Sarah Palin and Michele Bachmann Would Call 18th-Century Philadelphia Freedom Fighters 'Un-American'

Feb 21, 2011William Hogeland

flag-150In a brand new series, "Founding Finance", author William Hogeland challenges Tea Party myths about the early days of our Republic and reveals the rich progressive tradition of Americans fighting for economic justice.

flag-150In a brand new series, "Founding Finance", author William Hogeland challenges Tea Party myths about the early days of our Republic and reveals the rich progressive tradition of Americans fighting for economic justice.

At a recent speech in Iowa, Congresswoman Michele Bachmann induced widespread cringing with her claim that Americans of the founding period, no matter who they were, enjoyed exceptional freedom to pursue their hopes for betterment. Slavery and the U.S. Constitution's three-fifths clause don't qualify as little-known facts, and Bachmann seemed ignorant, too, of women's original exclusion from rights secured by the representative government established in the Constitution. Who knows how she'd evaluate the native population's historic situation.

There's another group that Bachmann might be surprised to learn suffered exclusion from political participation in founding-era America: Most of the free, white male artisans, laborers, and small farmers. That's right, an overwhelming majority of the white men in early America would dissent heartily from the idea that they were free to advance themselves, through work and pluck and luck, regardless of who they were and what they owned. Ordinary, working Americans of the period -- the very type the Tea Party constantly evokes -- were engaged in a ceaseless struggle against the wealthy, well-connected American merchants and landowners who sewed up business and barred the unprivileged from political power.

In that struggle, 18th-century populists came to articulate a radical new idea about the relationship of liberty and equality, anathema to the Tea Party politics of today. Securing true liberty, working Americans of the founding period insisted, requires government to regulate business and finance in the interest of economic fairness. They demanded such things as debt relief, an end to the regressive gold standard, the severing of rights from property, and legal curtailment of mercantile interests. Some wanted progressive taxation; some envisioned a social security program. Their real political ethos directly contradicts current right-wing efforts to cast passive government, unfettered markets, and wholesale tax resistance as the founding values of ordinary America.

Many progressives, too, will find it counterintuitive to contemplate an 18th-century American economic radicalism. Getting a clearer look at the period requires revisiting Philadelphia in 1776 -- but this time walking eastward on Chestnut Street, away from the soaring State House, one day to be called Independence Hall, where the Continental Congress meets, and peeking instead into the smaller but ruggedly beautiful artisan headquarters Carpenter's Hall. Delegates noisily crowding the floor here are writing a constitution for the newly independent Commonwealth of Pennsylvania. In dress, speech, and attitude these men are nothing like the well-heeled members of the fabled Congress up the street. These are small farmers, artisans, and laborers, the ordinary free white men of the period. They boast no well-placed family connections. They lack fancy educations and professions. Almost all of them are new to representative office.

While in some ways the men of Carpenter's Hall might appear to be ancestors of Sarah Palin's "real Americans"-- they hunt, fish, build, farm; they keep and bear arms (and serve in militias); they're political newcomers -- Palin would brand them socialists. They're here to create a radically new kind of government, one that restrains wealth, regulates business, and empowers labor. For the first meaningful time anywhere, their 1776 Pennsylvania Constitution will break the ancient connection between property and the political franchise, writing what we now call progressivism into law. Its legacy will survive in the Square Deal, the New Deal, the Great Society, and those programs' reverberations in the very policies that today's right condemns as categorically un-American.

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Did that radical Pennsylvania constitution gain approval from the better-heeled founders up the street? Hardly. (John Adams on the Pennsylvania document: "Good God!") Did it last? Only until 1790 (it was overturned by upscale forces whose power it had tried to restrict). Do historians give it much credit?  Many do -- but not Samuel Eliot Morison, for example. His suggestion in The Conservative American Revolution that the 1776 Pennsylvania Constitution impressed nobody but French revolutionaries epitomizes the mood of dismissal, at once airy and leery, that many big-name historians, both liberal and conservative, have adopted when considering our earliest radical movements for economic equality. Historians across the political spectrum who prefer American consensus to American conflict have downplayed the long struggle that came to a kind of fruition in 1776 Pennsylvania. So we don't know much about it.

