimed at supporting employment would shift the tax burden away from labor, and off of short-term capital, and place it instead on long-term capital accumulations. If this reduces the investment in fixed capital that is desired for other reasons -- in particular, investment with broad public benefits -- then that sort of investment should be done by public authority, funded by an infrastructure bank.

Thus as a general rule fixed assets -- notably land -- should be taxed more heavily than income. The tax on property is a good tax, provided it is designed to fall as heavily as possible on economic rents. This basic argument, going back to Ricardo, remains sensible, for it aims to not-interfere where there is, in fact, no public purpose to interfere with private decision-taking. Payroll taxes and profits taxes do interfere directly with current business decisions. Taxes effectively aimed at economic rent, including land rent and mineral rents, and at "absentee landlords" as Veblen called them, do not.
An important question is how best to treat the "quasi-rents" due to new technology and thus the incentives for innovation. These are presently held as long-term capital gains and they tend to escape tax to a very large degree, with the consequence that a small number of successful innovators (and patent holders) have become an oligarchy of never-before-equaled wealth.

The incentive for innovation is an important public policy objective. But it does not require the vast prizes presently available. And it does not require that those prizes escape tax indefinitely. A sensible approach is to tax unrealized capital gains after a certain amount of time has elapsed -- perhaps at fates that rise with time -- and again subject to a full charitable deduction. In the final analysis -- that is to say at death -- once again setting the estate tax at a high rate with a high exemption encourages the early transfer of large quasi-rents to independent foundations or other non-profit institutions (universities, hospitals, churches), and into activities consistent with public purpose. I would also favor raising required foundation payout rates, so as to assure that foundations do not last in perpetuity unless they find new donors.

7. Energy and Carbon. I have explained why I do not favor substituting a value-added tax for the income tax. It might however be sensible to replace the payroll tax. In view of the oncoming crises of energy security and climate change, a tax on energy or on carbon would make a good substitute for the payroll tax, especially if it were designed to hold working families harmless, while increasing the incentives for conservation facing companies, retirees, and those with non-labor incomes.

8. Summary. Tax law serves two broad goals: the regulation of effective demand and the pursuit of public purpose. The Tax Reform Act of 1986 was gave us an income tax structure that is viable for the long run. But its purposes are not ours. We face four pressing priorities: to create jobs, to change how we produce and use energy, to restructure our financial sector, and to curtail the pernicious power of a small number of wealthy persons - our new American oligarchs - who have taken undue advantage of past tax reforms. A shift of the tax burden away from labor, onto energy, and onto accumulated wealth - with the philanthropic escape clause - would help give us back a healthier, more egalitarian, and more democratic society in future years.

The statement by my EPS colleagues follows. I thank you again for your time and attention."

FEDERAL SPENDING AND THE RECOVERY: A Statement by Directors, Trustees and Fellows of Economists for Peace and Security, February 28, 2011.

The budget adopted by the House of Representatives on February 19, 2011 does not make economic sense and is likely to do more harm than good. First, the rationale for the measure is based on a false premise. Secondly, the budget cuts being proposed will impede and may end the recovery. If the recovery fails, unemployment will increase and the financial crisis could re-emerge.

The premise that the US government is broke is false. The US government has never defaulted and will not default on any of its financial obligations. Deficit spending is normal for a great industrial nation with a managed currency, and it has been our normal economic condition throughout the past century. History proves, and sensible economic theory confirms, that in recessions, increased federal spending -- not balancing the budget -- is the tried and true way to return to a path of sustained growth and high employment.

Eliminating waste in government spending is desirable. But that is not what the House proposes; indeed the House budget failed to address the largest waste in federal government, namely in the military, and the House failed to remove our most egregious subsidies, such as to oil companies. To adopt a policy of deep budget cuts at this stage of recovery is to surrender to irrational fears in the service of a political, not an economic, agenda.

As economists, as citizens, and as long-time critics of waste in government, we call on the Senate to reject the House proposal and to craft an alternative that places first priority on sustaining economic recovery and on dealing with the country's true economic and social problems, which include unemployment, home foreclosures, the fiscal crisis of states and cities, our infrastructure needs, energy security and climate change."

Clark Abt, Brandeis University and Cambridge College
Kenneth Arrow, Stanford University, Nobel Laureate
Marshall Auerback, Madison Street Partners
Barbara Bergmann, American University and University of Maryland
Linda Bilmes, Harvard University
Stanley Black, University of North Carolina
Alan S. Blinder, Princeton University
Andrew F. Brimmer, Brimmer & Co.
Kate Cell, Principal, Kate Cell Consulting
Lloyd Jeff Dumas, The University of Texas at Arlington
Gary Dymski, University of California, Riverside
James K. Galbraith, The University of Texas at Austin
David Gold, The New School
Robert J. Gordon, Northwestern University
Michael Intriligator, UCLA
Richard F. Kaufman, Bethesda Research Institute
Ann Markusen, University of Minnesota
Richard Parker, Harvard University
Dimitri B. Papadimitriou, The Levy Institute of Bard College
Gustav Ranis, Yale University
Kathleen Stephansen
Lucy Law Webster, Center for War/Peace Studies, New York

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Democratic Finance v. Banking Fraud in Early America

Mar 7, 2011William Hogeland

money-shark-150Ordinary 18th-century Americans fought for fair access to small-scale credit and usable currencies. Big finance fought back.

money-shark-150Ordinary 18th-century Americans fought for fair access to small-scale credit and usable currencies. Big finance fought back.

Calling modern banking "a widespread fraud," Rob Burns wants to push the finance industry out of everyday lending. A candidate for Congress in the fourth district of Illinois, Burns proposes using federally insured savings as a public fund for mortgages, student loans, consumer credit, business bridge loans -- the kind of borrowing engaged in by ordinary Americans, not entrepreneurs. On a different finance reform front, the technology pioneer and culture critic Douglas Rushkoff has been exploring complementary currencies. Rushkoff envisions new monetary units, exchanged via handheld devices, helping to break what he calls "the money monopoly."

