Funny Money: BTC or US$?

I recently read or heard various critics of Bitcoin compare it unfavorably to the US dollar. This short article explains why fundamentally they are not that different. Each relies on the trust people have in the currency to be able to use it as a store of value or a medium of exchange. Trust can be fractured in either case. The main difference between crypto and fiat currency is the fact that governments usually demand that we pay taxes in the national currency, but that can easily change. Crypto has the added trust factor in that it doesn’t rely on the prudence of politicians.

The true cost of make-believe money

spectator.us/topic/true-cost-make-believe-moneyEconomics

Biden commands trillions in the way previous presidents have commanded billions

by Lionel Shriver

May 6, 2021 | 8:24 am

I like Bill Maher. He’s a rare practicing left-wing comic who’s actually funny. But last week, his routine on cryptocurrency hit eerie harmonics.

‘I fully understand that our financial system isn’t perfect, but at least it’s real,’ he began. By contrast, crypto is ‘just Easter bunny cartoon cash. I’ve read articles about it. I’ve had it explained to me. I still don’t get it, and neither do you’.

Bitcoin is ‘made up out of thin air’ and is comparable with ‘Monopoly money’. As for conventional legal tender: ‘We knew money had to originate from and be generated by something real, somewhere. Cryptocurrency says, “No, it doesn’t”… Or as another analyst put it, “It’s an open Ponzi scheme”. It’s like having an imaginary best friend who’s also a banker.

‘Our problem here is at root not economic but psychological. People who have been raised in a virtual world are starting to believe they can really live in it. Much of warfare is a video game now; why not base our economy the same way? Cryptocurrency is literally a game.

‘Do I need to spell this out? There is something inherently not credible about creating hundreds of billions in virtual wealth, with nothing ever actually being accomplished, and no actual product made or service rendered. It’s like Tinkerbell’s light. Its power source is based solely on enough children believing in it.’

That monologue was broadcast in the same week Joe Biden promoted the third of his gargantuan spending programs, bringing his first 100 days’ total discretionary spending proposals to $6 trillion. (Context: total US GDP is $21 trillion.) This lavish largesse would be slathered atop the annual (and growing) nondiscretionary budget of nearly $5 trillion, against $3.5 trillion in tax revenue. Let’s tweak Maher’s routine, then:

‘I fully understand that our financial system isn’t perfect, but at least, or so I’ve imagined, it’s real. But the American dollar increasingly resembles Easter bunny cartoon cash. I’ve read articles about Modern Monetary Theory. I’ve had it explained to me. I still don’t get it, and neither do you.

‘Dollars are now made up out of thin air and comparable with Monopoly money. We thought we knew that money had to originate from and be generated by something real, somewhere. Modern Monetary Theory says, “No, it doesn’t”… Or as another analyst put it, “Quantitative easing is an open Ponzi scheme”. The Federal Reserve is like having an imaginary best friend who’s also a banker.

‘Our problem here is at root not economic but psychological. People who have been raised in a virtual world are starting to believe they can really live in it. Much of warfare is a video game now; why not base our economy the same way? The conjuring of “borrowed” money from ether, only to have that debt swallowed by a central bank and disappear, is literally a game.

‘Do I need to spell this out? There is something inherently not credible about the Fed creating not just hundreds of billions, but trillions in wealth, with nothing ever actually being accomplished, and no actual product made or service rendered. It’s like Tinkerbell’s light. Its power source is based solely on enough infantilized citizens believing in it.’

Somehow that monologue isn’t as funny in the second version.

While Maher decries the electricity squandered on crypto ‘mining’, at least the color of the Fed’s money is genuinely green. Tap a few keys, and voilà: trillions from pennies on the energy bill. So in the past year, the Fed effortlessly increased the world’s supply of dollars by 26 percent and is on track for a similar surge in 2021. But is drastic monetary expansion truly without cost?

I’ve made Maher’s Tinkerbell analogy myself, but to explain how traditional currency functions. I noted in an essay accompanying my novel The Mandibles, about America’s 2029 economic apocalypse: ‘Currency is a belief system. It maintains its value the way Tinkerbell is kept aloft by children believing in fairies in Peter Pan.’

In the novel, a fictional economics professor pontificates: ‘Money is emotional. Because all value is subjective, money is worth what people feel it’s worth. They accept it in exchange for goods and services because they have faith in it. Economics is closer to religion than science. Without millions of individual citizens believing in a currency, money is colored paper. Likewise, creditors have to believe that if they extend a loan to the US government they’ll get their money back or they don’t make the loan in the first place. So confidence isn’t a side issue. It’s the only issue.’

My confidence is going wobbly. Biden commands trillions the way previous presidents have commanded billions, while the public is so dazzled by zeros that they don’t know the difference.

I’ve my quibbles with the particulars. Spending in inconceivable quantity courts waste and fraud. Biden’s American Families Plan casts so many freebies upon the waters as to constitute a de facto universal basic income, and government dependency doesn’t seem characteristic of a good life. Pandemic-relief unemployment supplements (which many Democrats would make permanent) are so generous that small businesses can’t find employees willing to work even for two to three times the minimum wage. Biden is effectively reversing Clinton-era welfare reforms, which moved so many poor Americans from state benefits to self-respecting employment. Financing all these goodies by hiking corporate taxes is popular, but only because few people realize that every-one pays corporate taxes through lower pension-fund returns, job losses from corporate flight, lower wages and higher prices.

But it’s the bigger picture that unnerves me. Zero interest rates have installed an accelerating debt loop. Governments, companies and individuals borrow because money is free. Central banks won’t raise interest rates, lest the cost of servicing all this burgeoning debt bankrupt the debtors. Governments, companies and individuals borrow still more because money is free. The Federal Reserve has already announced it won’t raise interest rates even if inflation climbs, while refusing to cite what level inflation would have to hit before reconsidering. I’ve plotted this story before. It doesn’t end well.

