2008 Redux?

Current IMF head Christine LaGarde rocked the financial world this weekend, stating that Europe's banks need "urgent recapitalization." She even suggested that some of the (inadequate) EFSF fund set up to bail-out Greece, Portugal, Spain, Italy, Ireland, and Belgium could instead shore-up the banks. This comes on the heels of Bank of America's capitulation to Warren Buffett to pay punitive rates for fresh capital. Meanwhile, the Times of London reports that Europe's leaders may rather simply bail-out their banks than the problematic sovereigns of the Eurozone.

Such a plan amounts to a serious economic miscalculation. As Stephen Roach points out, a major policy error in he US occurred when the government rescued banks and bankers rather than their victims during the subprime fiasco. With trillions for banks and relative pennies for borrowers, those bailouts rang up massive US government debt but left consumers hopelessly sidelined with debt hangovers leading to our current economic malaise. Another recession now looms.

So now Europe rumbles down that same road--leave zombie borrowers to their own defense but by all means save the precious banks. It feels like the global economy faces another credit crisis (did the first one really end?) and global financial leaders operate under the working assumption that banks must be saved above all else. Such reasoning amounts to an economic death sentence.

We need to let banks fail. Economist Paul Romer advocated this fundamental truth way back in 2009. He argued that the old banks with their toxic assets would not lend. Time has proven Romer correct. Instead of bailing-out zombie banks we should form new banks and focus on balance sheet repair for over-extended borrowers.

Settling With the Big Banks?!

A quiet storm is brewing on Wall Street as the Obama Administration and the Attorney Generals of 49 states ready themselves to sign a settlement agreement with Wall Street banks that will have the effect of bringing to a close consumer lawsuits and state investigations into the root causes of the subprime mortgage crisis. For a flat-fee lump sum (originally said to be $20 billion), Wall Street banks will agree to pay a collective fine (ostensibly to pay for national loan modifications and consumer counseling), while the 50 states and the Justice Department will agree to end all investigations and lawsuits into the mortgage fraud and subprime recklessness that precipitated the meltdown of 2008.

One Attorney General is standing in the way of this so-called "progress." According to Gretchen Morgenson at the New York Times, New York AG Eric Schneiderman is standing alone in opposition to a deal that he deems excruciatingly premature. Per the NY Times:

"Schneiderman, the attorney general of New York, has come under increasing pressure from the Obama administration to drop his opposition to a wide-ranging state settlement with banks over dubious foreclosure practices, according to people briefed on discussions about the deal. . . . Mr. Schneiderman and top prosecutors in some other states have objected to the proposed settlement with major banks, saying it would restrict their ability to investigate and prosecute wrongdoing in a variety of areas, including the bundling of loans in mortgage securities."

Morgenson reports that the big banks are eager to sign a settlement to put the subprime fiasco behind them. The Obama administration is pushing for the settlement to allow Wall Street banks to have a finite settlement figure in order to plan budgets going forward and to assist homeowners with funds for loan modifications, etc. AG Schneiderman is coming under intense pressure to agree to the settlement but is standing against the agreement recognizing that any settlement figure at $20 billion or less, will woefully undercompensate consumers, pensions, investment funds, etc. for the fraud perpetrated by Wall Street in packaging junk mortgages in triple AAA investment vehicles peddled recklessly to investors.

Matt Taibbi at Rolling Stone writes a scorching post in opposition to the settlement "Obama Goes All Out For Dirty Banker Deal." Therein, Taibbi writes:

"This is all about protecting the banks from future enforcement actions on both the civil and criminal sides. The plan is to provide year-after-year, repeat-offending banks like Bank of America with cost certainty, so that they know exactly how much they’ll have to pay in fines (trust me, it will end up being a tiny fraction of what they made off the fraudulent practices) and will also get to know for sure that there are no more criminal investigations in the pipeline. This deal will also submarine efforts by both defrauded investors in MBS and unfairly foreclosed-upon homeowners and borrowers to obtain any kind of relief in the civil court system."

