The Breakdown of the U.S. Mortgage Market

Oct 19, 2010Mike Konczal

mike-konczal-2-100Newsflash: the system has been failing homeowners, and the rest of the market, for some time.

mike-konczal-2-100Newsflash: the system has been failing homeowners, and the rest of the market, for some time.

This is a placeholder for some ideas I want to develop further.  Obsidian Wings catches something I've noticed in this debate too: "In any event, I noticed commenters at every blog giving a ritual statement that 'of course I don't have any pity for people who are defaulting on their mortgages' before they get down to the business of apportioning blame."  If there's anything our elite can agree on, it is beating on the so-called 'losers' who are getting kicked out of their homes.

I think this is a backwards way of looking at what is going on with the foreclosure crisis. The way we deal with mortgages in this country is a brand new phenomenon, one that only dates back 15 years or so, and it is a failed system. It's like a car in an accident that wasn't tested, but instead of the airbag not deploying the car has exploded.  That a record numbers of homeowners are delinquent and defaulting is the sign of a sick system, and efforts to 'purge' delinquencies out doesn't get at what has gone wrong.

The real debate for me is: why are we having so many foreclosures?  Think of the iconic example of a local housing bubble, Texas in the 1980s. Here's how bad the foreclosure rate got:

That was after a pretty vicious oil and housing bubble popped around 1986, and we don't see anywhere near as many foreclosures as we do now (the number has gone up throughout 2009 and 2010).

Because the first rule of mortgage lending is you don't foreclose.  And the second rule of mortgage lending is you don't foreclose.  For all the talk about how principal modifications will harm other economic parties, it's the other way around. Imagine a house is worth $200,000, but the mortgage is worth $300,000. The homeowner can't make the payments at $300,000 but can at $250,000. If the homeowner's principal isn't written down, the bank seizes the house and sells it at... $200,000.  And that assumes they don't lose 30+%, as is common for a foreclosure sale.  This loss will raise the cost of capital for everyone else. Why is it breaking down this way?

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

One reason is that there isn't anyone standing in the center acting as the fiduciary. We only have to look at the structure of the servicers to see this. Designed to do automated, scalable and streamlined work, they are being asked to do work that is time and energy intensive. Then comes the incentive structure wherein it's less profitable for loans to be current and functioning. Built into this business model is the fact that delinquent loans will balance out the lack of profit from fewer mortgages being started (what they called a counter-cyclical diversification strategy).  This is what people like Amar Bhide are pointing out about local knowledge; issuing loans can harness economies of scale.  Servicing loans can harness economies of scale.  Managing loans that are delinquent and in need of modification is time and knowledge intensive.

The second is the structure of multiple liens. It was no accident that this structure makes it incredibly difficult to modify and deal with a mortgage crisis. If you go back and read the arguments put out by a conservative think tank like the American Enterprise Institute, arguments like Charles W. Calomiris and Joseph R. Mason's High Loan-to-Value Mortgage Lending: Problem or Cure? (which we discussed here), the idea that leveraging up and using your home as a credit card with multiple different entities having multiple different claims, junior claims that senior claims might not even know about, would lock you into having to be a more responsible party and also save you some pennies on that housing credit card. Calomiris:

Misplaced concerns about the riskiness of HLTV lending and the destabilizing effects of reloading and churning have led some in Congress to advocate altering personal bankruptcy law to allow cram-down -- or bifurcation -- of mortgage debt exceeding 100 percent of home value. Under such a scenario a borrower filing under Chapter 13 would avoid foreclosure. Mortgage lenders would retain senior claims on the borrower up to the amount of the fair market value of the underlying property at the time of bankruptcy. The HLTV loan would thus be second in line as a claim on borrower wealth up to a maximum of the value of the mortgaged property. The amount of the HLTV loan greater than the value of the underlying property at the time of bankruptcy would be treated as unsecured debt and placed on an equal footing in the bankruptcy process with other unsecured debt... Cram-down would essentially eliminate that special bargaining power of the HLTV lender.

So AEI thought it should be incredibly difficult to modify a failing mortgage so that homeowners could save a tenth of a percent on their house credit card.  It's worth noting that the "special bargaining power" is designed to eliminate modifications, or the simple Pareto-improving agreements between a senior debt-holding bank and a lender. As we noted before, it would be insane to allow this kind of structure to go on in the corporate bond market.

Another way to think of this more general idea is that if we seal someone inside a car and take out the airbags and seatbelts, they'll be the best driver ever. I had an economics professor back in business school who was proud of the fact that he never wore a bicycling helmet, even after he broke his collarbone in an accident, because he found some half-assed research saying that cars drive closer to people with bike helmets on.

This bizarre idea, known as risk homeostasis in the economic ideology, is useful as a thought exercise, but a dangerous way to run a mortgage system. And this is the system that we are dealing with.  Because it ignores the fact that sometimes a gigantic truck of global imbalances and a systemically large housing bubble and financial crash will be racing the opposite way, right in your direction.

Last bit of real talk: there's no point in making a partial payment on a mortgage from the standpoint of keeping the mortgage current. If your mortgage payment is $1,000, and you pay $900, you aren't any more current for it. Is there an instrument we can use to see if people are trying to stay current and make some sort of payment? Here's one from Mr. David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at a House committee on "Second Liens and Other Barriers to Principal Reduction as an Effective Foreclosure Mitigation Program":

It is important not to confuse payment priority with lien priority. In almost all scenarios, second lien holders have rights equal to a first lien holder with respect to a borrower’s cash flow. The same is true with respect to other secured or unsecured debt, such as credit cards or car loans. Generally, consumers can decide how they want to manage their monthly payments. In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.

So what you see is a lot of people, over half, who have stopped paying the first lien are trying to make some sort of payment. (In a way that strikes me as a weird conflict of interest if it's consistent across all servicers. Talk about bad financial literacy.)  If there's ever been evidence that rather than trying to leech out a vacation, there are a large number of people trying to get current on their loans, trying to pay something to stay in their homes, it's this number proving that people are paying the smaller junior lien first. Why can't the system meet them halfway?

Mike Konczal is a Fellow at the Roosevelt Institute.

Share This

QE2 Won't Save Our Sinking Ship

Oct 18, 2010L. Randall Wray

ship-150The Fed is between a rock and a hard economic outlook.

ship-150The Fed is between a rock and a hard economic outlook.

Fed Chairman Bernanke is signaling that a second round of quantitative easing will soon begin. In the first round, the Fed's balance sheet nearly tripled to nearly $2.3 trillion as it bought $1.7 trillion in Treasury securities and mortgage-related securities. Since the Fed appears to want to unwind its position in mortgages, QE2 will probably target federal government debt.

During Japan's long stagnation, Bernanke was famous for arguing that the Bank of Japan could have done far more to fight deflation. Since the BOJ's overnight interest rate target was effectively at zero, the conventional policy of lowering its interest rate target was not an option. Hence, Bernanke advocated quantitative, rather than price, activity -- the BOJ would purchase assets from banks, driving up their excess reserves, until they would finally make loans to stimulate spending that would reverse the trend of prices.

So when he had the opportunity, he put theory into practice in the US, driving short-term interest rates effectively to zero and filling bank balance sheets with excess reserves by purchasing their assets. So far, the impact has not been significantly different than Japan's experience. Indeed, Bernanke has been publicly warning of the dangers of a Japanese-style deflation, as US inflation has dropped nearly to zero, well below the Fed's informal target of two percent.

And so we are now set for round two of QE -- more of the same old, same old.