Far-reaching ideas for getting money, currency, and credit to flow more democratically through the American economy would probably draw all-purpose condemnations like "socialism!" from the rightists led by Sarah Palin and Michele Bachmann. Liberal high finance experts too might find such proposals dangerously chaotic. But regardless of practicalities and politics, it's useful to recognize that ideas like Burns' and Rushkoff's have deep roots in the American founding period. The Tea Party has done such a successful job of associating anti-government, free-market politics with essential American values -- and historians have been so eager to ignore the economic activism of ordinary, founding-era Americans in favor of assessing and re-assessing the elite founders' republican philosophies -- that it can be startling to confront the democratic theories about popular finance that prevailed in 18th-century America.

And "theories" is the right word. People of the founding period put forth their economic ideas in resolutions, petitions, and actions. In an earlier post in this series, I discussed traditional rioting in the context of struggles between American debtors and creditors. Long before the Stamp Act riots of Revolutionary fame, crowd action -- rowdy, creepy, theatrical, sometimes violent -- played an important role in American social life. Crowds dismissed by the upscale as "the mob" called their movements "regulations." From the North Carolina Regulation of the 1760's to Shays' Rebellion of the 1780's and beyond, American debtors, barred from fair representation in politics, engaged in obstruction, boycott, court closing, jury nullification, building teardown, and physical intimidation. They wanted their legislatures to restrain the power of wealth.

Just like Rushkoff and Burns today, 18th-century popular regulators focused on small-scale credit and readily negotiable currencies. Scarcities of cash gave merchants a monopoly on gold and silver coin, enabling them to dominate small farmers, artisans, and laborers through loan shark-style lending terms: debtors, in constant danger of foreclosure, could effectively become merchants' laborers. Hoping to elude the money monopoly's clutches, people looked to their colonial governments to create "land banks," where small operators could take small loans on reasonable terms. Spent by holders on purchases, land bank notes found their way into circulation, becoming a kind of currency that at times came even into the hands of the landless.

Another thing governments could do: issue paper currency. Government notes represented amounts in metal; their value depended on people's belief that they'd be worth roughly what was printed on them. A commonplace of American history has it that early paper currencies depreciated disastrously, but the reality is far more varied. New England had difficulty making paper finance work, but Pennsylvania successfully alleviated economic crunches using both land banks and its own paper. The trick to encouraging confidence and controlling depreciation was to issue limited amounts of the paper and then to retire it through scheduled taxes, payable in the notes themselves. Depreciation did occur, as it does today. But popular finance activists saw mild depreciation as a natural and democratic effect, benefiting debtors.

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Improvised popular currencies existed, too, complementary in Rushkoff's sense. A craft commodity like whiskey -- not a mere instrument of barter but always exchangeable for gold somewhere down the line -- held value well.

Merchant lenders, however, wanted to be paid in coin. They wanted the gold that, they believed, held perfect value in imperial trade and which ordinary people could rarely come up with. The people countered by pressuring governments to make paper currencies legal tender, forcing merchants to accept paper at face value for payments and principal -- a kind of government program to prevent foreclosure and debt peonage. Lenders forced to take payments worth less, against gold, than when loans were made disdained paper currencies as confiscatory, rotten, mobbish, and vile, "the curse of pulp."

Lenders may actually have contributed to financial crises by recoiling so violently from any hint of depreciation. Yet their philosophy had a certain consistency. American merchants were already calling the English government tyrannical for violating ancient rights to security in property. Now merchants feared that American governments, vulnerable to what they saw as another kind of tyranny, that of the mob, would take property in another way, through legal tender legislation and state enforced devaluation. The debtor class, for its part, had little interest in what merchants defined as the big picture.

So even as the country moved toward climactic conflict with England, a great social battle raged between American merchants and American working people over credit and currency. We've been distracted from that battle's significance by historians' relentless focus on merchants' frustration over Parliament's trade acts. Those acts included currency laws, which restricted paper emissions in the colonies: sometimes American merchants too had advocated issuing paper. But merchants came to hate paper's democratizing, socially equalizing tendencies in American society. By the time American elites began relying on ordinary people for help in opposing England -- especially on the people's facility with organized protest! -- working Americans' desire for economic, social, and political equality was driving the merchants' anxiety to a nearly hysterical pitch.

Our current financial crisis reflects those deep-seated American economic disagreements, wired into events and philosophies that gave birth to our country, were never resolved during that period, and glossed over in certified stories of our origins for more than two centuries. Many people today, of various political persuasions, will want to dismiss thinking like Rushkoff's and Burns', which goes far beyond finance reform and asks fundamental questions about how, and for whose benefit, we want credit and money to work in American society. To our little known 18th-century ancestors, the founding activists for democratic finance, those questions would be among the most important we could be asking.

William Hogeland is the author of the narrative histories Declaration and The Whiskey Rebellion and a collection of essays, Inventing American History. He has spoken on unexpected connections between history and politics at the National Archives, the Kansas City Public Library, and various corporate and organization events. He blogs at http://www.williamhogeland.com.

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Angelo Mozilo, Tea Partier?

Mar 4, 2011Matt Stoller

mozilo3Mozilo's emails expose a political philosophy borrowed from Ronald Reagan. **You can follow Matt Stoller on Twitter at http://www.twitter.com/matthewstoller

mozilo3Mozilo's emails expose a political philosophy borrowed from Ronald Reagan. **You can follow Matt Stoller on Twitter at http://www.twitter.com/matthewstoller

I was combing through the Financial Crisis Inquiry Commission resource materials, and I found an interesting email from former Countrywide CEO Angelo Mozilo to his senior executives. It was written in 2004, and the main subject was the declining credit quality of loans due to heavy competition from mortgage originators.

The last part of the email, though, got very political.

I must admit that the upcoming election has exacerbated my concerns in that a Kerry win could cause a serious disruption in the economy if he is successful in rolling back a substantial portion of the tax breaks initiated by Bush. It is the wage earners $200,000 and over that are the drivers of the economy and that is the group that Kerry has stated that he will attack. This could clearly cause a major bump in the road.

As you know I have no political bias but I would be concerned about any candidate that proposes a massive wealth transfer from the people to the federal government.