Historical marginalizing of our founding challenges to economic elites damages current political thinking. Modern progressives seeking precedents in history tend to travel backward through the New Deal, come to a screeching halt at the Populist and Progressive movements, squint approvingly back at Jackson, and fail to focus on the horizon where an economically egalitarian American spirit, more truly radical than Jackson's, seethes, neglected. Reclaiming that spirit -- at the very least exploring it -- would have the virtue of denying the Tea Party a monopoly on anything supposedly fundamental about the American founding and American values.

Reclaiming our founding tradition would also give a rest to the endless ideological tug of war over the famous founders. One of the most exciting things about our early popular movement is that it centered -- in a way that Jefferson's and Madison's philosophies of government, as brilliant as they are, didn't -- on just the kinds of real-life economic issues that still confront so many Americans today. Foreclosure epidemics, insider high-finance corruption, predatory lending, recessions and depressions, income disparity, mercantile exploitation of labor . . . ordinary 18th-century Americans applied themselves to these problems with both sophistication and courage.

So in succeeding posts, I'll dig into and expand on the welter of people, ideas, and actions that make the founding era such a surprisingly fertile and compelling one -- sometimes a problematic one too -- for progressive economics and politics today. My guiding theme, especially relevant these days, involves finance. As the historian Terry Bouton shows in his benchmark study Taming Democracy, ordinary 18th-century Americans had a grasp of public and private finance that many otherwise sophisticated people lack today. Further posts in this series will therefore get into 18th-century foreclosure crises and debtor uprisings; the founding bonded national debt; early labor organizing and popular demands on government; the structure and economic intentions of the 1776 Pennsylvania Constitution; the gold standard versus paper and other popular currencies; founding-era real-estate and debt-securitization bubbles; etc. Stay tuned . . .

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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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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Where's the Courage? America Must Stand Up to Corporations and Bought Politicians

Feb 17, 2011Joe Costello

raised-fist-150Who will have the guts to fix our broken political and economic system, as we did in the New Deal era?

raised-fist-150Who will have the guts to fix our broken political and economic system, as we did in the New Deal era?

It's hard to imagine the present American economy getting healthy without the housing market being fixed. Even a Dow at 36,000 would have limited impact with housing prices down another 10-20%, as very few in America have any wealth in the stock market, if they have any savings at all. Much of it is in their homes, and that continues to get eaten away. So Chris Whalen's Reuters piece accompanying his downgrading of Wells Fargo due to the continuing mortgage fiasco -- Yves Smith continues with best coverage on this issue -- is well worth the read.

Whalen makes an excellent point about the courts and mortgage crisis. He writes:

The US banking industry would have been far better off if they had allowed sane bankruptcy reform to be enacted with respect to restructuring of first mortgages. Over-burdened home owners could discharge unsecured debt and modify mortgage loans under the watchful eye of bankruptcy judges, who understand how to balance debtor and creditor rights.

Instead banks seeking foreclosure now face state court judges, who are elected by the people in their communities and not used to the intricacies of Wall Street finance. State courts are taking a much harsher line with banks than would federal bankruptcy judges. Banks seeking to conduct foreclosures are being met by a phalanx of judges that now say "show me the mortgage note and prove you are the one with the right to foreclose or I will not act on your pleadings."

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This is a lesson in American democracy 101 -- the separation of powers. The genius of the American system was not to centralize power in DC, but to separate it -- with three branches of government, but also balancing DC with the states, localities, and finally the ultimate power in the citizen, we the people. The agrarian era architecture of our government set up by America's founders always had a hard time dealing with the new industrial era and its most powerful and insidious creation, the corporation. In the 1930s, in response to the crisis of the national/global economy created by the industrial corporation, the New Deal was born, and liberals en masse headed to DC to rule briefly for a few decades. This lasted until the modern corporation and its entrenched interests could gain control, making present DC both eminently corrupt and dysfunctional, a fact our remaining liberals continue to either ignore or discount.