In truth, the Fed has done only two helpful things. First, during the liquidity crisis of 2007 and 2008, it lent reserves to financial institutions that faced a liquidity crisis. To be sure, it took the Fed far too long to figure out that in a liquidity crisis you must lend to any financial institution, and you should not look too closely at the quality of assets submitted as collateral. The Fed's bumbling made the liquidity crisis far worse than it should have been. But eventually we got through that phase.

We then moved on to the insolvency phase, as everyone discovered that banks were, and still are, holding assets whose value is far below the value of their liabilities. A flimsy "stress test" was concocted, designed to ensure that all institutions would pass. The government then injected a bit of capital into some of them and proclaimed the problem resolved. Next, banks cooked their books and showed healthy profits so that they could buy out Uncle Sam. More importantly, they wanted to party like it was 1999 so they could pay record bonuses to top management.

However, purchasing toxic assets from banks did help them -- the second useful thing done by the Fed. The problem is that the Fed did not and cannot buy enough of the waste to make banks healthy. There is simply too much of it. When the crisis hit, the US debt to GDP ratio was 500%, and that has hardly come down. A lot of the debt was bad even before the recession, but far more of it is bad now that we have lost 10 million jobs and half of homeowners are either underwater in their mortgages or soon will be. And there are tens of trillions of dollars of derivatives deals. To resolve the insolvency crisis would require that the Fed buy tens of trillions of dollars worth of questionable assets -- QE2 would have to be orders of magnitude larger than QE1. Putting a number on it is nothing but a guess, but it could be at least $20 trillion.

The Fed can certainly "afford" to buy up all the bad assets and take on any counterparty risk from the derivatives that might be triggered. As Bernanke has testified, the Fed buys assets by crediting bank accounts, through a simple keystroke, and there is no way the Fed can run out of keystrokes. But it is politically constrained in a number of ways.

First, there is no chance that inflation hawks would stomach Fed actions on that scale. They still believe that bank reserves generate loans that inevitably create inflation. Bernanke carefully tries to navigate these waters by agreeing with the hawks that in the long run, Fed creation of too many reserves would be inflationary, but argues that in current circumstances the greater danger is deflation. Still, he reassures markets that reserves creation is temporary, and that the Fed will "exit its accommodative policies at the appropriate time". Yet, if the Fed buys junk assets that will never have any value, it will not be able to sell these back to markets later -- so there is no way to remove the reserves it created when it buys trash.

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

Second, the Fed generally makes a profit on its operations and turns excess profit on equity over to the Treasury. Buying toxic assets will lead to losses, something Congress will not stomach. So the Fed is between the inflation rock and the hard place of losses. It cannot solve financial institutions' solvency problem without buying on a politically impossible scale.

This should come as no surprise. It has always been the central bank's role to deal with liquidity problems, and the Treasury's role to deal with insolvency problems. The difference is that US Treasury spending is directly controlled by Congress and accounted for in the federal budget. Bailouts by Treasury -- such as the rescue of the US auto industry -- inevitably generate a public debate. By contrast, bailouts by the Fed take place behind closed doors, and usually only come to light after the fact. Still, Congress and the public are fed up with the Fed and will tolerate such shenanigans no longer. That leaves the Treasury as the only chance for action, but President Obama claims it has already "run out of money". This is pure nonsense since Treasury also spends using "keystrokes", but it is a widely accepted myth.

So the Fed is left with the only option available to a central bank that has already pushed short-term interest rates to zero: buy longer maturity treasury bonds in order to push longer rates toward zero. It certainly can do this. It could, for example, buy all 10 year Treasuries, bidding up their prices until their yields fall to zero. Historically, 30 year fixed rate mortgages have tracked 10 year bonds fairly closely, so such an action could conceivably lower mortgage rates. But they are already below 4%, so it is not clear what could be gained. Dropping rates still further is not likely to bring forth any buyers except hedge funds that have been buying foreclosed homes. The "foreclosuregate" scandal has at least temporarily killed that demand.

Other potential buyers are waiting for house prices to fall further, or for a real economic recovery to begin -- one with job creation and rising wages. In short, the problem in real estate markets is not that mortgage rates are too high, but rather that prospects for real estate and job markets are too poor. The Fed is in a Catch 22: Interest rate policy will not spur borrowing until economic recovery is underway, but recovery will not begin until spending picks up. Only jobs and income will stimulate spending, but the Fed cannot do anything in those areas.

The Fed believes that it might spur bank lending by lowering returns on safe, liquid assets like Treasuries. If banks cannot generate sufficient returns by holding these assets, then they might have no choice but to take greater risks. But it takes two to tango -- banks need good and willing borrowers in order to make loans.

Recent data indicate that banks are instead trying to increase revenues through "churning" -- trading existing assets, which generates no new spending -- and by increasing fees and penalties. Conventional wisdom is that it costs banks up to 400 basis points (four percentage points) to operate the payments system that relies on checking deposits and credit cards. If Treasuries are paying less than half that, and mortgages are below that, the only way that banks can turn a profit is by charging customers for their deposits, debits, and charges. That is why they have been busy jacking up their charges. Yet if Elizabeth Warren is effective, she is going to make it harder for banks to gouge customers.

No matter how mad at banks we might be, we have got to leave them with a way to return to profitability that does not rely on speculative bubbles, pump-and-dump schemes, and accounting fraud. Pushing returns on relatively safe assets toward zero is not the answer. Pumping banks full of reserves that pay very low interest will not help, either. What Bernanke might understand, but most in the mainstream media do not, is that banks do not and cannot lend reserves. Reserves are just an entry on the Fed's balance sheet -- a liability of the Fed and an asset of banks. Rather, banks make loans by accepting the IOU of the borrower and issuing a demand deposit. Only financial institutions have access to the Fed's balance sheet, so it is literally impossible for a bank to lend out reserves.

So anyone who thinks that pumping banks full of reserves while driving interest rates toward zero is a way to encourage lending simply does not understand banking. (This also means, of course, that whether banks have $100 billion or $100 trillion of reserves has no implications for prospective inflation.)

Note that if we really wanted to use our central bank to resolve this economic crisis, it would be far better to have it directly buy houses and create jobs for the unemployed. But it makes far more sense to use our fiscal authorities for that.

QE2 does not represent a solution to our current quagmire. No, this Titanic is still headed underwater. The sooner that the Obama administration recognizes that what we need is jobs, more jobs, and mortgage relief, the sooner we can get this ship afloat.

L. Randall Wray is Professor of Economics at the University of Missouri-Kansas City.

Share This

Homeowners Ask Banks: Where's the Note?

Oct 15, 2010

As 50 state attorneys general look into the foreclosure mess, homeowners can take steps on their own to protect themselves. A new movement is growing called "Where's the Note?" that urges consumers to demand proof that their bank owns their mortgage. The website is "where to go to find out exactly who owns your mortgage note," says CBS news' Rebecca Jarvis, noting that "literally hundreds of thousands of people ha[d] visited the site" within its first day of operation:

As 50 state attorneys general look into the foreclosure mess, homeowners can take steps on their own to protect themselves. A new movement is growing called "Where's the Note?" that urges consumers to demand proof that their bank owns their mortgage. The website is "where to go to find out exactly who owns your mortgage note," says CBS news' Rebecca Jarvis, noting that "literally hundreds of thousands of people ha[d] visited the site" within its first day of operation:

While this crisis is just now starting to be uncovered, it didn't happen overnight, Jarvis says. "It started long ago when banks were going out, giving out loans to anyone and everyone... and then they started repackaging them, cutting them up, slicing and dicing them, selling them off to new people. And what that was was a very lucrative business, but now it's come home to roost." It seems that some paperwork may have gotten lost in all that shuffling.