Taibbi continues: "To give you an indication of how absurdly small a number even $20 billion is relative to the sums of money the banks made unloading worthless crap subprime assets on foreigners, pension funds and other unsuspecting suckers around the world, consider this: in 2008 alone, the state pension fund of Florida, all by itself, lost more than three times that amount ($62 billion) thanks in significant part to investments in these deadly MBS. So this deal being cooked up is the ultimate Papal indulgence. By the time that $20 billion (if it even ends up being that high) gets divvied up between all the major players, the broadest and most destructive fraud scheme in American history, one that makes the S&L crisis look like a cheap liquor store holdup, will be safely reduced to a single painful but eminently survivable one-time line item for all the major perpetrators."

With Schneiderman standing alone against this settlement, will he cave under the pressure being applied by an administration, other state Attorney Generals and members of the Federal Reserve? Will the big banks get out from under their responsibility for nearly crashing the global economy by writing a check for $20 billion (or less) and simply walk away? Apparently, member of the Federal Reserve believe this is just. According to the New York Times, "Kathryn S. Wylde, a member of the board of the Federal Reserve Bank of New York who represents the public . . . has criticized Mr. Schneiderman for bringing the lawsuit [opposing easy Wall Street bank settlements]. Ms. Wylde said in an interview on Thursday that she had told the attorney general 'it is of concern to the industry that instead of trying to facilitate resolving these issues, you seem to be throwing a wrench into it. Wall Street is our Main Street — love ’em or hate ’em. They are important and we have to make sure we are doing everything we can to support them unless they are doing something indefensible.'"

That a member of the Federal Reserve Bank of New York claims that "Wall Street is our Main Street" and that Wall Street must be supported unless they've done "something indefensible" is astonishing. Apparently, engaging in massive subprime mortgage loan fraud is not "something indefensible."


cross-posted on the Salt Law Blog

Origins of Our Debt Nightmare III: The Bush Economic Collapse

In prior posts, I posited that the Bush Tax Cuts and the bank bailouts (especially through the Fannie/Freddie bailouts) accounted for large portions of the current debt nightmare facing the US. The graph at left depicts the relative contributors to the US deficit and hence our debt problem. Obviously, the Bush Tax Cuts loom large over time. But, the next largest contributor is the Bush economic downturn.

To be fair, not all of the downturn can be attributed to the policies of the Bush Administration. The Clinton Administration pursued financial deregulation too, particularly through the repeal of Glass-Steagall. And, as I have argued since December of 2008, the Obama Administration failed to pursue adequate fiscal stimulus and failed to design its inadequate stimulus in an economically rational way, in particular relying upon tax cuts that would be saved by consumers and hoarded by the financial system rather than stimulating growth. Nevertheless, the Bush Administration's economic policy boiled down to just cutting taxes again and again and the evidence is conclusive that those tax cuts failed to stimulate sustainable growth.

Thus, according to former Reagan and Bush I Administration official Bruce Bartlett :

"It would have been one thing if the Bush tax cuts had at least bought the country a higher rate of economic growth, even temporarily. They did not. Real G.D.P. growth peaked at just 3.6 percent in 2004 before fading rapidly. Even before the crisis hit, real G.D.P. was growing less than 2 percent a year. . . .Real G.D.P. growth was 4.1 percent in 1994 despite widespread predictions by opponents of the 1993 tax increase that it would bring on another recession. Real growth averaged 4 percent for the balance of the 1990s. By contrast, real G.D.P. growth in the nonrecession years of the 2000s averaged just 2.7 percent a year — barely above the postwar average."

And, in terms of jobs, the Bush Administration holds a deplorable record, as demonstrated here:

Over eight years, from 2000 to 2008, employment in the US plunged, wiping out all of the robust job growth of the Clinton years of 1992-2000. The Bush Administration ushered in a lost decade of employment stagnation even before the recession hit. Those job losses translate into more debt for strapped households, more loan defaults, lost tax revenues and, ultimately, failed economic policies for the Bush Administration.

These failed economic policies form the foundation of the financial crisis which was triggered by too much consumer debt and not enough consumer income--i.e., a very weak job market notwithstanding (or perhaps because of) the very wasteful Bush Tax Cuts. This is the third part of our debt nightmare rooted in failed GOP policies.

Consumers vs. The Banks

The Consumer Financial Protection Bureau has begun its operations, tackling abusive practices in the financial sector. As the financial market crisis has its roots in the deceptive and negligent practices of this sector, the new bureau is working to shield Americans from any future predatory bank behavior. As the Consumer Financial Protection Bureau ramps up its activities, it is clear that the banking industry strongly contests this new governmental agency (indeed the sector lobbied intensely against it formation under the Dodd-Frank Act in the first place). Thus, it is important for the Obama administration to remain committed to its purpose.