I would like you to consider my concerns and let me know your thoughts.

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It's true Mozilo had no political bias in terms of who got favorable lending treatment; lots of Democrats took out low-cost Countrywide "Friends of Angelo" loans. But the rhetoric and politics he uses here are straight up Texas GOP.

The transfer of power from the people to the federal government, and with Obama, we’ve had a giant leap in that direction.

It originates, perhaps not surprisingly, from Ronald Reagan, as quoted by the "second coming of Reagan" and tea party darling Rep. Mike Pence.

The federal government has taken too much tax money from the people, too much authority from the states, and too much liberty with the Constitution.

He and Reagan were both government-haters. Now, Mozilo needn't have worried about the 2004 election, as John Kerry voted to extend the Bush tax cuts last year and probably would have found a way to extend them as President. It is interesting that Mozilo, whose business depended on the income of people in lower and middle income brackets, felt that it was people with incomes of $200k and up who drive the economy.

As for the rest of the email, Mozilo was clearly telling his executives in private something different than he told his investors. Here's what he told his execs.

I fully understand that our residuals have been modeled on a conservative basis but it is only conservative based upon historical performances. But the type of loans currently being originated combined with the unprecedented stretching of all aspects of credit standards could cause a bump in the road that could bring with it catastrophic consequences.

Here's Countrywide's 10K for 2004.

We develop cash flow and prepayment assumptions based on our own empirical data drawn from the historical performance of the loans underlying our other retained interests, which we believe are consistent with assumptions that other major market participants would use in determining the assets’ fair value.

So there you have it. Angelo Mozilo didn't just dump hundreds of millions of dollars of stock when he secretly knew that the loans Countrywide was originating couldn't support the stock valuation. He was also Reagan-esque as he did it.

Matt Stoller is a Fellow at the Roosevelt Institute and the former Senior Policy Advisor to Congressman Alan Grayson.

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Do We Want to be Ruled by Banks or the Law?

Mar 3, 2011

Yves Smith found a nice press release from North Carolina's Guildford County Register of Deeds regarding the continuing criminal fraud of the banks and mortgage industry. The elected county official, Mr. Thigpen, states:

For me the question is clear. Do we want land records in America to be governed by major banking conglomerates on Wall Street or the people and laws of the United States of America?

Yves Smith found a nice press release from North Carolina's Guildford County Register of Deeds regarding the continuing criminal fraud of the banks and mortgage industry. The elected county official, Mr. Thigpen, states:

For me the question is clear. Do we want land records in America to be governed by major banking conglomerates on Wall Street or the people and laws of the United States of America?

That indeed is the question for all of us on many matters -- financial, economic, and political. It is no mistake this question is coming not out of DC or NY, but the true foundation of this republic, the counties. As Jefferson said, "Divide the counties into wards." There America lies your reformation, revitalization, and renewal. The three Rs.

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Foreclosing the Foreclosers, Early-American Style

Feb 28, 2011William Hogeland

american_colonial_flagMemo to Tea Party: The major social battle raging during the time of the American Revolution was over the proper uses of money and credit. Not getting government out of the economy.

"I got debts that no honest man can pay ... "

american_colonial_flagMemo to Tea Party: The major social battle raging during the time of the American Revolution was over the proper uses of money and credit. Not getting government out of the economy.

"I got debts that no honest man can pay ... "

~~Bruce Springsteen, "Atlantic City"

O. Max Gardner III, a patrician lawyer in Shelby, North Carolina, has started a movement for resisting home mortgage foreclosures.

In what Reuters describes as "legal jiu jitsu," Gardner teaches techniques for using a bank's lumbering hugeness to enable people to stay in their homes long after banks want them gone. He's not alone. A foreclosure resistance movement has gained national traction in the past year. The Times has reported on local sheriffs' refusals to evict, and in an especially pointed act of guerilla theater, Patrick Rodgers of Philadelphia recently turned the tables on Wells Fargo by starting a foreclosure against the bank's local mortgage office. According to ABC News, the bank had not paid Rodgers a court-ordered judgment it sustained in the process of failing to respond to his demand under the Real Estate Settlement Procedures Act (RESPA) for information about his mortgage. Rodgers thought his foreclosure gesture would at least get the bank's attention.

The foreclosure resistance movement understandably disconcerts those who are concerned above all about fulfilling legal contracts and taking what the Tea Party-connected right calls "personal responsibility" for the inability to make mortgage payments. Yet the resistance has strong precedents in the same founding-era America to which the Tea Party constantly appeals. Conflicts not between American colonists and the British government but between small-scale American debtors and big-time American creditors illuminate struggles that continue today.

It can be hard to envision an early America seething with conflict between ordinary, hardworking Americans, stifled in their efforts to get ahead, and the rich, predatory Americans who stifled them. Prevailing historical fantasies of pre-Revolutionary America conjure a modestly thriving yeomanry, along with craftsmen, small businesspeople, and merchants participating together in a representative civics. In this fantasy, income and wealth disparities look minor and manageable; slavery and women's subjugation are terrible deviations from an ethos of liberty shared more or less democratically by free Americans of all types. The main problem for everyone is the restrictive influence of the British elements in government. The rosy narrative has it that a revolution dedicated to freedom of trade and thought and the proposition that all men are created equal will launch this society on a grand progress, embattled but irresistible, toward a democracy that includes everybody.

Of course many historians have added troubling nuance to that picture; some have debunked it entirely. Certain history students, possibly over-interpreting the work of Howard Zinn, routinely reduce famous American founders to self-interested hypocrites. Yet across the political spectrum, fuzziness about founding-era economics, credit and monetary policy persists. The fuzziness helps today's populist right cast nativism and unfettered markets as essentially American.

The possibly startling fact is that the major social battle raging before, during, and after the American Revolution was over the proper uses of money and credit in American life. For ordinary people of the period, these were hardly abstractions. The only real money in 18th-century America was metal -- silver and gold coin from England, Spain, and Mexico -- and for long, terrible periods, money was rarely seen by ordinary people. Small farmers and artisans, wanting to survive and improve their lot, had to borrow. Merchants, gaining access to metal through imperial trading networks, used their money to make money, becoming lenders. Well before the Revolution, Americans defined themselves in practical terms either as "debtors" -- poor and working people in small-scale enterprise -- or "creditors" -- well-heeled merchants growing their money by lending it.