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

Jarvis explains that your note is what you sign when you buy your home. "Who owns that now is important because whomever owns that now is the only bank that can legitimately foreclose on you," she says. And it's important for every homeowner to find this out, not just those who are facing foreclosure. After all, it's good to make sure you're shelling money out to the right people every month.

Share This

Foreclosure Fraud: We Need to Fix the Banks Again

Oct 15, 2010Marshall Auerback

marshall-auerback-100It's time to put the perps of this scandal in jail.

marshall-auerback-100It's time to put the perps of this scandal in jail.

Yves Smith, Bill Black, and Mike Konczal have already done yeoman's work in seeking to explain the lender fraud scandal in the securitized mortgage market and its possible legal ramifications. Here, I'd like to restrict my discussion to the optimal government response.

President Obama recently used a pocket veto on a bill that would allow foreclosure and other documents to be accepted among multiple states (and therefore make it difficult for homeowners to challenge foreclosure documents prepared in other states). But I worried that this action was not sincere. My concern was that, following the midterm elections, the Administration would eventually come up with some grand "compromise" solution, which would in effect give the banks everything they wanted.

In retrospect, it appears that even that was too favorable an assessment. Per the Washington Post:

The Obama administration does not support a nationwide moratorium on foreclosures at this time, Federal Housing Administration Commissioner David Stevens said Sunday in an e-mail response to questions.

"We believe freezing foreclosures for all banks in all states, whether we have reason to believe them to be in error or not, is simply not the prudent step to take in this fragile housing market," he said. (Our emphasis)

Banks 1, rule of law 0. In effect, the President is making the argument, "If we penalize people for not following the laws as they existed at the time, it will have really bad repercussions. So everybody gets a mulligan."

Additionally, the Administration seems to be buying the prevailing spin that the foreclosure problems are merely the product of "sloppy paperwork", rather than recognizing this disaster as a case of rampant, systemic fraud. That deserves punishment: fines and jail time, not additional government support.

Most of the current administration proposals are misguided because they continue to be based on the twin presumptions that big banks only face a liquidity problem, and that if this problem can somehow be resolved, the economy will recover. This is a fundamentally flawed view. Using any honest measure of accounting, the big banks are insolvent. The latest debacle illustrates that big banks cannot and should not be saved. They do not hold the key to recovery; if anything, their rampant criminality demonstrates that they are a barrier to a sustainable recovery. Since they were given their handouts, they have been working assiduously to resurrect the bubble conditions that led to this crisis. (Not to mention paying out huge bonuses in the process -- this year $144 billion, a record high for a second consecutive year, according to a study conducted by The Wall Street Journal.) Your tax dollars at work!

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

As Randy Wray and Eric Tymoigne presciently wrote over a year ago:

The best approach is something like a banking holiday for the largest 19 banks and shadow banks in which institutions are closed for a relatively brief period. Supervisors move in to assess problems. It is essential that all big banks be examined during the "holiday" to uncover claims on one another. It is highly likely that supervisors will find that several trillions of dollars of bad assets will turn out to be claims big financial institutions have on one another (that is exactly what was found when AIG was examined -- which is why the government bail-out of AIG led to side payments to the big banks and shadow banks). There probably are not ‘seven degrees of separation' -- by taking over and resolving the biggest 19 banks and netting claims, the collateral damage in the form of losses for other banks and shadow banks will be relatively small. Government lending, guarantees, and purchases of bad assets will be much smaller if we first consolidate the balance sheets of the biggest players, net the assets, and shut down the institutions. This will help to downsize the financial sector and reduce monopoly power. Moving forward, policy should favor small, independent, financial institutions.

In addition, it will be necessary to increase supervision and regulation of the financial sector. This can start with 3 simple measures, which were suggested to me by Bill Black (who was a long-time S&L investigator):

A. Replace every top banking regulator other than Sheila Bair and the head of the SEC. The regulators have to serve as the "sherpas" for any successful effort to prosecute and prevent frauds -- they do the heavy lifting and serve as the essential guides for the FBI. Two of the major banking agencies did zero criminal referrals. None has made putting the crooks in prison even a weak priority. Put new leaders in place who believe in regulating and jailing. End the instructions to regulators to view bankers as their "customers." The only client is the American people.

B. End the FBI's "partnership" with the Mortgage Bankers Association (MBA), the perps' trade association. The MBA has convinced the FBI that the lender was always the victim, never the perpetrator. That's why, along with regulatory failure, we have no top executives convicted, as opposed to over 1000 in the S&L debacle.

C. The Department of Justice needs new leadership. Do what we did in the S&L crisis. Create a "Top 100" priority list to ensure that we go after the elite criminals who caused the greatest wave of white-collar crime in world history -- and the Great Recession.

And we must get back to a fiscal policy that genuinely helps to sustain job growth and rising incomes -- this, in turn, will stabilize the economy. The costs of increased fiscal stimulus are dwarfed by the costs associated with an irrational reliance on monetary policy gimmicks such as "QE2". Fiscal austerity drains aggregate demand and induces reliance on PRIVATE debt. Today, a large number of Americans still suffer from high private debt levels and correspondingly sluggish income growth. Their ongoing reliance on the banks is becoming the 21st century equivalent of indentured servitude. With higher levels of debt comes higher levels of financial fragility and instability and then economic busts. With recessions we don't just experience extended losses of income. The accompanying costs manifest in the criminal justice system (rising crime), the health system (rising mental and physical illness), the family court systems (rising marriage and family breakdown), etc. The sum of these costs dwarf all other economic costs. And we should not forget that human lives are destroyed by prolonged recessions -- dignity is lost, self-esteem disappears and the children who grow up in jobless households inherit their parents' disadvantage.

If borrowers can meet their payments, lenders will receive their funds and will return to profitability; there will be less need for future bailouts. A full employment policy is also a financial stability policy. With a fully-employed population, you have consumers able to purchase goods with rising income. If they decide to expand those purchases or increase investment in a business via debt, they are better able to service it because a fully-employed person or a businessman with booming sales is far more able to service his debts, which means less write-offs for the banks and therefore less need for bailouts.

Amazingly, this is not only sensible economics, but also good politics. Yes, there is no question that some borrowers were overextended and probably took on mortgages they couldn't afford. But to use this as a reason to avoid the issue of fraudulent foreclosures strikes me as a colossal red herring. To be sure, one should not generally support the principle of abrogating loan agreements via strategic defaults, for example. But when the other contracting party is exposed as a rampant predator/fraudster, it changes the moral calculus considerably. If one ignores fraud, or downplays its significance here, it undermines the rule of law, the very basis for modern democracies. What's the "cost" associated with that? The fiscal austerians and defenders of bailout packages such as TARP (yes, I'm talking to you, Tim Geithner) ought to factor this into their calculations the next time they drone on about what a great "success" these programs have been, based on a bogus measure on how "little" it ended up costing the US taxpayer.

Wall Street bankers turned homeownership into an "investment", so owners ought to treat it like one -- walk away from bad investments. Business people do it every day and no one admonishes them about morality. But if we are going to sanction borrowers for strategic defaults, then it seems wildly inconsistent to avoid the issue of fraud, as well as recognizing that eliminating it (or significantly mitigating it) is the only basis on which we can construct a sound financial system going forward.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

Share This

The Foreign Exchange Mystery

Oct 13, 2010Wallace Turbeville

money-question-150Why would such a large swaps market be a possible exemption from FinReg?

money-question-150Why would such a large swaps market be a possible exemption from FinReg?