Debt Follies

The New Monetary Regime: An Expert Panel Discusses Debt and Inflation

Written remarks from our three panelists follow below:

U.S. Fiscal Profligacy and the Impending Crisis

by David P. Goldman

The Rise and Rise of Deficit Government

by Christopher DeMuth

The Costs of Our Debt

by Veronique de Rugy

These remarks from the symposium offer a revealing analysis of US financial and fiscal policy. I include in this post the essay by David Goldman, as I believe it offers a foundation for understanding the predicament we have created with poorly conceived financial policies that are now being accelerated and amplified. I have highlighted sections in RED.

May 5, 2021

Massive demand-side stimulus combined with constraints on the supply-side in the form of higher taxes is a sure recipe for inflation and eventual recession. The Fiscal Year 2021 US budget deficit will amount to 15% of US GDP after the passage of an additional $1.9 trillion in demand stimulus, according to the Committee for a Responsible Federal Budget, a proportion that the United States has not seen since World War II.

It is hard to avoid the conclusion that the Biden Administration’s fiscal irresponsibility arises from a cynical political calculation. It evidently proposes to employ the federal budget as a slush fund to distribute benefits to various political constituencies, gambling that the avalanche of new debt will not cause a financial crisis before the 2022 Congressional elections. The additional $2.3 trillion in so-called infrastructure spending that the Administration has proposed consists mainly of handouts to Democratic constituencies.

Where is Foreign Money Going?

During the 12 months ending in March, the deficit stood at 19% of GDP. Even worse, the Federal Reserve absorbed virtually all the increase in outstanding debt on its balance sheet. In the aftermath of the 2009 recession, when the deficit briefly rose to 10% of GDP, foreigners bought about half the total new issuance of Treasury debt. During the past 12 months, foreigners have been net sellers of US government debt. (See Figure 1.) The US dollar’s role as the world’s principal reserve currency is eroding fast, and fiscal irresponsibility of this order threatens to accelerate the dollar’s decline.

The Federal Reserve has kept short-term interest rates low by monetizing debt, but long-term Treasury yields have risen by more than a percentage point since July. Markets know that what can’t go on forever, won’t. At some point, private holders of Treasury debt will liquidate their holdings—as foreigners have begun to do—and rates will rise sharply. (See Figure 2.) For every percentage point increase in the cost of financing federal debt, the US Treasury will have to pay an additional quarter-trillion dollars in interest. The United States well may find itself in the position of Italy in 2018, but without the rich members of the European Union to bail it out.

The flood of federal spending has had a number of dangerous effects already:

  1. The US trade deficit in goods as of February 2021 reached an annualized rate of more than $1 trillion a year, an all-time record. China’s exports to the US over the 12 months ending in February also reached an all-time record. Federal stimulus created demand that US productive facilities could not meet, and produced a massive import boom.
  2. Input prices to US manufacturers in February rose at the fastest rate since 1973, according to the Philadelphia Federal Reserve’s survey. And the gap between input prices and finished goods prices rose at the fastest rate since 2009. (See Figure 3.)
  3. The Producer Price Index for final demand rose at an annualized 11% rate during the first quarter. The Consumer Price Index shows year-on-year growth of only 1.7%, but that reflects dodgy measurements (for example, the price shelter, which comprises a third of the index, supposedly rose just 1.5% over the year, although home prices rose by 10%).

If foreigners are net sellers of US Treasury securities, how is the United States financing an external deficit in the range of $1 trillion a year? The US has two deficits to finance, the internal budget deficit, and the balance of payments deficit, and here we refer to the second. The answer is: By selling stocks to foreigners, according to Treasury data. (See Figure 4.) Foreign investors have been dumping low-yielding US Treasuries and corporate bonds during the past year, according to the Treasury International Capital (TIC) system. Foreign investors bought $400 billion of US equities and nearly $500 billion of US agency securities (backed by home mortgages) during the 12 months through January, but sold $600 billion of Treasuries and $100 billion of corporate bonds.

This is a bubble on top of a bubble. [Double Bubble = Trouble.] The Federal Reserve buys $4 trillion of Treasury securities and pushes the after-inflation yield below zero. That pushes investors into stocks. Foreigners don’t want US Treasuries at negative real yields, but they buy into the stock market which keeps rising, because the Fed is pushing down bond yields, and so forth.

At some point, foreigners will have a bellyful of overpriced US stocks and will stop buying them. When this happens, the Treasury will have to sell more bonds to foreigners, but that means allowing interest rates to rise, because foreigners won’t buy US bonds at extremely low yields. Rising bond yields will push stock prices down further, which means that foreigners will sell more stocks, and the Treasury will have to sell more bonds to foreigners, and so forth.

The 2009 crisis came from the demand side. When the housing bubble collapsed, trillions of dollars of derivative securities backed by home loans collapsed with it, wiping out the equity of homeowners and the capital base of the banking system. The 2021 stagflation—the unhappy combination of rising prices and falling output—is a supply-side phenomenon. [Back to the Future of That 70s Show] That’s what happens when governments throw trillions of dollars of money out of a helicopter, while infrastructure and plant capacity deteriorate.

The present situation is unprecedented in another way: Not in the past century has the United States faced a competitor with an economy as big as ours, growing much faster than ours, with ambitions to displace us as the world’s leading power.

The source of the 2008 crisis was overextension of leverage to homeowners and corporations. I was one of a small minority of economists who predicted that crisis.

Federal debt in 2008 was 60% of GDP, not counting the unfunded liabilities of Medicare and the Social Security System. As of the end of 2020, Federal debt had more than doubled as a percentage of GDP, to 130%. The Federal Reserve in 2008 owned only $1 trillion of securities. US government debt remained a safe harbor asset; after the Lehman Brothers bankruptcy in September 2008, the 30-year US Treasury yield fell from 4.7% to 2.64%, as private investors bought Treasuries as a refuge.

The Treasury: Not a Refuge from, but a Cause of Crisis

Today the US Treasury market is the weak link in the financial system, supported only by the central bank’s monetization of debt. If the extreme fiscal profligacy of the Biden Administration prompts private investors to exit the Treasury market, there will be no safe assets left in dollar financial markets. The knock-on effects would be extremely hard to control

The overwhelming majority of over-the-counter (privately traded) derivatives contracts serve as interest-rate hedges. Market participants typically pledge Treasury securities as collateral for these contracts. The notional value of such contracts now exceeds $600 trillion, according to the Bank for International Settlements. Derivatives contracts entail a certain amount of market risk, and banks will enter into them with customers who want to hedge interest-rate positions only if the customers put up collateral (like the cash margin on a stock bought on credit) (See Figure 5) The market value (after netting for matching contracts that cancel each other out) is about $15 trillion. If the prices of Treasury securities fall sharply, the result will be a global margin call in the derivatives market, forcing the liquidation of vast amounts of positions.