Matt Taibbi has an excellent piece documenting the most open and not even the most egregious of crimes committed by banking and finance, which the complicit powers of DC ignore. No one goes to jail. It reminds me of the California Energy scam 10 years ago, where again no one went to jail and the Clinton FERC sat on its hands as the people of California were fleeced by multiple energy companies and Wall Street. The fact is the American system is broken, but paradoxically its redemption lies in restoring and evolving the system. At this point, what is missing most is courage.

It is time to think much larger than worrying every day about what happens in DC and to liberals. I can only point to a piece in the LA Times yesterday regarding Egypt:

Not wanting to be left out of the future government, two competing groups of young activists are meeting with the military and distancing themselves from longtime opposition figures they regard as inept and weakened from years of oppression by Egyptian security forces.

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

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Obama's Budget Speaks to Wall Street, Ignores Voters

Feb 14, 2011Tom Ferguson

Thomas Ferguson explains how the President's budget is way out of focus.

President Obama's budget proposal fails to address the real deficit culprits.

Thomas Ferguson explains how the President's budget is way out of focus.

President Obama's budget proposal fails to address the real deficit culprits.

Addressing long-term budget issues requires bringing US health care costs in line with those of other major countries with better records on providing adequate services to their populations. That is not done by fixing inflexible spending limits, but by allowing the government to bargain with Big Pharma over drug prices and making health insurers actually compete. In the long run, we probably need a single-payer system that eliminates all the wasteful duplication in medical forms, advertising, etc, that pass on costs to the consumer. If you also rein in military spending and regulate banks to prevent another financial crisis from wrecking both the economy and the budget again, much of the deficit problem disappears. Then you can admit the truth of what close students of Social Security already know: That there is no problem with that program for decades, if ever.

The President should have started us down that road today. He didn't. Instead, he's kicking off a race to the bottom with the Republicans that will will wreck America's future and further mystify the public. And don't fool yourself with talk about appeals to "independent voters." Almost no polls ask voters if they would like to tax the wealthy. The one poll that did found 61% opting for that. For the next two years, one number towers over all others: $1 billion. That's what the President's reelection campaign is going to cost. The real audience for the budget proposals is Wall Street, not any set of voters, and certainly not the popular movement that elected him.

**For more, check out a paper co-authored by Tom Ferguson and Rob Johnson: "A World Upside Down? Deficit Fantasies in the Great Recession"

Thomas Ferguson is Senior Fellow at the Roosevelt Institute and Professor of Political Science at the University of Massachusetts, Boston. He is the author of many books and articles, including Golden Rule: The Investment Theory of Party Competition and the Logic of Money-Driven Political Systems.

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The Gordon Gekko Mindset Still Rules Wall Street

Feb 11, 2011Bryce Covert

Among some good news from the COP about lower pay are signs that Wall Street is already finding a run-around.

Among some good news from the COP about lower pay are signs that Wall Street is already finding a run-around.

Remember how Wall Street isn't paid enough (even while executive pay has hit new records)? It looks like some people might disagree. The Congressional Oversight Panel, which oversees TARP, just released a report on the efforts of the specially created Office of the Special Master for Executive Compensation to deal with outrageous compensation at companies that preformed so badly they needed us to bail them out. The good news? The Special Master (a great title if ever there was one) has gotten compensation at the recipients of "exceptional taxpayer assistance" (i.e. AIG, Bank of America, Chrysler, Chrysler Financial, Citigroup, General Motors, and GMAC/Ally Financial) down 55% for the 25 top paid employees. The Master also shifted pay from cash to stock in an effort to actually tie pay to performance (a new concept around Wall Street). The hope is that this can help cut down on the freewheeling, risk-loving adventures that got us into this mess.

The bad news? The Special Master didn't find that any of the bloated pay given out before TARP was "contrary to the public interest" and therefore didn't claw any of it back. (This even though he found that $1.7 billion in payments were "disfavored" and "not necessarily appropriate.") The COP was pretty troubled by this tightrope walk -- its report stated that this

may appear to the public to be excessively legalistic, it may represent an end-run around Congress' determination that the Special Master should make every effort to claw back wrongful payments, and it may give the impression that the government condoned inappropriate compensation to executives whose actions contributed to the financial crisis.