The traded foreign exchange market is the big enchilada. It is the largest financial market in the world. The Bank for International Settlements estimates that the daily turnover in this market, including swaps, futures and spot purchases, is $4 trillion as of April 2010. This turnover increased more than 20% in the last 3 years. Trading is concentrated in London, accounting for 36.7%, while the New York share of the market is around 18%.

Since FX swaps and forwards are based on currency values, it is very easy to embed other financial transactions in a dealtransaction that involves exchange rates on its face. For instance, a loan can be the primary purpose for a swap of currency values. The danger in such obfuscation is illustrated by the foreign exchange transactions between the Greek government and Goldman Sachs, which disguised the debt burden of Greece and triggered a crisis.

In the Dodd-Frank Act, clearing (if available) is mandated for most derivatives, with "end user" hedging transactions carved out. But a second carve out, for FX swaps and forwards, is permitted if the Treasury orders it. There is significant concern among progressives monitoring the implementation of Dodd-Frank that the Secretary will soon exempt FX instruments from the clearing mandate. (See Mary Bottari, "Is Geithner Planning a Stealth Attack on the Wall Street Reform Bill" and David Wigan, "Traders Angered by Swaps Legislation.") Why did the Act envision this enormous exception? Why would Treasury implement the exemption? Why would it act now? These and other questions are shrouded in mystery, and that fact alone is of great concern.

Several knowledgeable individuals who were involved in the discussions of this provision during the drafting of Dodd-Frank report that Treasury never articulated a coherent rationale. It was clear that the New York Federal Reserve sought the exemption, but their motive was obscure. There was no structural impediment to mandating the clearing FX instruments: the Chicago Mercantile Exchange has a thriving FX futures business. It follows that Congress did not have the information to assess the proposed exemption, and the decision was delayed and delegated to Treasury.

According to Dodd-Frank, the Treasury Secretary must consider the following in deciding whether to grant the exemption:

1) "whether the required trading and clearing of foreign exchange swaps and foreign exchange forwards would create systemic risk, lower transparency, or threaten the financial stability of the United States;

2) whether foreign exchange swaps and foreign exchange forwards are already subject to a regulatory scheme that is materially comparable to that established by this Act for other classes of swaps;

3) the extent to which bank regulators of participants in the foreign exchange market provide adequate supervision, including capital and margin requirements;

4) the extent of adequate payment and settlement systems; and

5) the use of a potential exemption of foreign exchange swaps and foreign exchange forwards to evade otherwise applicable regulatory requirements."

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

If the Secretary decides to grant the exemption, he is required to submit specific information to the relevant congressional committees, including:

1) "an explanation regarding why foreign exchange swaps and foreign exchange forwards are qualitatively different from other classes of swaps in a way that would make the foreign exchange swaps and foreign exchange forwards ill-suited for regulation as swaps; and

2) an identification of the objective differences of foreign exchange swaps and foreign exchange forwards with respect to standard swaps that warrant an exempted status."

It is hard to imagine that, in the months of discussion that preceded the enactment of Dodd-Frank, these issues were not thoroughly analyzed by the Treasury and the Fed. Certainly there is nothing that has emerged since enactment that is relevant to these issues. Granting the exemption now doesn't make sense with the flow of events. Congress could have been presented with all relevant facts and arguments so it could have decided instead of delegating the decision to Treasury.

The process suggests that this delay and the procedure were designed to appease opponents to the exemption and those who were concerned that the rationale was insufficiently presented. If this is true, the result is probably inevitable, at least in the minds of those in charge of the Treasury and the Fed. It is really maddening that the administration and the Fed were unwilling or unable to lay out the necessary factors to allow Congress to decide on such an important segment of the market.

We are left to guess at the reasons the FX market is to be treated so differently from other derivatives markets. There are several distinctions:

• As stated above, it is large. Worldwide, it is the largest of the financial markets.

• There is no meaningful distinction between a forward purchase and sale and a swap. Buying euros for future delivery at a fixed dollar price is not materially different from a euro/US dollar swap. In contrast, if someone sells a bushel of corn, he or she must deliver it.

• There has been much debate about the proportion of hedging and speculation in the FX market. However, it is clear that, compared with other markets, the amount of speculation is quite large.

• Relative currency values are directly related to central bank activities.

• The London market, being twice the size of the US market, plays a central role.

• The market presence of US financial institutions is significant, but the larger participants are European banks.

None of these distinctions compels a decision to exclude FX transactions from mandatory clearing, a process in which trade data is reported and a standard system for margining is imposed. Until the Treasury and Fed fill the public in on their thinking, it is pointless to speculate (unless you are a bank speculating on foreign exchange rates). It is ironic that, in implementing legislation designed to bring transparency to the financial markets, the Treasury and the Fed are so unconcerned about their own lack of transparency.

Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co. He is Visiting Scholar at the Roosevelt Institute.

Share This

Foreclosure Fraud For Dummies, Part 3: What's the Worst and Slightly Better Case Scenario?

Oct 12, 2010Mike Konczal

mike-konczal-2-100The foreclosure crisis is heating up. Will it all come crashing down, or can we find a way out of the mess? **This is Part 3 in a series giving a basic explanation of the current foreclosure fraud crisis.

mike-konczal-2-100The foreclosure crisis is heating up. Will it all come crashing down, or can we find a way out of the mess? **This is Part 3 in a series giving a basic explanation of the current foreclosure fraud crisis. You can find Part 1 here and Part 2 here.

Right now the foreclosure system has shut down as a result of the banks' own voluntary actions. There is currently a debate over whether or not the current foreclosure fraud crisis could explode into a systemic risk problem that imperils the larger financial sector and economy, and if so what that would look like.

No matter what happens, the uncertainty about notes and what is currently going on with the foreclosure crisis is terrible for the economy. Getting to the heart of this problem so that negotiations can be worked out is important for getting the economy going again. There is little reason to trust whatever the servicers and the banks conclude at the end of the month, and the market will know that. Only the government can credibly clear the air as to what the legal situation is with the notes and the securitizations.

But I want to get some unlikely but dangerous scenarios on the table in which this blows up. Bangs, not whimpers.  The kind where Congress is pressured to act over a weekend.  I had a discussion with Adam Levitin about how this could explode into a systemic problem.

Title Insurance Market Breaks Down

The first scenario involves title insurance, specifically a situation wherein title insurers decide to take a month off from writing title insurance even on performing and current loans to investigate what is going on with note transfers.

If that happened, there would be no mortgage sales (except for those involving cash) in the country. The system would simply stop. Everyone with an interest, from realtors to Wall Street to construction to huge sections of the economy, would face a major crisis from this short-term pinch. There would be a call for Congress to step in immediately.

You can tell that the title insurance market, which is largely concentrated and also holding very little capital to deal with a nationwide crisis, is investigating the current problems.  They are holding off on certain types of foreclosed properties;  if they decide to hold off altogether, things could get seriously bad.

Lawsuits a Go-Go

The second would be a wave of lawsuits. As we discussed in Part Two, many of the servicing agreements allowed for the trustees to force the depositors and sponsors to purchase mortgages without notes. That would be 100 cents on the dollar for mortgages worth pennies. If the trustees don't take action, the investors could sue them. And the tranche warfare on this issue is intense, as foreclosures versus a few more payments radically change the balance between junior and senior tranche holders (See Tracy Alloway on tranche warfare here).