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Workings of the debtor-creditor relationship will sound unpleasantly familiar. Merchants had the money supply conveniently sewn up. Small farmers and artisans had to post the land and shops they hoped to develop as collateral for the credit they needed. Merchants might set interest rates as high as twelve percent -- per month. Default, often predictable at the loan's outset, subjected borrowers to foreclosures, which in bad times were epidemic. Families became indigent while their land, tools, and homes were snapped up at bargain prices, often by the merchants themselves, who speculated in land as well, and were building immense parcels. The rich got richer.

Is it any wonder that ordinary people viewed this disastrous economic predicament not as some incidental fallout from vigorous free-market competition, but as an egregious, systemic injustice with political, moral, even spiritual implications? They were being held back, exploited, and even ruined by a monopoly on money and credit. And unlike today's populist right, founding-era Americans did not imagine that government's simply leaving markets alone would create new and exciting opportunities for them. They believed their governments should make laws to restrain the overwhelming power of the creditors' metal and protect those who labored and produced goods from those who planned dynasties of descendants living in luxurious idleness.

And remember: unless people had property in excess of certain amounts, they couldn't vote. Whig elites -- the ones who became patriot leaders, lionized today -- axiomatically equated the right of representation with property. It took even more property to run for office. Legislatures erected counties to ensure that representation favored the rich and the cities. They placed cash fees on every imaginable transaction, paralyzing working people's efforts to pursue legal recourse and enriching lawmakers' friends and families appointed as collectors and administrators. Roads and other infrastructure built at public expense (and by coerced labor taxes) served the merchant interest, not the people's. Hardly an embryonic American democracy, representative colonial governments were monopolized by forces that small-scale debtors and tenant farmers could only view as a creditor conspiracy to exploit their labor, prevent their participation, and take what stuff they had.

­So they organized in vociferous protest. "Mob" is a loaded term; "crowd" is perhaps more fair, and early American crowd action should be understood as a tactic, in the absence of access to the franchise, for pressuring and even changing government. One of the most famous outbreaks occurred in the 1760's in North Carolina, when ordinary people briefly had a few champions in the legislature. They forcibly closed courts, tore down corrupt officials' homes, and finally went to war against the provincial government. Royal Governor William Tryon put that rebellion down -- but the King's appointee was more sympathetic to the people's plight than upscale American legislators and merchants were.

Crowds could be flamboyantly scary and even violent, but they did not run amok, merely venting. In carefully organized disruptions, people moved en masse into courthouses where debt cases were heard, shutting down a judicial process they considered unjust. They felled huge trees across roads to prevent sheriffs from repossessing homes. They enforced no-buy covenants when foreclosed property went up for auction. They staged daring rescues of prisoners held on debt charges. Serving on juries in debt cases, they refused to convict. Well before the famous Stamp Act riots and other acts of resistance to new British trade laws, American life involved orchestrated crowd actions to prevent financial injustice and push government to act on behalf of ordinary people. After the Revolution, the event known as Shays' Rebellion became only the most famous of the debtor uprisings that continued the people's struggle in a new political context.

While emulating Shaysite and other debtor crowd actions today would pose an interesting counter-demonstration to Tea Party efforts, the question this history really raises has to do with what Americans want from their government. Do we really want to roll back "nanny state" protections like RESPA, for example, under which an ordinary citizen like Patrick Rodgers was able to interrogate his bank? RESPA is but one detail in a program -- and a power -- that our ancestors painfully lacked.

Tea Party history insists ordinary, hard-working Americans of the founding era wanted nothing more than to reduce government and keep it out of economic markets. But what those Americans really wanted can be gleaned from their terminology. The rich called them rioters. The people called themselves regulators.

**Check out our series on the foreclosure crisis, Foreclosure 411.

William Hogeland is the author of the narrative histories Declaration and The Whiskey Rebellion and a collection of essays, Inventing American History. He has spoken on unexpected connections between history and politics at the National Archives, the Kansas City Public Library, and various corporate and organization events. He blogs at http://www.williamhogeland.com.

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AG Tom Miller Negotiating in Secret with Banks Over Whether to Put Bankers in Jail

Feb 26, 2011Matt Stoller

home-foreclosure-documentIf NFL fans are demanding negotiations be opened up, why are homeowners kept in the dark? **You can follow Matt Stoller on Twitter at http://www.twitter.com/matthewstoller

Zach Carter wrote a good piece on homeowners' demands of the big banks. National People's Action has coordinated thousands of homeowners in asking for an aggressive settlement with the banks on their handling of foreclosures. Iowa Democratic Attorney General Tom Miller, who is heading the 50-state investigation, is one of their prime targets.

But it's this video that makes it interesting.

home-foreclosure-documentIf NFL fans are demanding negotiations be opened up, why are homeowners kept in the dark? **You can follow Matt Stoller on Twitter at http://www.twitter.com/matthewstoller

Zach Carter wrote a good piece on homeowners' demands of the big banks. National People's Action has coordinated thousands of homeowners in asking for an aggressive settlement with the banks on their handling of foreclosures. Iowa Democratic Attorney General Tom Miller, who is heading the 50-state investigation, is one of their prime targets.

But it's this video that makes it interesting.

Here's the transcript, starting at around :53 into it.

Iowa citizen Mike McCarthy: How close are we to a settlement? And with the settlement, will we have mandatory modifications? Will we have mandatory principal reductions? Will we have restitution for families who were fraudulently kicked out of their home? And also we want to see that these bank officials who were responsible for committing mortgage or foreclosure fraud brought up on criminal charges. I'm gonna ask you again, like I did on December 14. Are we gonna put some people in jail?

Iowa Attorney General Tom Miller: We're really getting close to negotiations. I'm not gonna talk about, I really feel I shouldn't talk about what's gonna be in the agreement, what's not gonna be in the agreement. That's something we have to hammer out with the Justice Department, and the Federal people, and the banks in a negotiating session. So in terms of talking to you or to the press, we're pulling back on specific details.