Something like this occurred between March 6 and March 18, 2020, when the yield on inflation-protected US Treasury securities (TIPS) jumped from about negative 0.6% to positive 0.6% in two weeks. The COVID-19 crash prompted a run on cash at American banks, as US corporate borrowers drew down their credit lines. US banks in turn cut credit lines to European and Japanese banks, who were forced to withdraw funding to their customers for currency hedges on holdings of US Treasury securities. The customers in turn liquidated US Treasury securities, and the Treasury market crashed. That was the first time that a Treasury market crash coincided with a stock market crash: Instead of acting as a crisis refuge, the US Treasury market became the epicenter of the crisis.

The Federal Reserve quickly stabilized the market through massive purchases of Treasury securities, and through the extension of dollar swap lines to European central banks, which in return restored dollar liquidity to their customers. These emergency actions were justified by the extraordinary circumstances of March 2020: An external shock, namely the COVID-19 pandemic, upended financial markets, and the central bank acted responsibility in extending liquidity to the market. But the Federal Reserve and the Biden Administration now propose to extend these emergency measures into a continuing flood of demand. The consequences will be dire.

The present situation is unprecedented in another way: Not in the past century has the United States faced a competitor with an economy as big as ours, growing much faster than ours, with ambitions to displace us as the world’s leading power. China believes that America’s fiscal irresponsibility will undermine the dollar’s status as world reserve currency.

Here is what Fudan University Professor Bai Gang told the Observer, a news site close to China’s State Council:

Simply put, this year the United States has issued a massive amount of currency, which has given the US economy, which has been severely or partially shut down due to the COVID-19 epidemic, a certain kind of survival power. On the one hand, it must be recognized that this method . . . is highly effective. . . . The US stock market once again hit a record high.

But what I want to emphasize is that this approach comes at the cost of the future effectiveness of the dollar lending system. You do not get the benefit without having to bear its necessary costs.

A hegemonic country can maintain its currency hegemony for a period of time even after the national hegemony has been lost. After Britain lost its global hegemony, at least in the 1920s and 1930s, the pound sterling still maintained the function of the world’s most important currency payment method. To a certain extent, the hegemony of the US dollar is stronger than any currency before it. . . .

We see that the US dollar, as the most important national currency in the international payment system, may still persist for a long time even after US hegemony ends. Since this year, the US has continued to issue more currency to ease the internal situation. The pressure will eventually seriously damage the status of the US dollar as the core currency in the international payment system.

America has enormous power, but the Biden Administration and the Federal Reserve are abusing it. And China is waiting for the next crisis to assert its primacy in the world economy.

The Single Turning Point That Explains Our World Today.

As the story goes…

On the afternoon of Friday, August 13, 1971, Federal Reserve banking officials along with twelve other high-ranking White House and Treasury advisors met secretly with President Richard Nixon at Camp David. There was great debate about what Nixon should do, but ultimately Nixon, relying heavily on the advice of the self-confident Connally, decided to break up Bretton Woods by announcing the following on August 15:

Nixon directed Treasury Secretary Connally to suspend, with certain exceptions, the convertibility of the dollar into gold or other reserve assets, ordering the gold window to be closed such that foreign governments could no longer exchange their dollars for gold.

The significance of this policy action would slowly be felt over the next 50 years and puts us where we are today. The end of the US$ peg put the global monetary system on a floating exchange rate basis and currency trading exploded. However, in the 1970s and mid- 80s the US monetary authorities and markets were still operating under the previous regime where government borrowing and spending was restrained by gold redemptions, even though the redemptions had been closed. In 1981-82, Fed chairman Volcker contracted credit with sharply higher interest rates, plunging the US into a steep recession but wringing CPI inflation out of the system.

Credit became quite cheap, fueling a rapid technology-driven expansion in the mid-1980s that strengthened the US$. Then Volcker was replaced by Greenspan and soon after Black Monday hit the global markets that had been flying high on cheap credit. It was then that the Fed realized it had an open checkbook to throw at the markets and prevent them from crashing. This has been the policy ever since because the only consequence of excessive credit has been financial asset bubbles, primarily securities markets and real estate.

But fomenting asset bubbles has created severe disparities between those who own assets and those who don’t. During this period, the economic liberalization of the two most populous societies on the planet – China and India – has driven the world price of labor down across the board, depreciating the value of that labor, constraining cost-push inflation of consumer prices.

These three trends – cheap credit, technology, and globalization – have promoted casino capitalism encompassing asset speculation and the massive substitution of cheap capital for more expensive labor, reducing labor participation rates across developed countries, and greatly aggravating wealth and income inequality.

This puts us where we are today and unfortunately the cheap credit and technology trends are accelerating. Most people today think Donald Trump has something to do with our plight, but that’s absurd on the face of it. This has been a 50-year trend in policy choices by a slowly degenerating political class under the Federal Reserve in coordination with other developed countries’ central banks. It’s all great fun until the bubble bursts.

So, how much is your house worth? Don’t kid yourself. At some point, all asset prices will reflect real value or phony currency value. There will be a massive battle between those who possess the assets and those who hold the debts used to buy them.

As propounded by Herbert Stein’s Law, “If something cannot go on forever, it will stop.”

Mortgage Housing Follies

 

Some of us have been sounding this alarm for about 18 years, since the time the Greenspan Fed inflated the housing markets across the board by keeping interest rates too low. Since the inevitable crash in 2008, financial housing policy has doubled and tripled down on this folly to the point where in many areas of the country most homeowners live in houses they could never afford if they had to buy them again.

Recovery in any housing market requires housing prices to find fundamental value by shoring markets up at the margin, helping people who can’t afford their house, and never could, to sell to those who do have the necessary resources. And that doesn’t mean reflating private equity portfolios to become the new landlords of residential housing. Nor does it mean buying up mortgages at full value and then selling them at a deep discount to investors. Bad investments require taking losses and if necessary, going bankrupt.