Here's what this could look like. Read left side up for what the lawsuit screaming looks like and the right side down for the response:

Much of the activity would center around the four largest participants in these areas, the Too Big To Fail institutions of Wells Fargo, Bank of America, Citi and JP Morgan.

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

And many of these mortgage-backed securities are cheap. So in an interesting scenario, you could see hedge funds buying them for pennies just for the option to sue firms that are likely backstopped by the government.

If title insurance froze, or if the financial markets had a panic over fears of waves of lawsuits, there would be pressure for Congress to do something. Much of the law is New York trust law, so it isn't clear Congress can act.  But there will be pressure.

Because if this bad-case scenario happens, and there is a small but reasonable chance it could, progressives need to have a clear sense of what they want in exchange for negotiations when the financial industry comes flying in over the cliff -- a list of demands and questions to replace the in-large-part steamrolling of TARP over anyone's interests but the banks.  Even if that doesn't happen, and the slow bleed of the current dysfunctional mortgage market continues, progressive wonk policy initiatives that fix this crisis and get the mortgage market going again should be at the front of the debate.

What's likely to happen

Here's a guess:  In one month, the large banks will conclude that there are no problems with its foreclosure processes.  They'll say that the massive fraud that was committed on the courts was the result of a few bad apples, but those are now gone and it's back to business as normal.

At this point, either as a citizen or as a financial market participant, would there be any reason to believe them?   Is there any reason to believe that the servicer and foreclosure mill fraud is over?  That securitizations actually have the proper legal documentation necessary?  That borrowers and lenders are actually getting a chance to come to mutually beneficial situations?  Is there any reason to believe they aren't lying?

Because servicers aren't currently regulated.  They have a patchwork of state regulators and the OCC may regulate their parent company if it is a bank or thrift, but there's no government agent to provide any accountability here.  So without action, there's going to be no one to confirm or deny that anything has actually changed in the housing market.

In some ways this narrative already reminds me of the BP oil spill in the Gulf.  The Obama administration largely left it to BP to tell the government and the public what was wrong, hire the contractors and then also to tell everyone what the environmental damages were. It will surprise no one that the information BP sent out was wrong (see, for example, Kate Sheppard, "Not an Incidental Public Relations Problem"), but for better or worse, the Obama administration is now linked to whatever course and information BP chooses to pursue.

Why not choose a different course for this case?  One that emphasizes social justice by requiring powerful banks to follow the rule of law, demands corporate responsibility not to commit fraud, provides a space where those who are weak and poor get a fair say instead of being bulldozed by the rich and strong, and actually starts to dig out of the mortgage crisis that we are in? Check out Mike Lux's Exploding foreclosure fraud issue: An opportunity for Democrats to turn the tide. Not only is it relevant, but it demonstrates that there's a good chance this is going to get worse before it gets better. Why not get in front of it and change course from the disastrous path we've been taking?

What Just Went Wrong in the Government Response?

Because what we've done to this point hasn't worked.  Shahien Nasiripour and Arthur Delaney wrote the definitive account of the failure of the HAMP program, Extend AND Pretend: The Obama Administration's Failed Foreclosure Program. Instead of continuing HAMP, it's time for a fresh response.

Pat Garofalo of the Center for American Progress has The Fix Is Over: Mortgage Foreclosure Scandal Offers New Hope for Homeowners, which has a lot on what a new foreclosure relief program could look like:

...allowing housing counselors and other public entities to approve mortgage modifications directly, and if the borrower’s servicer doesn’t challenge the modification in 90 days, it automatically becomes permanent. Such a step would go a long way toward streamlining the program and getting borrowers who qualify through the maze of bureaucracy in a timely, clear fashion without leaving them in limbo for months on end.

Mortgage mediation programs—in which a bank must meet with a borrower, in the presence of a judge and housing counselors, before finalizing a foreclosure—should also be expanded.

And here's another new favorite policy option everyone should start considering, from the same piece:  "REMICs bestow enormous tax breaks to investors; these breaks should be revoked for any residential home mortgage loan holding entity that forecloses on more than a specified percentage of all of its mortgages."

We have to remember what went wrong with HAMP: the servicers were in the driver's seat. We need a process that is involuntary, government-run and is standardizable on both the modification and on the foreclosure end.  After this is instated the current crisis is cleared out in a way that confirms change has actually happened, we can start on a way out of this crisis.

Mike Konczal is a Fellow at the Roosevelt Institute.

Share This

Foreclosure Fraud For Dummies, Part 2: What's a Note, Who's a Servicer, and Why They Matter

Oct 12, 2010Mike Konczal

mike-konczal-2-100Mike Konczal defines the key players in the foreclosure fraud mess. **This is Part 2 in a series giving a basic explanation of the current foreclosure fraud crisis.

mike-konczal-2-100Mike Konczal defines the key players in the foreclosure fraud mess. **This is Part 2 in a series giving a basic explanation of the current foreclosure fraud crisis. You can find Part 1 here.

What is the note?

The SEIU has a campaign: Where's the Note? Demand to see your mortgage note. It's worth checking out. But first, what is this note? And why would its existence be important to struggling homeowners, homeowners in foreclosure, and investors in mortgage backed securities?

There's going to be a campaign to convince you that having the note correctly filed and produced isn't that important (see, to start, this WSJ editorial from the weekend). It will argue that this is some sort of useless cover sheet for a TPS form that someone forgot to fill out. That is profoundly incorrect.

Independent of the fraud that was committed on our courts, the current crisis is important because the note is a crucial document for every party to a mortgage. But first, let's define what a mortgage is. A mortgage consists of two documents, a note and a lien:

The note is the IOU; it's the borrower's promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid. The note is crucial.

Why does this matter? Three reasons, reasons that even the Wall Street Journal op-ed page needs to take into account. The first is that the note is the evidence of the debt. If it isn't properly in the trust, then there isn't clear evidence of the debt existing.

And it can't be a matter of "let's go find it now!" REMIC law, which governs the securitization, is really specific here.  The securitization can't get new assets after 90 days without a tax penalty, and it can't get defaulted assets at all without a major tax penalty. Most of these notes are way past 90 days and will be in a defaulted state.

This is because these parts of the mortgage-backed security were supposed to be passive entities. They are supposed to take in money through mortgage payments on one end and pay it out to bondholders on the other end -- hence their exemption from lots of taxes. The tradeoff is that they can't be de facto managers of assets, and that's what going to find the notes would require.

For Distressed Homeowners

The second is that it also matters a great deal for homeowners who are distressed. The note lays out the terms of late fees and other penalties. As we will discuss in the section on mortgage servicers, the process of trying to get people who are behind on their payments current instead of driving them into bankruptcy has broken down. But for now, it's clear that mortgage servicers don't have great incentives to get distressed homeowners' records correct.

There's well-documented evidence that extra fees are tacked on to mortgages that have fallen behind, fees that aren't following the terms of the note. This is usually only found out in bankruptcy where there is a lawyer (and multiple parties), not in foreclosure cases. But the terms of the note are necessary for the court if homeowners wants to challenge the servicers' claim of the final due amount.

This will matter a great deal for many homeowners. Small, marginal differences in the total owed could allow for a short sale. It could determine if the homeowner has any equity in their home. And this can only be determined by producing the note.