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Look at what he's saying. Miller has decided that he will keep the public in the dark about the negotiations over how banks will deal with the homeowners they hurt. They can't know when decisions will be made. They can't know if they will have principal reduced. They can't know if they will get loan modifications. They can't know if they will get restitution if they've been illegally kicked out of their homes. Miller will not even speak to criminal prosecutions of bankers over mortgage fraud because he is still negotiating with the criminals over whether to bring charges.

The backstory here is that Miller had exuberantly vowed jail time for bankers to Iowa citizens, before backtracking on his commitment. This level of deception by high officials is now routine when it comes to cracking down on lawbreaking by big banks.

It's not obvious to me why Miller backtracked. I don't think he ever had any intention of charging any bankers with any criminal charges, that's just not how law enforcement works these days. My guess is that he didn't realize that his initial promise to Iowa voters would be taken seriously, and then it blew up in the press. So he decided to stop talking and do the negotiating in secret.

This is not reasonable. If the NFL is being asked to open its books and NFL fans are asking that the negotiations between the players and owners take place in the open, surely the talks over foreclosure fraud can be done with some ability for the public to know what is happening.

Tom Miller may not realize that keeping homeowner victims in the dark while negotiating with the perpetrators is the wrong way to approach criminal activities. But the rest of us do.

Matt Stoller is a Fellow at the Roosevelt Institute and the former Senior Policy Advisor to Congressman Alan Grayson.

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The Housing Bubble, Not Unions, is Major Predictor of State Budget Gaps

Feb 23, 2011Mike Konczal

Despite what governors like Scott Walker say, there's little correlation between union membership and troubled state budgets.

Despite what governors like Scott Walker say, there's little correlation between union membership and troubled state budgets.

Amid all the public debate about how states are being bled dry by militant public unions, you wouldn't know that we just had a major housing bubble across the country followed by a financial system near-collapse and the most prolonged downturn since the Great Depression. Chris Hayes addressed this opportunism of those ignoring of the housing crisis to push long-standing right-wing priorities in the opening segment of The Rachel Maddow show last night, and I think it's worth looking deeper.

John Side posts some graphs of state budget shortfalls against public union density on his site The Monkey Cage:

And:

A commenter summarized the general finding:

I just coded the data "TheRef" posted to distinguish between states with no collective bargaining law and states with some sort of law (0=no law, 1=anything else) and used this to predict the 2011 shortfall as a percentage of budget. I have no idea if this coding is appropriate, but it should provide a rough estimate.

While the relationship was positive (like the r coefficient in the post) it explained less than 2% of the variance (R^2 = .017). This is actually less explained variance than that explained in the above post (.19*.19 = .04), though this could be due entirely to the linear compared to categorical nature of the predictors. Just to note, the unstandardized beta was 3.08.

Interesting, if not that significant. You know what is interesting, significant and recent? A multi-trillion dollar housing bubble.

I'm going to do the same graph with Total Shortfall as Percent of FY11 Budget from the CBPP (table four) as well as negative and near negative equity as percentage of mortgages, Q3 2010 from CoreLogic. Negative equity is correlated with all kinds of other bad things like unemployment, but from my point of view it's a good first approximation for how the housing bubble devastated a community. The more the bubble popped, the more people were hit by falling house prices, the more negative equity grows as a percent of mortgages. (Especially since Case-Shiller took their data to subscription only, and even then, I'm not sure there's a particularly better state-level approximation -- thoughts?)

Graph:

Significant (t-stat of 3.53), and it's significant with or without that outlier in the upper-right corner (Nevada). The mechanisms for how this contributes is important -- is it unemployment? Is it that state governments with a larger housing bubble got more confident and spent as if all those property taxes were on their way? Are there other important, causal mechanisms? These are all good and crucial questions for us to answer, ones we should take up when we finish scapegoating teachers.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Part 2: Regulation, Insurance, Resolution: An FDIC Model for GSEs

Feb 18, 2011David Min

mortgage-crisis-150In a two-part series, experts will tackle fundamental questions left over from the housing bubble crash: What should we do with Fannie Mae and Freddie Mac? How should we reform the market so that it is fair and risk-free?

mortgage-crisis-150In a two-part series, experts will tackle fundamental questions left over from the housing bubble crash: What should we do with Fannie Mae and Freddie Mac? How should we reform the market so that it is fair and risk-free? In the second part, David Min, Associate Director for Financial Markets Policy at the think tank Center for American Progress, argues for keeping the government involved in the housing market by creating an FDIC-inspired backstop. **Read part one here.

1. What went wrong with the GSEs?

Starting in the early 2000s, "private-label securitization," which was essentially unregulated, began to grow astronomically. This growth came primarily at the expense of the GSEs, whose market share dropped by a roughly equivalent amount. In an effort to regain their market share, the GSEs took on more risk, both in terms of the loans they guaranteed and also as far as the securities they acquired for their own account.

As we now know, the extraordinary growth in PLS was based on a fundamental mispricing of risk and structural problems in the process, including shoddy underwriting, misaligned servicing incentives, and bad credit ratings. This led to two distinct sets of problems for the GSEs. First, it created a housing bubble, which disproportionately impacted them, as they are entirely focused on housing finance. Second, the riskier products they acquired or guaranteed in their "race to the bottom" defaulted at rates much higher than expected.

2. What is wrong with simply privatizing the mortgage market?

First, we would be providing an enormous taxpayer-funded windfall to the big financial institutions that caused the financial crisis. Second, we would be effectively punishing many Americans by eliminating the New Deal legacy of broad availability of consumer-friendly mortgages to working- and middle-class households.

As we learned from the Great Depression, banking poses an enormous amount of systemic risk. Exacerbating this risk is the contemporary problem of "too big to fail" banks, which means that effectively, large financial institutions are believed to enjoy an implicit government guarantee on their obligations. It appears that this guarantee is already benefiting them, providing them with significantly lower funding costs than smaller financial institutions.

