I've been expecting a headline about the Federal Home Loan Banks and got it today. These banks have been leveraging up and acquiring mortgages at a record pace since this financial meltdown began. This should come as no surprise to anyone who has followed my blog (here and here in 2007 and here again). Here is some of the news from this Wall Street Journal Online Edition article:

Financial troubles at some of the Federal Home Loan Banks are raising questions about how well directors of these institutions are supervising their executives.

A plunge in the value of mortgage securities bought by several of the regional home-loan banks has forced them to halt dividends and curtail funding for local housing projects. An annual report issued by the banks' regulator this past week says some of them "paid insufficient attention" to credit risks and haven't invested enough in information technology.

Unlike giant banks or government-backed mortgage companies Fannie Mae and Freddie Mac, the 12 regional home-loan banks draw little public scrutiny. Created by Congress in 1932 to support the housing market, they are cooperatives owned by more than 8,000 banks, thrifts, credit unions and insurers. Because investors assume the government would bail them out in a crisis, they can borrow money cheaply in the bond market.

If the home-loan banks ever stumble badly, U.S. taxpayers would be called on to "rescue yet another financial entity," warns Karen Shaw Petrou, managing partner of Federal Financial Analytics, a research firm in Washington. These banks have about $1.26 trillion of debt outstanding, putting them among the world's biggest borrowers.

Here is a quote from the FHLB press release:

Operating Results and Affordable Housing Activity:
For the 12 FHLBanks, the combined net loss for the fourth quarter of 2008 was $715 million, compared to combined net income of $846 million for the fourth quarter of the previous year. Combined net income for 2008 decreased 57.3% to $1.2 billion, compared with $2.8 billion for 2007. Combined net income for 2008 was reduced by other than temporary impairment charges of $2.03 billion on certain private label mortgage backed securities (MBS) and home equity loan investments, as well as $252 million of writeoffs/reserves on receivables due from Lehman Brothers Special Financing.

FHLBank Affordable Housing Program (AHP) contribution expenses equaled $188 million in 2008, down from $318 million in 2007, due to the decrease in earnings.

Each FHLBank actively monitors the credit quality of its MBS. If delinquency and/or loss rates on mortgages and/or home equity loans continue to increase, and/or a rapid decline in residential real estate values continues, more FHLBanks could experience further reduced yields or additional losses on MBS investment securities.

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Fed Loans Losing Value

This seems like small potatoes now, but those Bear Stearns and AIG loans made by the Fed aren't doing too well. As of May 6, the Fed is under water by over $8 billion. Here are the details:



On the other hand, Commercial Paper Funding Facility outstandings are down from over $325 billion in December 2008 to $164.7 billion, and down $50 billion this past week alone.

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More Bailouts from Taxpayers

I was reading this article in The Wall Street Journal, Online Edition today titled The Next Housing Bust and had to put down an "I told you so." Here is a quote from the article:

The FHA is almost certainly going to need a taxpayer bailout in the months ahead. The only debate is how much it will cost. By law FHA must carry a 2% reserve (or a 50 to 1 leverage rate), and it is now 3% and falling. Some experts see bailout costs from $50 billion to $100 billion or more, depending on how long the recession lasts.

How did this happen? The FHA was created during the Depression to help moderate-income and first time homebuyers obtain a mortgage. However, as subprime lending took off, banks fled from the FHA and its business fell by almost 80%. Under the Bush Administration, the FHA then began a bizarre initiative to "regain its market share." And beginning in 2007, the Bush FHA, Congress, the homebuilders and Realtors teamed up to expand the agency's role.

This should come as no surprise to anyone who has been following this issue. I wrote about this in December of 2007. Keep listening because there may be more surprises, especially from the Federal Home Loan Banks.

Thanks to Val Ivanson for the link!

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Is Fiscal Stimulus The Right Medicine?

The asset bubble in the United States that has recently burst has wiped out an estimated $13-$14 trillion of net worth between declines in stock and real estate prices. The impact of this value loss is working its way through the economy with dramatic effect. GDP has fallen at a rate of over 6% for the past two quarters, several sectors of the economy are on life support from the government and the Federal Reserve, and we are now entering the 17th month of a recession that began in December of 2007. We already provided an economic stimulus package of approximately $160 billion under the former administration, and we are now looking at a much larger stimulus plan under the current administration. There has been some debate over the effectiveness of fiscal stimulus. Those opposing it claim that fiscal stimulus (that is, when the government borrows to spend and/or provide temporary tax relief) crowds out private sector investment thereby hurting the real economy. Another claim is that fiscal stimulus is ineffective because money that gets to individuals through the stimulus is used to repay debt rather than spent so the economy does not benefit from the multiplier effect of a dollar being spent several times over. I believe fiscal stimulus is the correct response to today’s economic situation, even if a large portion of it goes to repaying debt.