For Investors, Who Took This Seriously at the Beginning

Last reason: you can tell it's important because all the smartest finance guys in the room thought it was important. Let's look at a Pooling and Service Agreement form from 2006 (PSA) between "GS MORTGAGE SECURITIES CORP., Depositor, and DEUTSCHE BANK NATIONAL TRUST COMPANY, Trustee." (h/t Adam Levitin for this example.) Let's reproduce the chart from part 1 to see the chain between depositors and trustees who oversee the trust:

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

So what agreement did they come to when it comes to the proper handling of notes in securitization? Did they think this was no big deal, or that it is something serious? From the PSA (my bold):

(b) In connection with the transfer and assignment of each Mortgage Loan, the Depositor has delivered or caused to be delivered to the Trustee for the benefit of the Certificateholders the following documents or instruments with respect to each Mortgage Loan so assigned:

(i) the original Mortgage Note (except for up to 0.01% of the Mortgage Notes for which there is a lost note affidavit and the copy of the Mortgage Note) bearing all intervening endorsements showing a complete chain of endorsement from the originator to the last endorsee, endorsed "Pay to the order of _____________, without recourse" and signed in the name of the last endorsee...

The Depositor shall use reasonable efforts to cause the Sponsor and the Responsible Party to deliver to the Trustee the applicable recorded document promptly upon receipt from the respective recording office but in no event later than 180 days from the Closing Date....

In the event, with respect to any Mortgage Loan, that such original or copy of any document submitted for recordation to the appropriate public recording office is not so delivered to the Trustee within 180 days of the applicable Original Purchase Date as specified in the Purchase Agreement, the Trustee shall notify the Depositor and the Depositor shall take or cause to be taken such remedial actions under the Purchase Agreement as may be permitted to be taken thereunder, including without limitation, if applicable, the repurchase by the Responsible Party of such Mortgage Loan.

Read that again through to the end and use the chart to follow the chain. If more than 0.01% (!) of mortgage notes weren't properly transferred, the trust can force the sponsor (in this case, Goldman Sachs) to repurchase the bad mortgages.   And this is just one contract for one part of the ~$2.6 trillion dollar mortgage backed securities market.  How's that for systemic risk?  Especially if this is found to be widespread...

Looking at the documents, you see that the smart guys who created these mortgage-backed securities put large poison pills into them to try and prevent the kind of note fraud we are currently experiencing.  They took the policing and legal recourse (and legal ability to cover themselves) very seriously on this issue. So seriously they can force repurchases of this bad debt.

So don't believe anyone who says these are just technicalities; the people who wrote the contract didn't believe they were.

Who is a servicer?

Whenever I hear someone say there wouldn't be a problem with foreclosures if people just paid their mortgages on time, I'm reminded of Alan Grayson's paraphrase of the Republican Health Care Plan: "Don't Get Sick. If You Get Sick, Die Quickly." Yes, the world would be an easier place if people never got sick, or credit risk didn't exist, and people made payments perfectly all the time. But they don't, and we need a system of rules and a process for collecting and presenting evidence in order to kick a family out of their home. And we need a system where this process sets the ground rules that in turn allow for lenders and borrowers coming together and negotiating a situation that is best for both of them.

Because the first rule of mortgage lending is that you don't foreclose.  And the second rule of mortgage lending is that you don't foreclose.  I'll let Lewis Ranieri, who created the mortgage-backed security in the 1980s, tell you: "The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fudiciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary."

In the past you had Jimmy Stewart banks. The mortgages were kept on the bank's books. You had someone who you could go to in order to renegotiate your mortgage. With mortgage-backed securities, the handling of payments and working-out of troubles moved to servicers.  If you are learning about this crisis for the first time, understanding what is broken here is very important.

This is Not a New Problem With Servicing

Let's get some quotes from bankruptcy judges in here:

“Fairbanks, in a shocking display of corporate irresponsibility, repeatedly fabricated the amount of the Debtor’s obligation to it out of thin air.” 53 Maxwell v. Fairbanks Capital Corp. (In re Maxwell), 281 B.R. 101, 114 (Bankr. D. Mass. 2002).

“[T]he poor quality of papers filed by Fleet to support its claim is a sad commentary on the record keeping of a large financial institution. Unfortunately, it is typical of record-keeping products generated by lenders and loan servicers in court proceedings.” In re Wines, 239 B.R. 703, 709 (Bankr. D.N.J. 1999).

“Is it too much to ask a consumer mortgage lender to provide the debtor with a clear and unambiguous statement of the debtor’s default prior to foreclosing on the debtor’s house?” In re Thompson, 350 B.R. 842, 844–45 (Bankr. E.D. Wis. 2006).

(Source.) Notice that consumer rights groups were flagging this as a major problem back in 1999 and 2002 because judges were noticing it was a major problem in their bankruptcy courts. If the late 1990s to 2006 period is a Renaissance period of servicer fraud, then we can contrast it with the period we live in now, the Baroque period of servicer fraud.  Whatever unity there used to be between the forms and functions of the sloppy documentation and outright fraud in the art of servicing have become detached.

The forms of fraud have gone high art: serving documents on people who could never have been served, signing 10,000 affidavits a month, etc. They are all well-covered, and we'll list more later perhaps. Here are some of my favorites from last year, the reading list in Part One has even more. But what I want to focus on is the function of servicer fraud.

What Do Servicers Do?  A Case Study in Bad Design and Worse Incentives

Servicers in a mortgage-backed security have two businesses. The first is transaction processing. This means taking in your mortgage money on one end and walking it over to the crazy tranches and payment waterfalls on the other end. This is clean, efficient, largely automated, requires little discretion and works very well, and implicit in it is that it is most profitable when you can harness economies of scale.

In fact, it's considered a "passive entity", so there are no taxes applied in this passthrough mechanism. If servicers went "active", say by looking for mortgage notes not in the trust 90 days after the fact or mortgage notes that are not in the trust that have defaulted (which is what they'd likely have to do to get out of this foreclosure fraud crisis), they'd face very severe tax penalties.

Their other business is to handle default situations.  In addition to the fixed fee they get for servicing each individual mortgage, they get paid by default fees like late charges. They get to retain most, if not all, of these fees.

So right away they have a disincentive to negotiate to get a mortgage in a good state. They also have a strong incentive to keep a steady stream of fees and charges going to their books, rather than to investors.  So anything that puts servicers in charge of negotiating mortgages, say the Obama's administration's HAMP program, is designed to fail.

Because even without bad incentives, doing good work on modification is costly, time consuming, requires individual expertise and experience and doesn't benefit from automation or economies of scale.  Which is to say it has the opposite structure of their normal business.

And there are additional worries. Many of the servicers work for the largest four banks -- Wells Fargo, Bank of America, Citi, and JP Morgan -- and these four banks have large exposures to junior liens. These are second or third mortgages or home equity lines of credit that would have to be wiped out before the first mortgage can be modified. The four banks have almost half a trillion dollars worth of these exposures and, from the stress test, are valuing them at something like 85 cents on the dollar. Keeping a homeowner struggling to pay the second lien would be more worthwhile to these middlemen banks than getting him or her into a solid first lien to the benefit of the bond investor.

So keep these in mind as you read about the servicers here. There have been worries that they, as a designed institution, were simply not qualified for this job going back a decade. They have massive conflicts with the investors they are supposed to be working for. They profit when homeowners collapse and lose money when they are brought up to a normal payment schedule (made current). And if the instruments don't have the notes necessary to bring standing to carry out the foreclosures, they have to take a massive tax hit in order to take the note into the trust. And there is no regulation in place to handle this.