Yup, pretty much. The Special Master has also put the details of his decisions into a "black box," preventing any other experts from duplicating his work and cracking down on firms in the future.

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And while the goal of getting pay aligned with performance is important (if not a little forehead smackingly "duh"), tying it so heavily to stock might create its own perverse incentives. After all, executives can play risky games with the stock price to get their pay up. Not to mention that bankers have already found ways around this to increase their profits even when their company's stock suffers. A recent NYTimes story laid the details bare:

Using complex investment transactions, they can limit the downside on their holdings, or even profit, as other shareholders are suffering.

More than a quarter of Goldman Sachs's partners, a highly influential group of around 475 top executives, used these hedging strategies from July 2007 through November 2010, according to a New York Times analysis of regulatory filings. The arrangements were intended to protect their personal portfolios when the firm's stock was highly volatile, especially at the height of the crisis.

In some cases, executives saved millions of dollars by using these tactics. One prominent Goldman investment banker avoided more than $7 million in losses over a four-month period.

The government has barred those firms that received multiple bailouts from hedging until they've paid the funds back -- but others are getting in on the action now. And while most high-level execs are barred from this practice and shareholders can see whether they engage in it, the activity of lower-level execs is unhampered and mostly hidden. This makes it even more likely they will be personally aligned against the fate of their own company. As Patrick McGurn, a governance adviser at RiskMetrics, told the NYTimes, "Many of these hedging activities can create situations when the executives' interests run counter to the company."

Don't expect the Gordon Gekko-like practices to let up anytime soon.

Bryce Covert is Assistant Editor at New Deal 2.0.

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Crank Up the Casino! Hedge Funds to Short American States and Cities

Feb 9, 2011Lynn Parramore

Today, Washington's lawmakers began hearings on the massive fiscal problems the Great Recession dumped on American states and cities. The looming possibility of municipal defaults, which some say could total hundreds of billions of dollars, is causing grave concern. Hedge funds are also deeply concerned about America's municipal debt crisis. They worry about how to best profit from it.

Today, Washington's lawmakers began hearings on the massive fiscal problems the Great Recession dumped on American states and cities. The looming possibility of municipal defaults, which some say could total hundreds of billions of dollars, is causing grave concern. Hedge funds are also deeply concerned about America's municipal debt crisis. They worry about how to best profit from it.

The Wizards of Wall Street have looked over the catastrophe of cash-strapped America and found it good for business. In their corporate laboratories, they are working furiously to whip up wondrous new financial products that will allow them to reap millions from misery. You might think that after plunging the country into said Recession with their fancy financial products, these Wizards might feel a little indelicate about gearing up for a game of shorting a community near you. Clearly you don't know Wall Street. The Financial Times reports that once-boring muni bonds are suddenly sexy:

For decades, this $3,000bn bond market was safe, predictable and dull. The traditional buyers of the bonds issued by states, cities and other local bodies were wealthy local residents lured to them by the tax breaks on offer for individual investors. They bought the bonds, held them until they matured and then bought more. Not now. State deficits have ballooned, local authorities are grappling with huge public sector pension liabilities and triple A bond insurance that used to prop up even the riskier municipal bonds is harder to find. The mounting concern over "munis" has brought with it hedge funds and financial institutions who want to bet on the bonds' creditworthiness, or make money on the back of volatile "spreads" -- the premiums at which munis trade relative to benchmark debt.

So much suffering. So many ways to squeeze money from it. The FT quotes the head of municipals at Arbor Research and Trading, who sums up the current hedge fund frenzy building: "There is a lot of blood in the water in the municipal space. Hedge funds smell that blood and are trying to figure out the best way to make money in the marketplace."