To work through the current situation we need a few economic basics. Individuals earn income. We spend some of this income and we save some. When we save we provide a source of funds for businesses to invest. Our savings flow to businesses through the financial system and the institutions that make up the financial system. Banks are the prime example. Banks take deposits and then use those deposits to make loans. Businesses borrow from the banks to invest in new opportunities. The stock market is another example where businesses raise equity capital to invest from the savings of individual households. Business investment means more jobs and that means more income, more spending, saving, and so on. This is how the economy grows in normal circumstances. Today, however, circumstances are anything but normal. For a long time we borrowed from our future income to consume more in the present (and support a price bubble) running up household debt relative to our incomes. We borrowed for lots of reasons, but the primary asset we borrowed against was our real estate. To put this in perspective, our household debt (that includes mortgages, credit cards, auto loans, etc.) to disposable personal income (that is, income after taxes) has increased from 66% in 1983 to 135% in 2007. The graph below shows the trend in household debt to disposable personal income (debt-to-income) from 1977 through 2008.


(DPI from BEA.gov. HH Debt from Federal Reserve Z1)

The debt to income ratio peaked in 2007 at 135%. It has since fallen back to 130% by the end of 2008. 76% of the debt was mortgage debt in 2007 as opposed to 66% in 1987. The 2008 decline in the debt-to-income ratio illustrates the fact that people are now borrowing less than they were relative to their incomes. The lower level of borrowing means less spending. In addition, we have begun to save again. While we were on our borrow-and-spend spree of the last decade we also spent more of our incomes and saved a lot less. The next graph illustrates the trend in the personal savings rate.


(Personal Saving Rate from BEA.gov)

From this perspective we now see the impact of the rapid declines in housing and stock prices. This mountain of debt, concentrated in mortgage loans, is no longer supported by the price of the underlying collateral. Many homeowners owe more on their home than it is worth and the home as a source of collateral for borrowing additional spending cash has dried up. In addition to this balance sheet impact there is also the cash flow impact. As payments adjust upward incomes are squeezed making it difficult to spend or to borrow more. It’s like a huge number of families borrowed as much as they could and blew it on a mega-vacation and are now saddled with paying back the debt for years to come. Finally, there is the wealth effect. If you thought you had a large portion of your retirement needs accounted for in the value of your home and investments in stocks you are feeling a lot less wealthy today. For all of these reasons households have switched from borrowing and spending to saving as illustrated by the personal savings rate turning up and household debt-to-income ratio turning down. So, this sounds like we are on the right path. If everyone saves we will eventually pay down the debt and everything will be OK, right? Wrong.

Welcome to the paradox of thrift. Saving is good for individuals and for the economy. Remember that savings becomes investment and that helps the economy grow. But when everyone increases saving at the same time overall spending goes down. As we collectively start saving and stop spending business contracts. In this environment business investment falls because there are fewer good business opportunities. So, at the very time individuals start to save businesses don’t need the savings for investment. This is why I do not believe that government stimulus crowds out private investment in the current environment. When businesses are investing less there is nothing to crowd out. And when businesses aren’t investing, people aren’t finding new jobs. As more businesses cut back, more people lose their jobs and can’t find new ones. That means less spending again, and that leads to less investment, and fewer jobs, and so on. This is one way economies fall down into long-term underutilization. How far down and how long depend on a multitude of factors, including the size of the bubble that burst. The losses in tax revenue and other costs to society can be very dramatic. So what do we do about this problem?

Enter the Federal Government, the one borrower that can raise cheap money when everyone else is too worried to borrow and/or can’t find anyone willing to lend (the willing to lend problem is the other side of the rescue plan - repairing bank balance sheets to assure loan supply). As the government spends the money it borrows it provides income to individuals just when individuals need the income because many are losing their jobs and needing to save. If the government provides enough stimulus it may stop the downward spiral of lower incomes and investment discussed above. If those receiving income from the stimulus spend the income there will be some immediate impact on demand in the economy and that could help jump-start business investment. On the other hand, if those who receive the income from the stimulus use it to pay down debt there will be less of an immediate impact on the economy but incomes will be supported while individuals pay down debt. Once debt levels are back to normal individuals should return to spending more of their income. In effect, we are replacing private debt with public debt by providing income through fiscal stimulus to avoid the potential devastation that can result from the de-leveraging of household balance sheets that needs to take place. So even if the recipients of stimulus income use the money to repay debt the economy benefits from the resulting de-leveraging necessary for economic activity to return to normal.