It is these largest financial institutions that would benefit the most if we adopted either of the Obama administration's privatization proposals. The $5.5 trillion in mortgage financing for the working- and middle-class that is currently provided by the GSEs would need to be replaced by either lenders willing to buy and hold loans on their balance sheet or by private-label securitization. The six largest U.S. financial institutions-Bank of America, Wells Fargo, JP Morgan Chase, Citigroup, Goldman Sachs, and Morgan Stanley-account for over $1.2 trillion in balance sheet-funded mortgage lending, over a third of all such loans. Moreover, these firms, which currently hold about $9.275 trillion in assets, have even greater market power in the investment banking sector, particularly given the consolidation that has occurred in the aftermath of the financial crisis. Thus, they are likely to dominate a private-label mortgage securitization market, when and if this returns to becoming a major financing channel.

If these large financial institutions (and other very large or systemically significant firms) held or guaranteed any significant portion of the $5.5 trillion in mortgage loans currently financed through Fannie and Freddie, it would clearly escalate the problem of "too big to fail", particularly given the importance of residential mortgage debt both for the financial markets and the broader economy.

Privatization would also be bad for consumers. There is limited evidence of what a privatized mortgage market would look like. Since the New Deal, the U.S. government has supported a large segment of the mortgage market either through federal deposit insurance or guarantees on securitization. And there is no developed economy in the world that does not provide significant amounts of government support. (For example, in Canada the government explicitly guarantees up to 70% of outstanding mortgages; in western European countries, governments implicitly guarantee 100% of their mortgage markets.)

The pre-New Deal era illustrates why privatized residential mortgage systems are so rare. Mortgages were only available to higher income and higher wealth borrowers, and even then only on terms that would be considered predatory today: short-term, interest-only, high rates, and high down payments (typically 50%). While this is obviously a very dated example, it is striking that in some important ways, it resembles the current market for commercial real estate finance. As Elizabeth Warren has noted, commercial real estate loans today generally have terms that closely resemble pre-New Deal residential mortgages: short-term, interest-only, high interest rates, and high (often 50%) down payments. And of course these loans are generally reserved for higher wealth borrowers.

All of this points to the same conclusion: privatization would lead to a sharp reduction in mortgage liquidity and a transition away from consumer-friendly products.

3. What does the experience of the jumbo mortgage market tell us about whether a privatized mortgage market can well serve the broader mortgage needs of America?

Nothing. The jumbo market serves higher wealth, higher income Americans, and no one disputes that private capital, absent a guarantee, can provide mortgages to this class of homebuyers as it has always done. It is also clear that since the New Deal, private capital has provided jumbo loans with consumer-friendly terms and prices that are reasonably competitive. But to simply note these facts misses the point.

The questions at issue are these: 1) will private lenders continue to provide affordable and consumer-friendly loans if we get rid of the government-guaranteed portion of the market; and 2) in the absence of a government guarantee, will the private markets make such products broadly available to all Americans (including working- and middle-class households)? As I noted above, the limited historical evidence suggests that the answer to both of these questions is no. This finding is reinforced by our experience in the 2000s, as private non-guaranteed capital exhibited a strong bias towards high cost, predatory products when it gained significant market share. Moreover, it is important to note that the availability of competitively priced jumbo 30-year fixed-rate loans is based in large part on the existence of deep and liquid markets for Fannie and Freddie securities, which allows private securitizers to finance, rate-lock, and hedge their own securities backed by jumbo 30-year fixed-rate loans.

The jumbo market argument also fails to appreciate the important differences between jumbo financing and the rest of the market. Jumbo mortgages are financed either by lenders who originate and hold loans or through private-label securitization. Most all other mortgages are financed by investors in government-guaranteed MBS. These investors include foreign central banks, fixed income investors and regulated financial institutions, which purchase government-guaranteed securities either because of investment objectives or regulatory incentives. The attraction is that they have essentially no credit risk, don't require due diligence, and are very liquid.

In the absence of a government guarantee, these investors would be looking at securities that carry significant credit risk, require high levels of independent due diligence, and are highly illiquid (particularly after the PLS debacle of the last decade)-in other words, exactly the opposite of their preferences. It seems implausible that these investors would purchase such securities in the amounts necessary to make up the $5.5 trillion in mortgage financing currently provided by the GSEs.

4. Will there be 30-year fixed-rate mortgages in the future? What are the consequences of this?

Under privatization proposals, 30-year fixed-rate mortgages would clearly not be widely available. Some advocates of privatization dispute this claim, primarily based on their availability in the jumbo markets. As I noted in the previous section, that argument is flawed, even more so when it comes to this particular product. The long 30-year duration gives significant interest rate and liquidity risk to lenders. As a result, banks and thrifts have dedicated an increasingly small amount of their balance sheet lending to 30-year mortgages since the high interest rate increases of the late 1970s and 80s. And as explained above, there is likely to be a lack of investor capital for this product from securitization.

Only one other country in the world, Denmark, provides broadly available 30-year fixed-rate mortgages, and the Danish government implicitly guarantees 100% of the market (most recently evidenced in a series of sweeping bailouts, including a blanket guarantee for its entire banking system.)

But why should we want the 30-year fixed-rate mortgage? I have made the argument more thoroughly in a brief I wrote last year, but here are two reasons. First, it provides borrowers with cost certainty in housing, the largest single monthly expense for most families. This is increasingly important in a world where working households are taking on greater amounts of risk and uncertainty. Its value is at its highest during periods of housing market distress-when interest rates are rising and the availability of refinancing options has decreased. Given the high near- to medium-term likelihood of interest rate and house price volatility, this cost certainty will be ever more important to household stability. Second, the 30-year FRM places interest rate risk and others with parties that are better suited to handle them-sophisticated investors who can plan for, capitalize against, and sometimes hedge against them.