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What the Wizards have to do is figure out how to take short positions that will soar in value as the creditworthiness of munis fall into the crapper. And it's to credit default swaps -- those "innovative" financial products that helped bring you the financial crisis -- that the hedge hogs are turning. Credit default swaps are like insurance. Except that unlike insurance, which you can only buy on assets you really own, you can buy these goodies on your neighbor's house, too. The moral hazard problems of this sort of nonsense are well known, which is why Wall Street fought so hard to make sure credit default swaps were not regulated like insurance. Once upon a time, as my colleague Tom Ferguson explained to me, English insurers discovered that scoundrels would buy insurance on ships they didn't own and then leak voyage details to the French navy, so they could collect. Guess who sells most municipal bonds? Many of the same people who'll be betting on their failure now. See a problem here? If you don't own the underlying asset, then credit default swaps are simply gambling. So what we are talking about is an extension of casinos to every state and city in America. The European Union is finally moving on these vultures. But not us, it seems.

The perversity of gorging on suffering never seems to bother the American financial sector. JPMorgan feeds on our hunger with its lucrative food stamp card business. And AIG gets into the game of letting strangers bet on your life. Why shouldn't hedge funds make a little extra dough from the collapse of your hometown?

Lynn Parramore is Editor of New Deal 2.0, Media Fellow at the Roosevelt Institute, and Co-founder of Recessionwire.

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Food Stamps: JPMorgan & Banking Industry Profit From Misery

Feb 9, 2011Bryce Covert

Maxing out your knowledge of the tricks and traps in consumer debt.

This week's credit check: A record 43.6 million Americans are using food stamps. JPMorgan's segment that makes food stamp debit cards made $5.47 billion in net revenue in 2010.

Maxing out your knowledge of the tricks and traps in consumer debt.

This week's credit check: A record 43.6 million Americans are using food stamps. JPMorgan's segment that makes food stamp debit cards made $5.47 billion in net revenue in 2010.

You might think that if you're on food stamps, big banks won't be very interested in you. What could they possibly want with someone who's struggling just to put food on the table? But it turns out that you're actually part of a profitable business for big bank JPMorgan. While the money to pay for the stamps comes from the government, the technology to access it lies in private hands. Food stamps used to be literally stamps -- that is, pieces of paper -- but in this day and age paper is so old fashioned. Now you get your food stamps with a debit card, and JPMorgan knows all about creating plastic credit products.

As the head of this division at JPMorgan, Christopher Paton, told Bloomberg, "They act and feel very much like a debit card. A lot of stores increasingly take food stamps." What convenience! And Paton points out that his bank is the largest processor of food stamps in the country. These are boom times for such services -- a new report from the US Department of Agriculture reports that 43.6 million Americans are now using food stamps, nearly 14% of the population, which is a record number. Paton notes this trend himself: "Volumes have gone through the roof in the last couple of years," he says. "This business is a very important business to JPMorgan in terms of its size and scale." And the numbers bear him out. According to the company's most recent quarterly filing with the SEC, the Treasury & Securities Services segment, which is the division that includes the food stamp business, was up 2% in the last three months of last quarter and brought in $5.47 billion in net revenue for most of 2010.

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Paton's quick to point out that this isn't just about profit at JPMorgan -- it's also serving a "useful social function." And department execs don't have to sit around hoping for unemployment to skyrocket so they can make a buck -- more than 40% of food stamp recipients have a job, as Paton notes. Even if you get a job, you still have an almost one in two chance of still not being able to buy groceries, so JPMorgan can continue to make its profits as unemployment falls (someday).

But it does show a misalignment between what the banks want and what's good for the rest of us. It turns out that JPMorgan also provides unemployment benefit debit cards in some states on top of the food stamp cards. Talk about marketing off of misery -- the profit made from these cards shoots up as workers lose their jobs and can't pay for food. Whether or not they're providing a needed service, you would be hard pressed to find a way in which the business interest of this segment is not aligned with further economic ruin for America's workers. Instead of profiting when we all do well, they profit off of our misery.

And the decision to place card creation in private hands can turn out to be complicated for the actual users. While the government outsourced its card creation needs to JPMorgan, the bank in turn outsourced the customer service end to India. So if you're a food stamp user who has a problem or a question, don't expect to actually get someone in your own country to help you out. They can't be bothered to actually deal with the people they're giving such a necessary service to.

Bryce Covert is Assistant Editor at New Deal 2.0.