In the end, whether fiscal stimulus is a smart investment depends on its impact on the economy. If it helps to prevent a long protracted depression but costs less than a long protracted depression would, then the stimulus provides a positive economic return. Of course we will never know the true cost-benefit analysis because we will have no way of measuring exactly how much of an economic downturn was prevented.

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Income Inequality

This link is to a summary of research on income inequality in the United States since WWI. I have looked at similar issues on this blog in the past, for example here. This research is much broader and covers a much longer period of time. I think it puts the issue of income inequality into historical context and provides a good understanding of where we are today. For the full report you can visit the authors website here.

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Are We There Yet?

An Opinion Piece.

I started writing about the subprime crisis back before it was a crisis. I was warning of taxpayer bailouts on the way and pointing fingers at those I believe to be responsible for the massive increase in household debt over the past decade. Since last September, however, I have stepped back because we ended up in a true financial crisis – one that could have seen the shut down of credit cards and ATM machines across the country. In such circumstances I give the authorities a pass as I do not want to find out first hand what happens when the grocery store shelves are bare (I do not own a gun). At this point, however, I think we have averted the total collapse scenario. I am not bullish on the economy or the stock market just yet, but I am no longer worried that my access to cash will be shut off. If we have indeed averted the nightmare and are now on the road to a long recovery period, then it is time to go back to asking the tough questions about how we got here and what to do about it. I think we have arrived at this point and it is time to start holding people and institutions responsible for what has transpired.

I am very angry with some of the back door dealings and subversions that have occurred in connection with bailing out financial institutions at the expense of United States taxpayers. From Paulson's "no review" $700 billion bank scheme to revelations regarding the disposition of taxpayer funds through AIG, the manner in which this situation continues to be handled is, I believe, a disgrace. For example, when I hear Goldman Sachs tell us that the $12.9 billion or so it received from AIG through taxpayer funds was unnecessary because it was properly hedged against AIG risk I automatically think, "well, OK then, give it back." So where is it? The arrogance and insensitivity to the general public is obscene. What we have had is a devastating bout of bad behavior by our financial and political institutions. What we need now is to find those responsible, hold them to account, recover the proceeds of their ill-gotten gains the best we can, and prevent this from happening again. This is in addition to shutting down the insolvent institutions before they create even more bad loans in their attempts to become profitable. So far I don't see any of that happening. What I do see is Citibank charging friends of mine 30% interest on their credit cards while at the same time this institution has access to virtually free money from the Federal Funds market and infusions from taxpayers on giveaway terms. This is too much for me to reconcile even with the current financial crisis and the pressure on the banking system.

There are several things that currently trouble me a great deal. The back-door contribution of taxpayer funds through the toxic asset purchase program to the very financial institutions that perpetrated this massive destruction of household and financial sector balance sheets for private gain bothers me. The very fact that Timothy Geithner is Treasury Secretary after his tenure at the New York Fed during the creation of this crisis (not to mention his tax "issue") is troubling. The push to concentrate regulatory power into the hands of the Federal Reserve, the very institution responsible for overseeing our financial system during the drive to leverage up the United States household and financial sectors for the profits of the financial sector (and, more directly, those individuals within it) seems out of touch. The "modification" of mark-to-market rules is shady. The blatant conflicts of interest when the former and, as suggested by Matt Taibbi, the current CEO of Goldman Sachs construct a taxpayer bailout for AIG that provides the most financial gain to - Goldman Sachs - is astounding. The refusal to take the steps we ourselves tell other countries they need to take in times of financial crisis is embarrassing. (For a good read on this point see This article by Simon Johnson in The Atlantic.) These are momentous events, and though I detect the populist rage (for example, this piece by Matt Taibbi in The Rolling Stone) it seems to me that we as a population are at risk of letting this entire affair pass us by without holding anyone accountable or truly learning the lessons we need to from it.