5. What does your plan do to fix the problems?

Our plan tries to essentially keep the significant benefits created by the New Deal while reining in systemic risk and protecting the taxpayer from loss. In addition to specific measures designed to encourage mortgage liquidity to underserved communities and borrowers, including for rental housing, what we have essentially proposed is a replication of the FDIC model of regulation, insurance, and resolution around an explicit, very limited government guarantee for certain conforming MBS. We would require firms that receive this guarantee to put up significant amounts of capital (somewhere between 4-9 times the levels currently put up by the GSEs), which would stand against non-catastrophic credit losses. Should these amounts be insufficient, and the CMI effectively insolvent, resolution authority would be exercised and a Catastrophic Risk Insurance Fund, modeled after the FDIC's Deposit Insurance Fund and funded by assessments on the industry, would step in to make timely payment of interest and principal to guaranteed MBS investors.

To be clear, under our proposal investors in government-guaranteed MBS would first be paid from the underlying mortgages that collaterize the MBS. If these were insufficient, they would be paid by the CMI's assets. Only if the CMI's assets were insufficient and it had to be taken over by regulators would the industry-funded Catastrophic Risk Insurance Fund be tapped. And only if this Fund, which would have the ability to tax the industry on a going forward basis to make up shortfalls, went insolvent would taxpayers be on the hook for a single dollar. We think these various firewalls against taxpayer loss, coupled with strong regulatory oversight, are sufficient to ensure that such a loss never occurs.

Conversely, if we privatized the mortgage finance system and handed it over to the largest financial institutions, there would be no protections against taxpayer losses.

6. What happens if we misprice the fee or let regulation go lax?

First, the private sector hasn't shown itself to be particularly good at pricing risk either, as evidenced most recently in the PLS debacle, and we've seen that its losses in today's "too big to fail" era can cause taxpayer losses.

Second, the government doesn't need to price risk perfectly, but to ensure it doesn't underprice risk (and expose taxpayers to losses). Moreover, in the event that a CMI failure caused the Fund level to dip excessively low, it would have the ability to levy prospective fees on surviving CMIs to replenish itself.

Finally, it is worth noting that the government actually has successfully provided similar forms of catastrophic risk insurance in the past, including with the FDIC, the Federal Housing Administration, and the Terrorism Risk Insurance program.

David Min is Associate Director for Financial Markets Policy at the think tank Center for American Progress.

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Part 1: Deliver Housing Support Directly to Those Who Need It

Feb 18, 2011Christopher Papagianis

house-in-hands-150In a two-part series, experts will tackle fundamental questions left over from the housing bubble crash: What should we do with Fannie Mae and Freddie Mac? How should we reform the market so that it is fair and risk-free?

house-in-hands-150In a two-part series, experts will tackle fundamental questions left over from the housing bubble crash: What should we do with Fannie Mae and Freddie Mac? How should we reform the market so that it is fair and risk-free? In the first part, Christopher Papagianis, Managing Director of the New York City office at the think tank e21, argues for full privatization with direct government subsidies to ensure access to credit for all. **Read part two here.

1. What are the GSEs and what went wrong with them?

Fannie and Freddie buy and guarantee mortgages, converting the mortgage payments into guaranteed cash flows for MBS notes and standardizing the notes to enhance investor acceptance and market liquidity. Before they blew up, their investors would capture the guarantee fees on the mortgages and pass through the rest of the mortgage payments to MBS holders. They also used their ability to issue implicitly guaranteed debt to build massive portfolios of the same mortgage-backed securities (MBS) they issued. These portfolios were the source of huge profits during the boom years. The profits came from the gap between the yields on mortgages and the interest rate Fannie and Freddie paid on their own borrowings, which was just slightly greater than Treasury rates thanks to government sponsorship.

The analytical challenge before us is that the most egregious excesses of the previous GSE model are not what precipitated all the taxpayer losses. For example, the first instinct of many reformers would be to ensure that the GSEs (or their successors) are never again able to build big mortgage portfolios. Once a pool of mortgages was converted into GSE-guaranteed MBS notes, there was no need for them to then issue additional debt to repurchase the guaranteed MBS. These big portfolios served "no credible purpose" aside from a profit center for GSE shareholders and management. The second instinct would probably be to strictly limit the mortgages that would qualify for purchase or guarantee.

While both make sense and would have made for sound reform in 2005, focusing on these two issues now more or less ignores the big lessons from the 2006-2010 market meltdown. Of the GSEs' combined $226 billion in losses, over $166 billion (73%) came from the guarantee business. The investment portfolio accounts for just $21 billion (9%) of losses. Had the investment portfolios been eliminated in 2005, the GSEs would have still suffered losses from guaranteed mortgages that would have wiped out their capital base several times over.

For many, the challenge ahead seems to be designing a strategy that maintains a government guarantee for mortgage credit risk while attenuating some of the more egregious elements of the old GSE model. The problem with operating under this framework, however, is that it was the mispricing that arose from the government guarantee itself that really turned out to be the big source of taxpayer losses.

2. Is there a role for the government in the housing market?

Yes. Today, almost all of the new mortgage originations in this country are done with some government involvement. In addition, the government dedicates roughly $300 billion each year to directly subsidize housing, split roughly evenly between tax subsidies and direct government spending. In all, it cuts across several agencies and over 28 different programs to support both homeowners and renters. Given all of the current support that's in place, the real question is how can we comprehensively rationalize the role for government in the housing market.

Unlike the fairly straightforward accounting and (on-budget) treatment of all the different tax provisions related to housing, the subsidies on the spending side are more complex and confusing. On behalf of taxpayers, the federal government issues, guarantees, and insures mortgages. Taxpayers subsidize the redevelopment and sale of vacant properties and foreclosed homes. They subsidize housing vouchers, a public housing program, and at least eight more block grant initiatives for rental housing. The budgetary costs of these programs are measured in three different ways - on a cash flow basis, on a present value basis, and on a present value basis adjusted for market risk. Without an apples-to-apples comparison, it is nearly impossible for policymakers to compare the effectiveness of these programs and to allocate scarce budgetary resources in ways that do the most good.

With regards to Fannie and Freddie, there appears to be a consensus now that the inherent flaw of the "government-sponsored" business was a lack of transparency and accountability in the allocation of the underlying subsidy: profits went to private shareholders and losses were socialized, or ultimately covered by taxpayers. As policymakers review housing subsidies and consider alternatives, they must be careful to make clear the risks and costs of subsidizing housing investment. Government loan guarantees can appear to be low cost since they pay out only if a borrower defaults and official estimates often exclude a premium for market risk. But we have learned that such guarantees are contingent on an accurate assessment of the various risks involved and they can be extremely expensive if those risk assessments are wrong or if the defaults all occur at the same time. Improperly scored loan guarantees also create a moral hazard, as the implementing agencies can assume too much risk by lowering their lending standards over time.