However, the bureau’s start has been inauspicious. The Consumer Financial Protection Bureau currently lacks a director, and thus cannot regulate at its full capacity. Richard Cordray has been nominated by President Obama to lead the new agency, but his nomination has been met with disdain by Senate Republicans who are working to defeat Cordray’s nomination unless Senate Democrats are willing to diminish the bureau’s power. Cordray’s confirmation hearing was rescheduled recently from early August to September. While Obama may have signaled capitulation already when he passed over Elizabeth Warren as bureau chief, the creative mind behind the bureau, Richard Cordray needs the administration’s full support to not only win the nomination, but to also take on the banks in the future and protect consumers from abusive practices.

Origins of our Debt Nightmare II: The Bush Tax Cuts

I have no doubt that the Bush Administration will prove to be the most economically backward time in our history--a time when deregulation ran amok, the US debt binge reached a crescendo, surpluses transmogrified into massive deficits, the nation's credit cards paid for unnecessary wars, and economic inequality surged. The Bush economy yielded a few big winners and left the vast majority of Americans with stagnating or declining economic prospects.

Central to the dementia were the Bush Tax Cuts. Basically, the Bush credo, still followed by extremists today is that we should abolish taxes. They would rather default on our debt than raise taxes. Bush never saw a tax cut he could oppose. Their simplistic propaganda basically evinces a total repudiation of the Oliver Wendall Holmes dictum that "Taxes are the price we pay for a civilized society." Even life-long Republicans now recognize that "the Bush tax cuts were responsible for increasing the debt by $3.2 trillion — 27 percent of the fiscal deterioration since 2001." This recklessness continues today in pursuit of the economically incoherent concept that cutting taxes always increases revenues. This is nonsense.

Thus George W. Bush presided over the most dramatic fiscal reversal (massive surplus to massive deficit) in the history of the US:

The bottom line is that the most powerful economic elites pay less in taxes than anytime since World War II, as illustrated here:


Their efforts to continue this enormous giveaway marks this generation of economic elites historically irresponsible. Warren Buffet correctly assesses the dementia here.

Financial Market Crisis Lands Heaviest on Communities of Color

The Pew Research Center just published a report that provides a stark reminder that the disparity in wealth between whites, Latinos and African Americans in this country is a nightmarish problem. In the single largest drop since Pew began collecting data in 1984, Latinos saw their median wealth drop 66% during the period of 2005 to 2009, and African Americans did not fare much better, with a 53% drop in median wealth during the same period.

This precipitous drop in median wealth for Latinos and African Americans during the period of the financial market crisis of 2008 can be attributed to the fact that minority wealth is often tied into home ownership and equity, thereby making minority communities extremely vulnerable during housing crises. Contrarily, whites are generally in a better position to diversify their assets between home equity, stocks, bonds and other investment alternatives. The housing crisis not only widened the existing wealth gap, as white wealth better weathered the mortgage meltdown based on diversified portfolios, white families saw their median wealth drop only 16% because of this diversification. Furthermore, according to the Pew Report, almost one third of Latino and African American households reported zero wealth—that is, having more debt than assets.

The most startling statistic is that while whites had an average median wealth of $113,149 according to Pew; African Americans had a median wealth of only $5,677, and Latinos had a median wealth of $6,325 – simply alarming. The financial market crisis exacerbated this wealth gap, indicating that the mortgage crisis has landed heaviest on communities of color.

The Wrong Worries

Paul Krugman hit the nail on the head last week with his New York Times Op-ed “The Wrong Worries.” With the wild volatility of the markets these past days, it has become painfully obvious that the United States has not seen the end of The Great Recession. While the recession was to have officially “ended” at year-end 2009, the employment markets continue to struggle as job growth is stagnant and unemployment remains too high (nearly 10%).

Per Krugman: "The economy isn’t recovering, and Washington has been worrying about the wrong things. It’s not just that the threat of a double-dip recession has become very real. It’s now impossible to deny the obvious, which is that we are not now and have never been on the road to recovery."