Widespread housing and land ownership are the foundation of the middle class, and we’re quickly destroying it. We are experiencing Einstein’s definition of insanity.

The Bailout Miscalculation That Could Crash the Economy

When Donald Trump signed the $2 trillion CARES Act rescue on March 27, there was immediate praise across the political spectrum for section 4022, concerning homeowners in distress. Under the rule, anyone with a federally-backed mortgage could now receive instant relief.

Forbearance, the law said:

…shall be granted for up to 180 days, and shall be extended for an additional period of up to 180 days at the request of the borrower.

Essentially, anyone with a federally-backed mortgage was now eligible for a six-month break from home payments. Really it was a year, given that a 180-day extension could be granted “at the request of the borrower.”

It made sense. The burden of having to continue to make home payments during the coronavirus crisis would be crushing for the millions of people put out of work.

If anything, the measure didn’t go far enough, only covering homeowners with federally-backed (a.k.a. “agency”) mortgages. Still, six months or a year of relief from mortgage payments was arguably the most valuable up-front benefit of the entire bailout for ordinary people.

Unfortunately, this portion of the CARES Act was conceived so badly that it birthed a potentially disastrous new issue that could have severe systemic ramifications. “Whoever wrote this bill didn’t have the faintest fucking clue how mortgages work,” is how one financial analyst put it to me.

When homeowners take out mortgages, loans are bundled into pools and turned into securities, which are then sold off to investors, often big institutional players like pension funds.

Once loans are pooled and sold off as securities, the job of collecting home payments from actual people and delivering them to investors in mortgage bonds goes to companies called mortgage servicers. Many of these firms are not banks, and have familiar names like Quicken Loans or Freedom Mortgage.

The mortgage servicing business is relatively uncomplicated – companies are collecting money from one group of people and handing it to another, for a fee – but these infamously sleazy firms still regularly manage to screw it up.

“An industry that is just… not very good,” is the generous description of Richard Cordray, former head of the Consumer Financial Protection Bureau.

Because margins in the mortgage service business are relatively small, these firms try to automate as much as possible. Many use outdated computers and have threadbare staffing policies.

Essentially, they make their money collecting in good economic times from the less complicated homeowner accounts, taking electronic payments and paying little personal attention to loan-holders with issues.

They rely on lines of short-term financing from banks and tend to be cash-poor and almost incompetent by design. If you’ve ever tried to call your servicer (if you even know who it is) and failed to get someone on the phone, that’s no accident — unless you’re paying, these firms don’t much want to hear from you, and they certainly don’t want to pay extra to do it.

Last year, the Financial Stability Oversight Council (FSOC), which includes the heads of the Treasury, the Commodity Futures Trading Commission, the Fed, the aforementioned CFPB and others issued a report claiming mortgage service firms were a systemic threat, because they “rely heavily on short-term funding sources and generally have relatively limited resources to absorb financial shocks.”

For Cordray, who has a book out called Watchdog that chronicles his time heading the CFPB, the worry about mortgage servicers was serious.

“Nonbanks are very thinly capitalized,” he says. “They haven’t been very responsible in building up capital buffers.”

Enter the coronavirus. Even if homeowners themselves weren’t required to make payments under the CARES Act, servicers like Quicken and Freedom still had to keep paying the bondholders every month.

It might be reasonable to expect a big bank like Wells Fargo or JP Morgan Chase to front six months’ worth of principal and interest payments for millions of borrowers. But these cardboard fly-by-night servicer firms – overgrown collection agencies – don’t have that kind of cash.

How did the worst of these firms react to being told they suddenly had to cover up to a year of home payments? About as you’d expect, by trying to bully homeowners.

Soon after the passage of the CARES Act, reporters like Lisa Epstein at Capitol Forum and David Dayen at the American Prospect started hearing stories that servicers were trying to trick customers into skipping the forbearance program. As David wrote a few weeks ago:

I started hearing from borrowers that they were being told that they could apply for three months forbearance (a deferment of their loan payment), but would have to pay all three months back at the end of the period…

It soon came out that many servicers were telling homeowners that even if they thought they were getting a bailout break, they would still have to make it all up in one balloon payment at the end of the deferral period. This was a straight-out lie, but the motivation was obvious. “They’re trying to get people to pay any way they can,” is how Cordray puts it.

Dayen cited Amerihome Mortgage and Wells Fargo, but other names also started to be associated with the practice. Social media began to fill up with stories from people claiming firms like Mr. CooperBank of America and others were telling them they had to be prepared to make big balloon payments.

Same with the CFPB’s complaint database, which began to be filled with comments like the following, about a firm called NewRez LLC:

If you have 4 months of mortgage payments laying around at the end of the COVID-19 pandemic you will be fine if not good buy [sic] to your house. I understand its a business and they will make a lot of money with I’m sure a government bailout and lots of foreclosures from not helping any american home buyers…

Suddenly regulators and politicians alike were faced with a double-edged dilemma. On the one hand, the poorly-designed CARES Act placed servicers in genuine peril, an issue that left unfixed might break the mortgage markets – not a fun experience for America, as we learned in 2008.

The obvious solution was to use some of the apparently limitless funding ammunition in the Federal Reserve to help servicers maintain their responsibilities. The problem was the firms that needed such help the most were openly swindling homeowners. If there’s such a thing as regulatory blackmail, this was it.

Should the Fed open its war chest and create a “liquidity facility” to help mortgage servicers? If so, how could this be done in a way that didn’t put homeowners at more risk of being burned in some other way?

“This is the script of a heist flick, where homeowners get screwed in the end while servicers get the money,” says Carter Dougherty of Americans for Financial Reform. “If you combine money for servicers with strong consumer protections and a vigorous regulator, then the film could have a happy ending. But I’m not holding my breath.”