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In Mind-blowing Show of Hypocrisy, AIG Bites Hand That Feeds It

Feb 4, 2011Lynn Parramore

In the world of American Big Business, memory is short and chutzpah is long. At a little gathering of insurance folks in Washington, D.C., AIG's chief Robert Benmosche revealed that the company which used Uncle Sam as the Great Sugar Daddy deems the 'liberal' culture of relying on government bad for business. Bloomberg reports:

In the world of American Big Business, memory is short and chutzpah is long. At a little gathering of insurance folks in Washington, D.C., AIG's chief Robert Benmosche revealed that the company which used Uncle Sam as the Great Sugar Daddy deems the 'liberal' culture of relying on government bad for business. Bloomberg reports:

"American International Group Inc.'s mortgage insurer does more business in Republican-leaning states as it signs up more reliable customers than those in "more liberal" areas, Chief Executive Officer Robert Benmosche said.

"All of the states where we're a leader, where we're the No. 1 insurer, are red states, all of the states where we're at the bottom are blue states," Benmosche, 66, said yesterday at a conference in Washington. "Part of what we found out is that our model is about culture and it's about the attitude in the public. And what we find is where there's more of a tendency for people to be more liberal, more that the government is responsible for what happens to me."

After getting away with defrauding investors and then sucking up boatloads of taxpayer cash in a massive 182 billion government bailout initiated by red-stater George W. Bush, Benmosche condemns a culture of irresponsibility he believes is bred in blue states. Never mind that red states generally receive much more in federal dollars than they pay into the system. Such niceties of logic are irrelevant to corporate welfare kings who have been so emboldened by their post-financial crash free ride that they now have the temerity to trash the notion of government assistance.

You would be forgiven for thinking that the Bloomberg report is a parody. My colleague Tom Ferguson, Roosevelt Institute Fellow and U Mass Boston Professor of Political Science, could hardly believe his ears: "I wonder if it's really true," said Ferguson. "It sounds more like a CEO spouting at the end of some long, boring day spent talking to government officials about getting still more aid from taxpayers or 'regulatory relief' so his company can take even bigger risks at potential public expense. And if it is true, there may be a very simple explanation. The product he's talking about is mortgage insurance. Where would you expect to need the most insurance? Of course, in Republican states that went ga-ga on deregulation at the behest of companies like AIG. Benmosche's jeremiad may simply be the the 21st century's equivalent of of the plea to the judge for mercy because he's an orphan by the kid who killed his parents."

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AIG, of course, boasts an internal culture for which the word 'irresponsible' hardly seems adequate. 'Twisted' and 'sociopathic' come to mine. So does 'criminal'. In 2009, after receiving still more taxpayer rescue funds in the wake of accounting fraud revelations and posting monumental losses, AIG execs handed themselves $123 million in bonuses as a reward for incompetence and malfeasance. The company has also been fingered for engaging in macabre "stranger originated life insurance" practices which allow someone to bet against another person's life. Nice!

Memo to AIG: Next time you come begging for a bailout, you might want to skip the blue states.

Lynn Parramore is Editor of New Deal 2.0, Media Fellow at the Roosevelt Institute, and Co-founder of Recessionwire.

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Why Elizabeth Warren Is Still the Best Choice for CFPB Director

Feb 3, 2011Mike Konczal

She's handled staffing and criticism while building bridges. What more could you ask for?

She's handled staffing and criticism while building bridges. What more could you ask for?

The Consumer Financial Protection Bureau just launched its website. Meanwhile, Shahien Nasiripour has a story that found "... if the White House can't get a nominee through the Senate by July, the bureau will lack the authority to supervise nonbank lenders, according to a Jan. 10 report by the inspectors general of the Treasury Department and Federal Reserve obtained by The Huffington Post." One of the main reasons for creating a Consumer Financial Protection Bureau is to close a loophole called "regulatory arbitrage," which lets a lot of these nonbank subprime lenders avoid following the same rules that regular banks do when it comes to lending. So if there isn't a nominee soon, the CFPB is going to encounter a serious problem in doing one of the most important parts of its job.