No Regulator

Because for all the talks of regulatory burden, there is no current federal government agency that regulates the servicers. Not the Federal Reserve. Not the Treasury. This is what happens when the financial industry writes the deregulation. Instead, you have a patchwork of state regulators and attorney generals.  Notice how President Obama has nobody to turn to and tell the press that "So and So is on the case." In theory, the OCC regulates servicers if they are part of a bank or a thrift. This regulation must fall to the new regulatory counsel and the Consumer Financial Protection Bureau to investigate, where it will properly belong.

(The Fair Debt Collections Act, which applies to debt collectors, doesn't apply to servicers. Here's a fun idea for an enterprising staffer: if there is no producible note, are servicers still legally servicers and thus exempt from the Fair Debt Collections Act? Just a thought...)

Is it any wonder that servicers are rushing these foreclosures and making a mockery of the courts and producing systemic risk in the process? There needs to be an investigation of what is being done and why, because this problem is not taking care of itself.

(Special thanks to Katie Porter and Adam Levitin, who you can read at credit slips, as well as Tom Adams and Yves Smith, who you can read at naked capitalism, for in-depth discussions on this material.)

Mike Konczal is a Fellow at the Roosevelt Institute.

Share This

Josh Rosner Goes After the Children Who Ran the Banks

Oct 12, 2010

Sunlight is the best disinfectant, and there is a lot of rot to uncover in the mess that lead to the financial crisis. ND20 contributor Josh Rosner appeared on the new CNN show Parker Spitzer to discuss documents that prove a solid 28% of mortgages in securities didn't even meet investment banks' own underwriting standards. The banks ignored the warnings, ratings agencies turned a blind eye, and the securities got sold to investors, Rosner explains:

Sunlight is the best disinfectant, and there is a lot of rot to uncover in the mess that lead to the financial crisis. ND20 contributor Josh Rosner appeared on the new CNN show Parker Spitzer to discuss documents that prove a solid 28% of mortgages in securities didn't even meet investment banks' own underwriting standards. The banks ignored the warnings, ratings agencies turned a blind eye, and the securities got sold to investors, Rosner explains:

"There's a real problem here and these documents do seem to highlight that the investment banks did have reason to know that these loans didn't even meet their own standards," Rosner explains. Ratings agencies claim they have no obligation to verify information, so "it seems they intentionally avoided collecting this information," he adds. "This is what happens when the children are in charge. We saw the risk management culture of the investment banks disappear, the trading desks really took over this business," he says. Things would have been fine if housing prices kept rising -- but we all know the end to that story.

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

So is this fraud? Rosner claims, "I'm not a lawyer. I don't play one on TV." But Eliot Spitzer is -- and he proposes someone should "drop a subpoena on every investment bank saying I want to track this information... see where in the company [the documents] went, who saw them, who knew about them, who had a conversation about them, and what did they do." And if someone saw the documents and pushed these securities anyway? "Boom, charge them right there." Time will tell if anyone else takes the hard line against this behavior.

Share This

How Much Will Currency Policies Really Affect Our Economy?

Oct 6, 2010J. W. Mason

downarrow-money-150Does the math really add up on these potential solutions to our economic problems?

downarrow-money-150Does the math really add up on these potential solutions to our economic problems?

A number of economists of the liberal Keynesian persuasion have been arguing recently that dollar devaluation is an important step in moving us back toward full employment. In principle, of course, a cheaper dollar should raise US exports and lower US imports. But what's missing from many of these arguments is a concrete, quantitative analysis of how much a lower dollar would raise demand for American goods.

In the interest of starting a discussion, here is a very rough first cut. There are four parameters to worry about, two each for imports and exports: how much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity). We can't observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. But once we assign values to them, it's straightforward how to calculate the effect of a given exchange rate change. And the values reported in published studies suggest that the level of the dollar is a relatively minor factor in US unemployment.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US "price to market".) The OECD's global macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al (2007), -0.93; Crane, Crowley and Quayyum (2007), -0.47 to -0.63; Mann and Plück (2005), -0.28; Marquez (1990), -0.63 to -0.92. (Studies that use the real exchange rate rather than import prices generally find import elasticities between -0.1 and -0.25, which is consistent with a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about -0.75; there is no support for a value beyond -1. Estimated export elasticities vary more widely, but most fall between -0.5 and -1.

So let's use values near the midpoint of the published estimates. Let's assume import passthrough of 0.33, import price elasticity of -0.75, export passthrough of 1 and price elasticity of -1. And let's assume initial trade flows at their average levels of the 2000s -- imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, the US trade deficit shrinks by 1.9 percent of GDP.

That might sound like a lot. But keep in mind, these are long-run elasticities -- in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can't happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP for two to three years. And then, of course, the stimulus ends unless the dollar keeps falling. This is less than half the size of the stimulus passed last January. (Although to be fair, increased demand for tradables should have a higher multiplier than the mix of direct spending, transfers and tax cuts that made up the Obama stimulus.) The employment effect would probably be of the same magnitude -- a reduction of the unemployment rate by between 0.5 and 1.0 points.

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

So it's not a trivial effect, but it's also not the main thing we should be worried about if we want to get back to broadly-shared prosperity. We should remember, too, that a policy of boosting US demand by increasing net exports has costs that a policy of boosting domestic demand does not.

And what about China? At least as often as we hear calls for a lower dollar, we hear calls for China to allow its currency to rise. How much could that help?

Unfortunately, there aren't as many good recent studies of bilateral trade elasticities between the US and China. And the BEA's published series for Chinese import prices only goes back to 2003, which isn't enough for reliable estimates. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn't affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is an implausibly high 1.5; then a 20 percent appreciation of the Chinese currency only provides a boost to US demand of less than one half of one percent of GDP in total, spread out over several years.

And of course, those are all wildly optimistic assumptions. A recent Deutsche Bank report uses an estimate of -0.6 for the exchange rate elasticity of Chinese exports. They don't give any estimates for US-China flows specifically, but given the well-established empirical fact that US imports are unusually exchange-rate inelastic, we have to assume that the number for Chinese exports to the US is substantially smaller than for Chinese exports overall. Consistent with that, my own simple error-correction model, using 1993-2010 data and the relative CPI-deflated bilateral exchange rate, gives an exchange rate elasticity of US imports from China of -0.17. If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP -- and of course much of even that tiny demand shift will be to goods from other low-wage exporters. This last point makes a focus on the Chinese peg particularly problematic as an explanation of US unemployment. If you are talking about reducing the value of the dollar against our trading partners as a whole, any resulting shift away from imports has to be to domestic goods. But presumably the closest substitutes for Chinese imports are usually other imports, not stuff made in the USA.

These are rough calculations and only intended to start a conversation. But it's a conversation we very much need to have. Before we launch a trade war with China for the sake of American workers, we need more concrete answers on the size of the potential gains.

Historically-minded critics of China and other surplus countries often quote Keynes' writings from the 1930s and '40s, with their emphasis on the importance of "creditor adjustment". The implication is that it's China's responsibility to reduce its net exports. But this is a misleading reading of Keynes. In fact, his concern was only ever to ensure that no country was prevented from pursuing full employment by the need to earn foreign exchange. The US, as the supplier of the world reserve currency, cannot face a balance of payments constraint; if we fail to pursue full employment, we have no one to blame but ourselves. If Keynes were alive today, I suspect he would be telling American policymakers to forget about China and focus all their efforts on boosting US demand -- by public investment in infrastructure, by unconventional monetary stimulus, by paying people to dig holes and fill them up again if need be. Because he knew that the only reason to worry about the trade balance was to gain the freedom to pursue "a policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment program directed to the optimum level of domestic employment, which is twice blessed in the sense that it helps ourselves and our neighbors at the same time."