In early April, a group of Senators led by Virginia’s Mark Warner sent a letter that pleaded with Treasury Secretary Steven Mnuchin to use some of the $455 billion economic stabilization fund to solve the problem. The letter included a passage that essentially says, “We know these companies suck, but there’s no choice but to bail them out”:

While we understand that some nonbank lenders may have adopted practices that made them particularly susceptible to constraints on their liquidity during a severe downturn, imposing a broad liquidity shock to the entire servicing sector is not the way to go about reform…

The Senators put the problem in perspective, noting that as much as $100 billion in payments might be forborne under the CARES Act. This was a major hit to an industry that last year “had total net profits of less than $10 billion.”

The CARES Act was written in March with such speed that it became law before anyone even had a chance to catch, say, a $90 billion-sized hole in the bailout’s reasoning. Still, when the forbearances began and it started to look like the servicers might fail, there was talk among regulators and members of congress alike of letting failures happen, to teach the idiots a lesson.

But ultimately the Senators on the letter (including also Tim Kaine, Bob Menendez and Jerry Moran) decided this would ultimately be counterproductive, i.e. letting the economy collapse might be an unacceptably high price for the sending of a message to a handful of dirtbag companies.

“The focus now should not be on longer-term reform, but on ensuring that the crisis now unfolding does as little damage to the economy as possible,” is how the letter put it.

Although the letter essentially urged the creation of a new Fed bailout facility to contain the mortgage-servicer ick, that didn’t happen, even after mortgage servicers stepped up lobbying campaigns. In mid-April, a string of news stories appeared in which servicers warned reporters of snowballing market terror – as the New York Times put it, the “strain is expected to intensify” – that would only be solved with a bailout.

No dice. In a repeat of the often-halting, often illogical responses to mushrooming crises of 2008, the first pass at a solution came in the form of a move by the Federal Housing Finance Agency (FHFA), the overseer of Fannie and Freddie.

On April 21, FHFA announced they were coming to the rescue: servicers would no longer need to come up with six months of payments. From now on, it would only be four:

Today’s instruction establishes a four-month advance obligation limit for Fannie Mae scheduled servicing for loans and servicers which is consistent with the current policy at Freddie Mac.

Which was fine, except for one thing: from the standpoint of most of these woefully undercapitalized servicing firms, having to cover four months of payments is not a whole lot easier than covering six. “It still might as well be ten years for these guys,” is how one analyst put it.

Absent an intervention from the Fed, a bunch of these servicing firms will go bust. There will be chaos if even a few disappear. As we found out in 2008, homeowners facing servicer disruptions can immediately be confronted with all sorts of problems, from taxes going unpaid to payments vanishing to incorrect foreclosure proceedings taking place. Such problems can take years to resolve. Service issues helped seriously prolong the last crisis, as I wrote about in 2010.

Also, if your servicer disappears, someone still has to do the grunt work of managing your loan. To make sure your home payments are collected and moved to the right place, some entity will have to acquire what are known as the Mortgage Servicing Rights (MSRs) to your loan.

But MSRs have almost no value in a battered economy, which means it’s likely no big company like a bank will be interested in acquiring them in the event of mass failures, absent some kind of inducement. “They’re not going to want that grief,” is how one hill staffer puts it.

A third problem is that if some of these nonbank servicers go kablooey, a likely scenario would involve their businesses being swallowed up by big banks, perhaps with the aid of incentives tossed in from yet another bailout package.

This would again mirror 2008, in that a regulatory response would worsen the hyper-concentration problem and make big, systemically dangerous banks bigger and more dangerous, again.

As Dougherty says, the simplest solution would be opening a Fed facility to contain the servicer disaster, coupling aid with new measures designed to a) force servicers to keep more money on hand for a rainy day and b) stop screwing homeowners.

But the more likely scenario is just a bailout for now, with a vague promise to reform later. This would lead either to an over-generous rescue of some of our worst companies, or an industry wipeout followed by another power grab by Too Big To Fail banks.

The whole episode is a classic example of how governmental ignorance married to corporate irresponsibility can lead to systemic FUBAR, though we still don’t know how this particular version will play out. As Cordray puts it, it’s not easy to predict where failures in the mortgage servicer industry might lead.

“What’s easy to predict, though,” he says, “is that it will be a mess.”


Yeah, no kidding.

Financial Moral Hazard

If we believe this Houdini act then we have only ourselves to blame.

How Many Bank Bailouts Can America Withstand?

The architects of the 2008 rescues pretend they’ve been vindicated.

Ten years after the financial crisis of 2008, the architects of the bailouts are still describing their taxpayer-backed rescues of certain financial firms as great products which were poorly marketed to the American people. The American people still aren’t buying.

A decade ago, federal regulators were in the midst of a series of unpredictable and inconsistent interventions in the financial marketplace. After rescuing creditors of the investment bank Bear Stearns and providing a partial rescue of its shareholders in March of 2008, the feds then shocked markets six months later by allowing the larger Lehman Brothers to declare bankruptcy. Then regulators immediately swerved again to take over insurer AIG and use it as a vehicle to rescue other financial firms.

Within days legislative drafts were circulating for a new bailout fund that would become the $700 billion Troubled Asset Relief Program. Throughout that fall of 2008 and into 2009, the government continued to roll out novel inventions to support particular players in the financial industry and beyond. Some firms received assistance on better terms than others and of course many firms, especially small ones outside of banking, received no help at all.

In the fall of 2008, Ben Bernanke chaired the Federal Reserve, Timothy Geithner ran the New York Fed and Hank Paulson served as U.S. Treasury secretary. Looking back now, the three bailout buddies have lately been congratulating themselves for doing a dirty but important job. They recently wrote in the New York Times:

Many of the actions necessary to stem the crisis, including the provision of loans and capital to financial institutions, were controversial and unpopular. To us, as to the public, the responses often seemed unjust, helping some of the very people and firms who had caused the damage. Those reactions are completely understandable, particularly since the economic pain from the panic was devastating for many.

The paradox of any financial crisis is that the policies necessary to stop it are always politically unpopular. But if that unpopularity delays or prevents a strong response, the costs to the economy become greater. We need to make sure that future generations of financial firefighters have the emergency powers they need to prevent the next fire from becoming a conflagration.