With the grim prospect that many Americans are facing long-term or possibly permanent unemployment, Krugman argues that policymakers must adjust their priorities to assist the U.S. out of this ugly slide. While partisan politicians seek to cast blame on their foes, in truth, all the political leaders are to blame for the continuing failure of the economy.

Job creation proposals can no longer be rhetoric—now is the time for President Obama to move on what he should have been doing the last two years, holding the GOP accountable—and getting people back into the workforce.

Origins of our Debt Nightmare: The GSE Bailouts of the Megabanks

On September 7, 2008, Bush Treasury Secretary seized Fannie Mae and Freddie Mac (the GSEs). At the time, the GSEs backed $5.4 trillion in mortgage loans, or one half of the total residential mortgage market. Up until that date, the GSEs benefited from an implicit guarantee. After government seizure, the guarantee became explicit.

Yesterday, in its report downgrading the US, S&P cited their earlier report projecting total losses to the government approaching $700 billion from the assumption of the GSE's liabilities. Others suggest a worst case scenario of $1 trillion. As of August 2010, total losses reached $226 billion and the government had injected $148 billion in capital. Since then losses continue to mount with the announcement yesterday that Fannie increased its loss reserves for mortgage losses to $75 billion. So by any measure, the bailout of the GSEs constituted an enormous expense incurred by the last administration that greatly contributed to our debt problem and the S&P downgrade yesterday.

The Fannie and Freddie bailouts have been termed "the mother of all bailouts." This seems apt due to both the huge amount of money at stake in the ultimate unwinding of the GSEs as well as the centrality of Fannie and Freddie to the US financial system. Mortgage backed securities issued by the GSEs constitute 29% of the taxable bond market in the US, nearly as much as Treasuries. Currently, the spread between Treasuries and GSE securities are near record lows as illustrated by this graph:


This graph shows that the market currently believes that GSE paper is about as safe as Treasury obligations. It also shows that the bailout was an unadulterated giveaway to holders of GSE obligations. More specifically, to the extent the spreads have compressed over time due to the more explicit government guarantees, holders achieve a windfall in the form of higher bond prices for their holdings arising from the more explicit guarantee. None of this windfall went to debtors on the underlying mortgage backed securities (MBS), as they continued to be obligated at stated interest rates on notes entered into prior to the more explicit guarantee. In other words, 100 percent of the government's expenditures to make good on the MBS guaranteed by the GSEs went to wealthy holders of the MBS (bond investors, banks, and foreign governments like China) on September 7, 2008, and none of it benefited the home owners obligated on those debt obligations. Thus, we bailed out bondholders and banks and rich investors, not homeowners on September 7, 2008.

After the bailout homeowners benefited from lower mortgage rates, but this benefit may not last much longer. The Housing and Economic Recovery Act of 2008 granted the Treasury the authority to provide the GSEs with unlimited capital (by purchasing their stock) in order to maintain their solvency, and Treasury exercised this power to cover losses through 2012 (plus $200 billion each). After that, unless Congress acts, the GSEs are on their own. Their fate will be in the hands of this current Congress--the very Congress that just triggered an S&P downgrade based on "political brinkmanship." As managing director of S&P John Chambers stated: "The political gridlock in Washington leads us to conclude that policymakers don't have the ability to put the public finances of the U.S. on a sustainable footing." The GOP arson squad lacks sufficient political maturity to deal with the GSEs in a responsible way.

Therefore, it would be hard to imagine that the GSEs would maintain their credit ratings much longer. And, unlike Treasury debt, the market for GSE paper could see a disorderly unwinding as investors who currently believe they hold bonds nearly as safe as Treasuries are in fact subject to the whims of the current Congress. That could spell trouble for the financial markets, bank capital, the residential real estate market and the economy generally.

FLASH: GOP Arson Squad Triggers Downgrade

Despite the fact that both other major ratings agencies declined to do so, S&P downgraded US debt today. I have not hesitated to criticize the Obama Administration on this blog, but the most proximate cause of the downgrade was the unprecedented use of the debt ceiling for political leverage and the obstinate refusal to consider any tax increases to address the deficit by the GOP extremists that have taken control of the party. Neither party escapes blame--I just think the GOP arson squad holds disproportionate responsibility because they specifically attempted to jam their agenda down our throats through unprecedented political blackmail. Obama on the other hand put entitlement reform on the table. Here is the operative quote from S&P that fully supports my position:

"We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade."