Where possible, it would be more transparent and far more efficient for Congress to deliver housing-related subsidies directly to the homeowner. This is the primary way the government subsidizes food with food stamps or charity through the tax code. Private financial institutions then would no longer have the ability to capture some of that subsidy for their managers and shareholders, as Fannie and Freddie did for so many years. Direct subsidies would also reduce the risk of another economic crisis.

3. What does your plan do to fix the problems?

The government has a terrible track record for pricing guarantees correctly. There are other ways to subsidize housing if that's what Congress and others would like to do. Providing housing-related subsides directly to the individual is probably the only way to avoid the moral hazard that comes with a mortgage guarantee.

Therefore, it appears as though the most promising path for Congress is to commit to a credible strategy that puts the GSEs in receivership and liquidates their operations over a 5 to 7 year period. Taxpayers would cover any shortfalls so no creditor loses anything in a wind-down or is tempted to sell their securities. In the future, Congress would keep Federal Housing Administration (FHA) mortgages available for borrowers under certain income and mortgage loan thresholds and leave the rest of the market to the private sector.

4. Given that there are many plans, what is the strength and weaknesses of your approach?

The strength is little to no moral hazard moving forward. We stop obscuring just how much taxpayers are put at risk by indirectly or implicitly subsidizing housing.

The weakness is that without some other actions by Congress, mortgage costs would presumably go up, as the old guarantees would now be paid for directly by mortgage borrowers.

However, Congress does have some options if it wants to try and offset some of this cost increase. Several scholars have suggested subsidizing interest rates on certain loans or providing a flat housing credit. (See Charles Calomiris and Raj Date for more on how interest rates could be subsidized through swaps. See Josh Rosner for more on how the mortgage interest rate deduction could be reformed to reward building equity over adding more debt and how establishing clear securitization disclosures could help re-start this market.)

5. What will the mortgage market look like if your plan is enacted, for both people who want to lend money and people who want to buy a home?

In the future, prospective homebuyers would still work with banks and brokers to find the best loan for the price. And since nobody is talking about winding down Fannie or Freddie tomorrow, the private market could be folded back into the equation steadily over time. This would give the securitization market time to develop. Obviously, you'd want to make sure reforms were in place as this happened so that the future system would be equipped with the information required to evaluate/measure credit risk over time. Perhaps a covered bonds market could also be started as well. Portfolio lending would also likely increase.

6. Will there be 30-year, fixed loans in the future? What are the consequences of this?

Yes. First, FHA will still offer its 30-year product. Second, I think that 30-year fixed loans will still be available in the private market for borrowers who can extend a meaningful downpayment. The jumbo mortgage market is probably a good analog.

Borrowing in general, however, will probably cost more because there will be no under-priced government guarantee involved to shield investors from losses. This means that some borrowers who qualified for certain loans during the boom would face new and real trade-offs. Put more bluntly, credit would (and should) not be as readily available - compared with the boom years.

Surely, some individuals (or families) will end up renting. Others will save more so they can extend a larger downpayment or purchase a less expensive home.

7. Hasn't TARP taught us that the government will always be some sort of implicit backstop? How can the government ever credibly commit to not jumping in at the last moment?

By this logic, the government should just come out and guarantee most large institutions or even asset classes.

There is a fundamental question that people need to ask when they think about GSE reform and the future of housing finance. Is it in the long-run interests of the economy to provide continued credit support for housing (at least at the current pre-crisis magnitude)? Housing is a form of consumption and its continued subsidization diverts capital from other more productive uses.

This question is also wrapped up in the Too Big To Fail issue. The GSEs proved to be TBTF. Several of the top big banks were also deemed TBTF. In a world without Fannie and Freddie, there is a risk that investors will just assume that the government will step in and protect the banks that are necessary to maintain a liquid mortgage market. I am concerned about this.

Yet, while I do not think Congress solved the TBTF issue with the Dodd-Frank law, I still hold out hope that it will find a solution. I guess I'm not pessimistic enough to concede defeat and just assume that the government will be better off by explicitly taking on all the tail risk in the housing market.

8. If we go with full privatization, we'll see the private securitization market grow as a percentage of total mortgages. But didn't private securitization markets fail in many ways over the past 10 years? Didn't hedge funds and middle-men make a lot of loans that went bad and increased volatility, and won't that happen again?

It is not a foregone conclusion that securitization will be re-born. The alternative to securitization markets - and shadow banking generally - has always been the traditional banking model of funding mortgages through deposits. It may be that the low-cost guarantee written by the GSEs made the traditional banking model uneconomic and that the elimination of this guarantee will make banks more willing to hold loans on balance sheet. We should not be so quick to write off the possibility of greater on-balance sheet lending. The GSEs' portfolios, for example, are a perfect example of its profit potential. The challenge for private lenders had been managing the interest rate risk and attracting funds of sufficiently low-cost to compete with the GSEs.

The future of securitization is likely to be much better than many anticipate. There is little evidence of systematic mis-rating of mortgage-backed security (MBS). The big problems came with CDOs and other re-securitization products. For example, why is it unreasonable for $75 million of a $100 million deal with 400 (high credit quality) mortgages with an average principal balance of $250,000 to receive a AAA rating? For investors in this tranche to suffer losses, half of the mortgages would have to default and suffer loss rates of 50% on average. Subordination of this magnitude is likely to suffice in all but the worst housing environments, as is seen by the surprisingly strong performance of the GSEs' subprime portfolios. Will a CDO market re-start and create new problems? Perhaps, but there does not seem much appetite for mezzanine ABS CDOs at the moment and it seems reasonable to believe the next blow-up will occur elsewhere, given investors' and rating agencies' experience (and new information demands) with regards to these products.

Christopher Papagianis is Managing Director of the New York City office at the think tank e21.

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