The authors say that their actions saved the United States and the world from catastrophe, but of course this claim cannot be tested. We’ll never get to run the alternative experiment in which investors and executives all have to live with the consequences of their investments. But Stanford economist John Taylor has made the case that massive ad hoc federal interventions were among the causes of the conflagration. On the fifth anniversary of the crisis he noted that in 2008 markets deteriorated as the government was taking a more active role in the financial economy, which may have contributed to a sense of panic:

…the S&P 500 was higher on September 19—following a week of trading after the Lehman Brothers bankruptcy—than it was on September 12, the Friday before the bankruptcy. This indicates that some policy steps taken after September 19 worsened the problem… Note that the stock market crash started at the time TARP was being rolled out… When former Treasury Secretary Hank Paulson appeared on CNBC on the fifth anniversary of the Lehman Brothers failure, he said that the markets tanked, and he came to the rescue; effectively, the TARP saved us. Appearing on the same show minutes later, former Wells Fargo chairman and CEO Dick Kovacevich—observing the same facts in the same time—said that the TARP… made things worse.

CNBC reported at the time on its Kovacevich interview:

TARP caused the crisis to get “much greater,” he added.

“Shortly after TARP, the stock market fell by 40 percent,” he continued. “And the banking industry stocks fell by 80 percent. How can anyone say that TARP increased the confidence level of an industry, when its stock market valuation fell by 80 percent.”

Perhaps the argument can never be resolved. What is known but is conveniently left out of the Times op-ed is an acknowledgment of the role that regulators played in creating the crisis by encouraging financial firms to invest in mortgage debt, to operate with high leverage and to expect help in a crisis. The Times piece includes no mention of Mr. Bernanke and his Fed colleagues holding interest rates too low for too long, or the massive risks at Citigroup overseen by Mr. Geithner’s New York Fed, or the mortgage bets at AIG approved by the Office of Thrift Supervision at Mr. Paulson’s Treasury Department.

Foolish regulators creating bad incentives was nothing new, though Beltway blunders had rarely if ever occurred on such a scale. What was of course most shocking for many Americans in 2008 was observing so many of their tax dollars flowing into the coffers of large financial institutions. For months both the financial economy and the real economy suffered as Washington continued its ad hoc experiments favoring one type of firm or another.

In 2009 markets began to recover and, thanks in no small part to years of monetary expansion by the Federal Reserve, stock investors enjoyed a long boom. But when it comes to economic growth and wages for the average worker there was no such boom, just an era of discouraged Americans leaving the labor force. And by keeping interest rates near zero for years, the Fed punished savers and enabled an historic binge of government borrowing.

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That federal borrowing binge was also enabled by the rescue programs. The basic problem was that once Washington said yes to bailing out large financial houses, politicians could hardly say no to anyone else. It was no coincidence that just months after enacting the $700 billion TARP, lawmakers enacted an $800 billion stimulus plan. So began the era of trillion-dollar annual deficits. Since the fall of 2008, federal debt has more than doubled and now stands at more than $21 trillion.

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The expansion of government also included record-setting levels of regulation, which limited economic growth. A financial economy heavily distorted by federal housing policy was cast as the free market that failed, and decision-making affecting every industry was further concentrated in Washington.

Messrs. Bernanke, Geithner and Paulson make the case that they saved the financial system but failed to sell the public on the value of their interventions. It’s a sale that can never be made. Even if the bailouts hadn’t led to an era of diminished opportunity and skyrocketing federal debt, Americans would have resisted the idea that our system requires occasional instant welfare programs for wealthy recipients chosen by un-elected wise men.

The bailout buddies are now urging the creation of more authorities for regulators to stage future bailouts. The Trump administration should do the opposite, so that bank investors finally understand they will get no help in a crisis.

This column isn’t sure how many bailouts of financiers the American political system can withstand but is certain that such efforts will never be welcomed by non-financiers.

***

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Why…

…Aren’t Presidential Candidates Talking About the Federal Reserve?

Yes, why? Much of our economic and financial lives are being guided by an unelected board of Federal Reserve governors who have been flying blind for about 8 years now…manipulating interest rates and asset markets to what end? Nobody seems to know, except to try to prevent a financial reckoning for previous misguided policies. A less charitable interpretation is the financial industry’s desire to keep the casino open as the only game in town.

By Jordan Haedtler

In an election fueled by populist anger and dominated by talk of economic insecurity, why aren’t any of the presidential candidates talking about the Federal Reserve?

After nearly a decade of high unemployment, severe racial and gender disparities and wage stagnation, voters are heading to the ballot box in pursuit of a fairer economy with less rampant inequality. In California and New York, low-wage workers are celebrating historic agreements to raise the minimum wage to $15 per hour. And the economy and jobs consistently rank among the top concerns expressed by voters of all political stripes.

One government institution reigns supreme in its ability to influence wages, jobs and overall economic growth, yet leading candidates for president have barely discussed it at all. The Federal Reserve is the most important economic policymaking institution in the country, and it is critical that voters hear how candidates plan to reform and interact with the Fed.

Related: The Federal Reserve Bank, Explained [Well, kind of.]

The Fed too often epitomizes the problems with our economy and democracy over which voters are voicing frustration: Commercial banks literally own much of the Fed and are using it to enrich themselves at the expense of the American working and middle class. When Wall Street recklessness crashed the economy in 2008, American families paid the price.

At the time, JP Morgan Chase CEO Jamie Dimon sat on the board of the New York Federal Reserve Bank, which stepped in during the crisis to save Dimon’s firm and so many other banks on the verge of collapse. Although the Fed’s actions helped Wall Street recover, that recovery never translated to Main Street, where jobs and wage growth stagnated.

Commercial banks should not govern the very institution that oversees them. It’s a scandal that continues to threaten the Fed’s credibility. An analysis conducted earlier this year by my parent organization, The Center for Popular Democracy, showed that employees of financial firms continue to hold key posts at regional Federal Reserve banks and that leadership throughout the Federal Reserve System remains overwhelmingly white and male and draws disproportionately from the corporate and financial world.

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When the Fed voted in December to raise interest rates for the first time in nearly a decade, the decision was largely driven by regional Bank presidents — the very policymakers who are chosen by corporate and financial interests. In 2015, the Fed filled three vacant regional president position, and all three were filled with individuals with strong ties to Goldman Sachs; next year, 4 of the 5 regional presidents voting on monetary policy will be former Goldman Sachs insiders. Can we trust these blue-chip bankers to address working Americans’ concerns?