"The political brinkmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy."

S&P specifically singles out the GOP's refusal to raise taxes:

"[N]ew revenues have dropped down on the menu of policy options. . . .[c]ompared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues."

Read the full report and weep--this is an indictment of our political leadership and was not necessary.

Globalization and the Great Debt Machine

Today the Dow plunged 512 points, on top of prior losses over the past two weeks that now exceed 1297 points, a development that should not surprise any reader of this blog (particularly this, this and this). The downturn arises from growth concerns as well as Europe's debt malaise which I first blogged upon over one year ago, warning: "That [it] could cause a huge financial crisis like what occurred in late 2008." Over $1.9 trillion in wealth vaporized in this equity sell-off, in the US alone, enough to fund the kind of fiscal stimulus needed to restore sustainable growth and reduce debt burdens.

And, debt is the core issue plaguing the global economy. The subprime debacle, the problems in Greece and the Eurozone, and the American fiscal problem all boil down to too much debt. That debt is a direct result of our distorted model of globalization, a topic on which I have written three or four law review articles. Consider the US current account deficit depicted in the above chart. In order to cover the current account deficit someone in the US must write an IOU. Usually, that someone is the American government or the US consumer. While the current account deficit moderated a bit after the subprime crisis, the chart above shows it continues in full swing again today, after a rapid deterioration in the last few quarters.

The flip side of the American current account deficit is the currency reserves held by developing nations. These reserves are usually held in highly liquid and safe debt instruments such as Treasury obligations. Recent data from the IMF show that the world now holds $10 trillion in currency reserves, including at least $5.5 trillion in dollar denominated instruments and $1.4 trillion in Euros. Of course, the constant demand for Eurozone and American debt implicit in these enormous reserves lowers interest rates in the Eurozone and the US, thereby inducing excess debt than otherwise. In other words, when interest rates are artificially lower than they otherwise would be debt becomes more enticing than otherwise because it is cheaper.

This is the basis for John Maynard Keynes' dictum that the nation that furnishes the reserve currency increasingly gets into debt.

So, as the markets continue their meltdown in response to a global financial system that is choking on debt keep in mind that the primary source of that excess debt is the rigged system of globalization that is specifically designed to create excess debt in the Eurozone as well as the US.

Market Verdict: DEBT DEAL SUCKS; STIMULUS NEEDED

President Obama took a serious misstep by veering sharply to the right and pursuing an unnecessarily (according to this analysis by Nate Silver, among others) draconian and conservative approach to the debt ceiling negotiations. In my view, the President gets his economic advice from someone determined to inflict further economic pain and render him a one term president. Ironically, my view does not differ much from former economic adviser Lawrence Summers.

The market reaction to the so-called debt deal ranges anywhere from brutal to horrific. Sine the weekend "deal," the Dow extended its losing streak which right now exceeds any since the meltdown in 2008. The Dow fell 265 points today and Asian Markets right now are all off similar amounts. The flight to safety caused gold to soar, Treasuries to trade higher and Spanish and Italian bonds to fall.

The essential problem is that the global economy desperately needs stimulus and austerity has run amok most notably in the US which was the last source of stimulus, however modest. As The Economist puts it: "action needs to be taken in the long term to tackle the US's fiscal burden but too much austerity in the short term risks damaging an already fragile economy." I argued last week that the dismal GDP mandated stimulus now and austerity later. This week a fresh report shows that the American consumer is simply in too much debt to continue spending and cannot fuel any growth. Elsewhere, the Eurozone appears on the brink of a major crisis as Spain and Italy both face prohibitive increases in the cost of rolling over their debt.

When an economy reaches a liquidity trap (massive capital flight to safety such as cash, excess reserves, Treasury obligations, and precious metals) only the government can convince investors to take risks again by credibly pursuing fiscal shock and awe (like World War II), as I first argued in December of 2008. Tax cuts will not work because people will save them. Monetary policy will not work because it leads to excess reserve accumulation at the Fed. Only massive government spending and employment programs will lure capital out of hibernation once an economy reaches the zero bound.

The debt deal is directly opposite to what the economy needs--more stimulus.

The Obama Administration appears determined to perish in order to vainly defy this basic truth. That is the only explanation for the Obama debt deal.