I think we are there – at the point where we begin to take seriously the need to recall the army of finance, accounting, and legal experts who are compensated with outsized rewards to find ways they and their clients can circumvent the regulatory schemes put into place to protect us from this very problem. Those brilliant thinkers who can conceptualize the gray areas between legislative and regulatory words and intent to find avenues of attack for profitable private gain without concern for the impact on the population at large – the public risk. We also need to cleanse the system of the influence money, in all of its cancerous forms, that results in politicians carrying the torch for a favored industry. This will require at least two steps. Step one is to find out exactly what happened, who knew what when, and hold those who behaved recklessly to account for their actions. It is easy to find out who they are – just follow the money while ignoring the cries of "witch hunt" and "class warfare" that will be shouted in protest by those responsible (and their shills). Step two is develop a set of regulatory rules and enforcement that are principals based where actions that are contrary to the spirit of the regulatory framework bring swift consequences. The regulatory changes must address both the finance industry and the political process to remove the incentives for reckless legislation and deregulation. For example, if you are a business that borrows short term funds and invests those funds in longer term assets for profit, you are subject to regulation whether you have a bank charter or not. If you provide any assurance against the risk of loss you are an insurance company. If you engage in any of these activities without registering to be regulated you are promptly shut down, fined, and prosecuted. Once registered you are subject to capital requirements and oversight. Ultimately, these are the things that need to be done.

The more we allow taxpayer rescue of financial institutions without holding those institutions to account from this point forward, the more we are doing a disservice for the American taxpayer, and the more likely it is that we will pass through this crisis into another one in the future. I believe we have arrived at the point in time when we should be swiftly moving from crisis aversion to long-term cleanup – lets get started. I hope the Obama administration, as infiltrated as it already is by insiders from Wall Street, steps up to the plate and begins to take charge. The approach to the auto industry last week was a refreshing wake up call that there is a limit to what taxpayers will stand for. At the same time it highlights the enormous benefits bestowed on the financial sector even after such monumental failures, and the concurrent lack of accountability for the devastation on our economic lives. I want accountability and I want it at the institutional and individual levels. I want a complete investigation by qualified independent investigators. I feel that until we demand it we are no better than those who should be held accountable because we are being complicit.

*A note on my belief that there are specific people to be held accountable:

I believe that any seasoned lender understands that you cannot turn a package of bad loans to people with no income into an AAA security through "structuring." At some level, people had knowledge that what was going on was bound to collapse at some point. Perhaps the analyst didn’t, perhaps the loan officer didn’t, but at some level people knew what was transpiring. I don’t really care if they had insurance from AIG, they should have demanded to see AIG’s total exposure and taken that into account. What happened represents, at the very least, reckless activity and I believe could be characterized as fraud in certain circumstances. The facts revealed in the very incomplete "investigation" into the rating agencies participation in this mess revealed this to be true, and I would bet that any true investigation into the behavior of the financial institutions involved would result in similar findings. This Bill Moyers interview of William Black provides an interesting perspective on whether or not fraud was actually involved. In any case, whether what happened meets the legal definition of fraud is something we should be investigating and, if the answer is no, then we probably need a new definition or standard to protect us from this behavior in the future.

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GM and Washington - Finally an "Adult" Response

I just finished listening to President Obama’s speech regarding the auto industry and I found it refreshing compared to the rhetoric that has been dealt us up to this point. It sounds to me as though we are headed for a pre-packaged bankruptcy for GM with the government standing in as the DIP financier. This is what I thought should have happened in the first place, but I think the last administration kicked the can down the road. Thankfully, down the road was an adult who picked up the can to begin cleaning up the mess.

Of course this will mean some disturbing things, especially for union employees. In particular, this probably means lower wages and cuts in benefits to both employees and retirees. Even if bankruptcy is avoided the stakeholders are now under intense pressure to give up ground. It’s hard to see how we get back on track when we cut wages – this doesn’t help stimulate aggregate demand. In fact it enforces the deflationary momentum. (Hold on, I need to mute the television. That Kudlow guy is on making some noise about this. How is he still a commentator on CNBC after being dead wrong about almost everything over the past couple of years? Goldilocks economy my a$$.) Anyway, I am encouraged that the administration is taking what I consider to be the correct position on the automakers even though there is downside on the wage front. The entire mess brings the issues of trade front and center, and I expect this will be one of the most difficult dances for us to do. Is it too late to stop pushing the US down to a Global wage or can we somehow reverse this trend at a time when we need the world to finance our bailouts? Any thoughts?

Stay tuned.

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