Yet despite the enormous power it wields and the glaring problems it continues to exemplify, the Fed has received little attention this election cycle. As noted by Reuters last week, two of the remaining candidates for president, Hillary Clinton and John Kasich, have been mute on what they would do about the central bank. Donald Trump’s sporadic statements about the Fed have been characteristically short on details, prompting former Minneapolis Federal Reserve Bank President Narayana Kocherlakota to call for Clinton, Trump and all presidential candidates to clarify exactly how they plan to oversee the Fed’s management of the economy. Ted Cruz has piped up about the Fed on a few occasions, although his vocal endorsement of “sound money” and other policies that contributed to the Great Depression warrant clarification. [One expects that none of the candidates really understand the arcana of central banking and prefer to leave well enough alone.]

The most detailed Fed reform proposal from a presidential candidate to date was a December New York Times op-ed in which Bernie Sanders wrote that “an institution that was created to serve all Americans has been hijacked by the very bankers it regulates,” and urged vital reforms to the Fed’s governance structure.

On Monday, Dartmouth economist Andy Levin, a 20-year Fed staffer and former senior adviser to Fed Chair Janet Yellen and her predecessor Ben Bernanke, unveiled a bold proposal to reform the Federal Reserve and make it a truly transparent, publicly accountable institution that responds to the needs of working families. [That’s pretty vague, as the interests of all are best served by a monetary policy that insures the stability of the price level and value of the currency as a unit of exchange and store of value. Employment growth is best addressed through fiscal policy.]

The New York primary provides a perfect opportunity for the remaining presidential candidates to tell us what they think about the Federal Reserve. Candidates in both parties should specify whether they support Levin’s proposals, and if not, articulate their preferred approach for our federal government’s most opaque but essential institution.

As Trump, Cruz and Kasich gear up for a potentially decisive primary, they would do well to respond to the many calls for clarity on the Fed. And on Thursday night, Sanders and Clinton will have the chance to clarify their stances on the Fed when they debate in Brooklyn, just a few miles away from Wall Street and the global financial epicenter that is the New York Federal Reserve Bank.

As New York voters get ready to decide which of the remaining candidates would make the best president, they will be asking themselves which candidate will better handle the economy. The candidates’ positions on the Fed must be part of the equation.

Over Fed

America’s Bank – A Review

Interesting book review with highlights of the history of the Federal Reserve. We should keep in mind that all financial crashes are rooted in excess credit creation. Unconstrained credit creation has now become the primary strategy of our central banks.

An All Too Visible Hand

When Wilson signed the Federal Reserve Act into law in 1913, the very idea of a macroeconomy—something to be measured and managed—was yet to be invented

By James Grant

The Federal Reserve is America’s problem and the world’s obsession. When will Janet Yellen choose to lift the federal-funds rate from its longtime resting place of zero, thereby upending or not upending (it depends on whom you ask) individuals and markets in all four corners of the earth? Her subjects await a sign. While tapping their feet, they may ponder how things ever came to this pass. How, indeed, did such all-powerful body come into existence in the first place—and why?

Roger Lowenstein’s “America’s Bank,” which chronicles the passage of the 1913 Federal Reserve Act, is victor’s history. Its worldview is that of today’s central bankers, the bailers-out of markets, suppressors of interest rates and practitioners of money conjuring. In Mr. Lowenstein’s telling, what preceded the coming of the Federal Reserve was a financial and monetary dark age. What followed was the truth and the light.

It sticks in the craw of good Democrats that, in 1832, their own Andrew Jackson vetoed the rechartering of the Second Bank of the United States, the predecessor of the Federal Reserve. Just as galling is the fact that Old Hickory’s veto message is today counted as one of America’s great state papers. In it, Jackson denies to Congress the power to delegate its constitutionally given duty to “coin money and regulate the value thereof.” To do so, Jackson affirmed, would render the Constitution a “dead letter.”

America’s Bank

By Roger Lowenstein

Mr. Lowenstein contends that, in the creation of the Federal Reserve 80 years later, Congress and the people commendably put that hard-money Jacksonian claptrap behind them. Mandarin rule is the way forward in monetary policy, he suggests—the Ph.D. standard, as one might call it, under which former tenured economics faculty exercise vast discretionary power over the value of money and the course of interest rates, financial markets and business activity. Give Mr. Lowenstein this much: As the world awaits the raising of the Fed’s minuscule interest rate, the questions he provokes have never been timelier. Not for the first time the thoughtful citizen must wonder: What’s money and who says so?

When Woodrow Wilson signed the Federal Reserve Act into law in 1913, the dollar was defined as a weight of gold. You could exchange the paper for the metal, and vice versa, at a fixed and statutory rate. The stockholders of nationally chartered banks were responsible for the solvency of the institutions in which they owned a fractional interest. The average level of prices could fall, as it had done in the final decades of the 19th century, or rise, as it had begun to do in the early 20th, without inciting countermeasures to arrest the change and return the price level to some supposed desirable average. The very idea of a macroeconomy—something to be measured and managed—was uninvented. Who or what was in charge of American finance? Principally, Adam Smith’s invisible hand.

How well could such a primitive system have possibly functioned? In “The New York Money Market and the Finance of Trade, 1900-1913,” a scholarly study published in 1969, the British economist C.A.E. Goodhart concluded thus: “On the basis of its record, the financial system as constituted in the years 1900-1913 must be considered to have been successful to an extent rarely equalled in the United States.”

The belle epoque was not to be confused with paradise, of course. The Panic of 1907 was a national embarrassment. There were too many small banks for which no real diversification, of either assets or liabilities, was possible. The Treasury Department was wont to throw its considerable resources into the money market to effect an artificial reduction in interest rates—in this manner substituting a very visible hand for the other kind.

Mr. Lowenstein has written long and well on contemporary financial topics in such books as “When Genius Failed” (2000) and “While America Aged” (2008). Here he seems to forget that the past is a foreign country. “Throughout the latter half of the nineteenth century and into the early twentieth,” he contends, “the United States—alone among the industrial powers—suffered a continual spate of financial panics, bank runs, money shortages and, indeed, full-blown depressions.”