J. W. Mason is a graduate student in economics at the University of Massachusetts, Amherst. A version of this post previously appeared at The Slack Wire.

Share This

Main Street is Dying a Death by a Thousand Spending Cuts

Oct 5, 2010Marshall Auerback

marshall-auerback-100The evidence is everywhere that fiscal austerity only prolongs our misery.

marshall-auerback-100The evidence is everywhere that fiscal austerity only prolongs our misery.

According to the Telegraph.co.uk in an article entitled "Savers told to stop moaning and start spending," Charles Bean, deputy governor of the Bank of England, said, "Savers shouldn't necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital a bit." Mr. Bean also said savers "might be suffering" from the low bank rate, but they had done well from higher rates in the past and would do so again. Encouraging Britons to spend was one reason why the Bank had cut interest rates, he added.

Spend what exactly, Mr. Bean? Why is it that central bankers find it easy to recall the following equation: C (consumption) + I (investment) + G (gov't spending) = GDP (gross domestic product), but they can't seem to learn this one: HU (high unemployment) + HD (high debt levels) + 0 (no interest income) = AZS (almost zero spending).

I know why: because the latter depends on fiscal policy, and central bankers consistently agitate against fiscal policy. This continues despite the fact that expansionary government spending by accounting identity helps to sustain the private sector desire to save. Unfortunately, Charles Bean of the Bank of England fails to understand that today's predisposition to save is a natural reaction to the credit binge that preceded the crisis. Had the increased private sector saving that occurred over the past few years not been accommodated by rising deficits, then the negative income adjustments would have been more severe and the private sector's plans to return some safety margin to their balance sheet positions would have been thwarted. But he and his fellow central bankers appear incapable of acknowledging this fact.

Each week new evidence emerges that categorically demonstrates that the fiscal austerity proponents are clueless about the functioning of real economies and monetary systems. So today in Britain we have a new government committed to significant budget cuts, despite mounting evidence that cuts already undertaken are drastically curtailing their economic activity. The recently released Markit/CIPS UK Manufacturing Purchasing Managers' Indices, which is calculated from data on new orders, output, employment, supplier performance and stocks of purchases, fell to a ten-month low of 53.4 in September, down from a revised figure of 53.7 in August. Similarly, Ireland finds itself in the midst of a major banking crisis -- Anglo-Irish Bank was recently nationalized, for example -- despite the fact that the Irish government has steadfastly continued to apply the fiscal austerian measures urged on it by the ECB. In reality, this is because of the austerity measures it is taking. The budget deficit, as a percentage of GDP, now stands at 32 percent! Those are wartime-type levels of expenditures.

Yet the conditions attached to the European Central Bank's ongoing financial support of Ireland and the rest of the euro zone is continued fiscal austerity. The so-called PIIGS nations remained trapped between Scylla and Charybdis as a consequence of this Faustian bargain with the European Central Bank. If the ECB stops buying national government debt on the secondary markets, those governments are likely to default, and the big French and German banks it is protecting will be in crisis. Alternatively, every day governments like Ireland or Portugal continue with this policy, the more their economies continue to implode. Ultimately there will be mayhem. The euro itself could once again be threatened.

Don't get us wrong: we think such deficits ultimately put a floor on demand and will help the economy recover. But policy makers need to let these economies breathe for a time, rather than crushing them with additional threats of fiscal austerity. Isn't it interesting that the very policy prescriptions designed to eliminate the so-called "scourge of public debt" are actually increasing it? Shouldn't that make our policy makers pause in their enthusiastic embrace of fiscal austerity? Even the high priests of austerianism, the International Monetary Fund, are now conceding in their latest report that these current policies will condemn Southern Europe to death by slow suffocation, as well as leaving northern Europe, the UK, and the US in a slump for a long time to come.

Policy makers here in the US continue to hint at accounting tricks such as quantitative easing on the premise that central banks swapping one financial asset for another will help incite more speculation. That seems to be doing the trick for the stock market. But this does nothing to boost underlying aggregate demand. How about a solution for Main Street?

Sign up for weekly ND20 highlights, mind-blowing stats, event alerts, and reading/film/music recs.

Even as the markets continue to make new post-2008 recovery highs, governments continue to construct policies around bailing out fundamentally insolvent financial institutions. These policies ensure that the bankers and others can continue to get their exorbitant and totally unjustifiable bonuses, thereby sustaining the very practices that created the crisis in the first place. Lloyd Blankfein of Goldman Sachs warned that the bank could shift its operations around the world if regulatory crackdown becomes too tough in certain jurisdictions. To which any politician with an ounce of backbone ought to say, "Good! Take your socially polluting activities elsewhere and leave our populations alone."

Of course, they don't do that. The more likely supine response (as we've already seen in Basel III and Dodd-Frank) is a further undermining of any kind of serious regulation. We tinker around the edges but make no fundamental, structural reforms. It's a national scandal that our most elite businessmen and professionals, who have destroyed the global economy through an unprecedented orgy of mortgage and accounting fraud, have to date gotten away with it scot-free and continue to have a major hand in policy making. Equally incredibly, our governments continue to trumpet the "success" of abominations such as TARP along with their enablers in the media.

As the risk of being called a whiner by Vice President Biden, it has to be pointed out that these very same governments hand out little in spending to underpin the real economy, even as unemployment remains in double digits around the globe. Government support for the real economy via fiscal policy is minimal compared to the trillions thrown at the financial sector. But before we see any kinds of real reductions in unemployment, the cries of "socialism" and "intergenerational theft" rise. The fiscal austerians launch counter-attacks to mobilize against further fiscal expenditures that support employment growth. The expansion of fiscal policy is stopped dead in its tracks.

Curiously, progressives have come to be seen as the enemy because they dare to point out the incoherence and incongruity in current government policy.

For all of the recent hoopla in the stock market recently, much of the latest economic data is consistent with a slow to stagnant economic environment. In the US, inventories are rising. ISM new orders are now just barely hovering above 50, which usually marks the onset of falling levels. The same thing can be said of the leading indicator (which has been falling since the second quarter), and the coincident to lagging indicator ratio. Weekly chains store sales continue to slip toward the April/May lows, while mortgage applications for refinancing are also tipping over, despite the recent drop in mortgage rates. Second quarter revisions of GDP were mild, although this probably marks peak profit margins

Overseas, Japan appears to be reverting back into a recession. Additionally, very few people are looking at the direct impact of China's trade policies and how Beijing's mercantilism is beginning to hollow out other countries' manufacturing bases -- not just in the US but also in other parts of Asia (which are also experiencing decelerations in their exports and purchasing manufacturing indices).

Consumer expectations are tipping over, and we are concerned with a relapse back to a low level of confidence, which never improved from the recession lows. Euro zone company and macro data flow are starting to reflect more fiscal retrenchment , and with the euro higher, exporters may find more competition in the quarters ahead.

Message to today's policy makers: the public debt ratio will fall again when growth resumes. Growth will not resume very strongly unless it is continued to be supported by discretionary fiscal stimulus. There is no magical alternative. Hacking away the last vestiges of fiscal support will simply ensure much more misery, unemployment and social turmoil in the years ahead.

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

Share This

Pages