So it's time to talk about who should lead it. People are currently having this conversation, putting forward potential candidates for the job. I've been following this since the bill passed and, at this point, I think Elizabeth Warren is the obvious choice. Warren is obviously credentialed enough -- a Harvard Law professor who came up with the idea, who has written extensively on the topic and is the third most cited scholar on bankruptcy and consumer-related finances. During the previous debate, there were three major critiques about her running the CFPB: that she wasn't experienced enough in starting a new agency, that she was disliked by industry, and that she wasn't confirmable. Since then she's done an excellent job starting up the agency, hitting the ground running. She has stalemated the critiques from industry and Republicans. And the Republicans have shown that they hate the agency itself but don't actually mind Warren as far as candidates go, so she's relatively more confirmable than people imagine.  She's made as good of a transition from campaigning to governing as anyone would have expected, and then some.

Starting Up The Agency

As for staffing, Warren is managing a team of 150 as they continue to build and launch the bureau. As far as all reports go, she's doing an excellent job. She is under some intense scrutiny, particularly from established regulators and lobbyists, and surviving a round of hostile questioning from a resurgent Republican House. There have been no horror stories. By all accounts, Warren and the CFPB team are getting along with Secretary Geithner and Treasury.

She has signed up Holly Petraeus to work on military affairs, giving the bureau a scope that builds on many different fronts. (The GOP has supported consumer protection bills for the military in the past.) And the most important hire, from my point of view, is former Ohio Attorney General Richard Cordray to help lead enforcement, an AG who is serious about getting to the bottom of the foreclosure fraud crisis. Warren has assembled a fantastic team with few, if any, pitfalls.

While assembling the team, Warren has also contributed to the complicated, yet very important, battle over servicing fraud, helping to veto an ill-advised notarization bill early on. She has been able to staff an impressive team while also contributing to one of the most important, ongoing situations in consumer finance.

Working With Community Banks

As Carter Dougherty has written at Bloomberg, Elizabeth Warren has worked closely with community banks. This has been a conscious effort to include their concerns in the process.

Community banks had two main objections during the fight to create the CFPB. The first was that they didn't need a new regulator because they already had several focused on consumer regulation. The second was that they didn't cause the crisis; the crisis was generated by the shadow banking sectors of fly-by-night mortgage originators, originators that Greenspan could have regulated but chose not to. One can imagine the community bankers being skeptical of someone promising to consolidate regulators, thus upsetting established bureaucrats, as well as taking on something that regulators have ignored in the past.

By all accounts, Warren is making inroads. The whole idea was based on regulatory consolidation from early on. If you look at what Elizabeth Warren wrote for the Roosevelt Institute's Make Market Be Markets conference, it was clear this was a goal of hers. You can see that she gets their concerns in her Politico op-ed, which was well received.

New Potential Allies

Rep. Jeb Hensarling (R-TX) has called the bureau a "consumer credit rationing agency." Reading his critique and other conservative GOP critics on the topic, I'm almost surprised by how impersonal their criticism is. If it was anyone else, they would still be trying to go after the CFPB's budget, scope and independence.

And many Republicans even seem to be warming to Warren. Rep. Randy Neugebauer (R-TX) has said, "She wouldn't be my last choice. I don't know whether she's my first choice, but she certainly wouldn't be my last choice... If [the Consumer Financial Protection Bureau] isn't going away, then what we have to do is deal with what we've got, and I think it's easier to deal with an agency where we have a little bit more permanency about its operations..." Which isn't that bad. She discussed consumer finance in a press release with Republican Senator Snowe. The Wall Street Journal seems almost surprised by how much outreach Warren is doing with the GOP. She has done extensive outreach to State Attorneys General, both Republicans and Democrats. She's emphasized transparency in her work as well. She is as well-respected by the GOP as any effective leader is going to be.

I'm never a good judge of conventional wisdom, but if it's that Warren can't get through the Senate, I think it's wrong, or at least very overstated. I think she'll have a better shot than anyone else. Warren and the CFPB aren't on the tea party's radar, and the Chamber has had real difficulty astroturfing this topic. The left is energized about this nomination, even more so since the strong role the CFPB will need to play in foreclosure fraud and servicing regulations has become clear. So what's the downside of her being the nominee?

Mike Konczal is a Fellow at the Roosevelt Institute.

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