If this were even half correct, American history would have taken a hard left turn. For instance, William Jennings Bryan, arch-inflationist of the Populist Era, would not have lost the presidency on three occasions. Had he beaten William McKinley in 1896, he would very likely have signed a silver-standard act into law, sparking inflation by cheapening the currency. As it was, President McKinley signed the Gold Standard Act of 1900, which wrote the gold dollar into the statute books.

The doctrine that interest rates are the Federal Reserve’s to manage has come to be regarded, at least by the mandarins, as settled science. It was not so when the heroes of Mr. Lowenstein’s story were conspiring to create a new central bank. Abram Piatt Andrew Jr. took to the scholarly journals to denounce the government’s attempts to pin down money-market interest rates.

Indiana-born, Andrew came East to study, taught economics at Harvard and lent his talents to the National Monetary Commission in 1909 and 1910—the group that conducted the field work to prepare for the grand banking reform. Somewhere along the line, he conceived the idea that the money market should be free of federal manipulation. As prices had been rising—a gentle inflation had begun just before the turn of the 20th century—interest rates should have followed prices higher. That they did not was the complaint that Andrew laid at the doorstep of the government.

Andrew contended that the Treasury Department—under Lyman J. Gage, who served from 1897 to 1902, and his successor, Leslie M. Shaw, who resigned in 1907—“succeeded in keeping the money rate of interest below the rate which would have been ‘normal’ or ‘natural.’ . . . They had kept alive a continuously excessive demand for credit by making it available at less than the normal cost. They had sown the wind and their successor was to reap the whirlwind.”

It is an indictment that comes ready-written against the Federal Reserve’s policy today. Interest rates are prices. Far better that they be discovered in the marketplace than administered from on high. One has to wonder what Andrew would say if he were spirited back to earth to read a random edition of this newspaper in the seventh year of the Fed’s attempt to create prosperity through the technique of zero-percent interest rates. He might want a quiet word with Ms. Yellen.

Andrew is not the only vivid personality in this tale of unintended consequences. Mr. Lowenstein entertainingly limns a gallery of them: Paul Warburg, a German-banker immigrant eager to import European ideas into his adopted country; Carter Glass, an irritable Virginia newspaperman turned congressman (later senator) and currency reformer; Nelson Aldrich, a suspiciously affluent Rhode Island senator and central-bank exponent; Robert Owen, a former Indian agent from the Oklahoma Territory who pushed the Federal Reserve Act through the Senate; William Gibbs McAdoo Jr., the Treasury secretary who married the boss’s daughter; that boss himself, Woodrow Wilson; and Frank Vanderlip, president of what today is Citigroup.

Vanderlip, not alone among his fellow agitators for a central bank, was keen on the gold standard and “fervent,” as Mr. Lowenstein puts it, in his “denunciations of government control.” Here is a fine piece of irony. Government control is exactly what the authors of the Federal Reserve Act unintentionally achieved, though Andrew, at least, might have anticipated this public-policy reversal. He noticed that, under Leslie Shaw’s meddling stewardship in the early years of the 20th century, the Treasury had shifted government deposits to private institutions in times of crisis. “Outside relief in business, like outdoor charity,” as Mr. Lowenstein quotes him saying, “is apt to diminish the incentives to providence, and to slacken the forces of self-help.”

Centralized government control arrived in force with the Banking Act of 1935. It established the centralization of monetary power within the Federal Reserve Board in Washington, and it repealed the so-called double-liability law on bank stocks: No more would the holders of common stocks in failed banks be assessed to help defray the debts of the institutions in which they had invested. Anyway, there would be precious few failures to deal with, proponents of the new thinking contended. Knowing that the Federal Deposit Insurance Corp. stood behind their money, depositors would give up running; they would rather walk to the bank.

The new doctrines repulsed H. Parker Willis, a key player during the organization of the Fed and later a professor of banking at Columbia University. “It is far better, both for the depositor and the banker,” said Willis of the FDIC, “that the actual net irreducible losses growing out of bank failure should fall where they belong. The universal experience with this kind of insurance—if it may be called—has pointed to the danger of increasing losses as the result of bad banking management induced by belief in deposit guarantee.”

Willis didn’t imagine the half of it. On top of deposit insurance evolved the notion that some banks—Citi, for instance—were too big to fail. They must be nurtured through subsidy and bank-friendly monetary policy: low money-market interest rates, for example. It happened that the Citigroup that evolved from Vanderlip’s National City Bank became a ward of the state in 2008. The massive federal bailout of Citi exacted many costs, including a level of regulatory micromanagement that Vanderlip could not have begun to conceive.

J.P. Morgan Chase, which did not fail in 2008, recently went public to describe the intensity of the federal oversight it labors under. More than 950 employees, it revealed, are dedicated to complying with 750 requirements laid down by 21 government entities to achieve and maintain capital adequacy. The Fed itself is high among those demanding overseers. The workers shuffle 20,000 pages of documentation and manipulate 225 econometric models.

The rage to micromanage spans the world. “It can’t be,” the head of Sweden’s Nordea Bank was quoted forlornly saying last year in the Financial Times, “that the only purpose of banking is to stop banks from going bankrupt.” Oh, yes it can.

One thinks back to the supposed financial dark ages when, in 1842, New Orleans bankers, setting down a kind of operational manifesto, succeeded in committing the essentials of safe and sound banking practice to one side of one page. They prospered by simple maxims—e.g., do what you will with your own capital but do not abuse the depositor’s funds—well after the Civil War. Some may protest that banking has become more complex since those days. The boggling, 23,000-page length of the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (complete with supporting rules) would suggest that it has become 23,000 times more complex. I doubt that.

The legislation to which President Wilson affixed his signature in 1913—Mr. Lowenstein observantly notes that he signed with gold pens—included no intimation of the revolutionary techniques of monetary control that would come into being after 2008: zero-percent interest rates, “quantitative easing,” and central-bank-sponsored bull markets in stocks and real estate, among others.

The great value of “America’s Bank” is the comparison it invites between what lawmakers intend and what they achieve. The act’s preamble described a modest effort “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States and for other purposes.” “And for other purposes”—our ancestors should have known.