Few Australians understand the workings of the US financial system nor the manipulation and undermining of the institutions and processes that have lead us down the path to economic ruin. Even fewer have a clear understanding of the extent of the impending doom.
Briefly, these are my perceptions of some of the recent events and a brief outline of an understanding of the key structure, the US Federal Reserve. Some details may be incorrect but overall I think the thrust might be fairly accurate.
Federal Reserve is a semi government body. It has a 12-person Board of Governors, which makes all the significant decisions affecting the economy. It forms monetary policy and is charged with overseeing the effective operation of the US banking system.
Appointments to its Board are made by the US President. He appoints the Chair and vice Chair. One member he appoints must come from one of the 12 Regional Federal Reserves, usually from the New York Regional Federal Reserve.
It is supposedly independent of the government and the banks. It is the government’s banker. It is the depository for the private banks reserves. These reserves are a percentage of all deposits into private banks. Its level is set by the Board.
A key component of the Federal Reserve is the Federal Open Market Committee, (FOMAC). This is the real guts and power of the Federal Reserve. It’s where the levers are pulled on interest rates, money supply, discount rates, credit availability, deposit reserve levels and so on.
It is a 12-member committee. Seven members must come from the Board of Governors. One of those is always the Board of Governors member from the New York Regional Federal Reserve.
One other member must also always be appointed from the New York Regional Federal Reserve and the other four are appointed on a rotating basis from the other 11 Regional Federal Reserves.
Regional Federal Reserves are important in maintaining the power and influence of the Federal Reserve. There are 12 of them, the major one being the New York Regional Federal Reserve. As stated earlier The New York Regional Federal Reserve always has, in practice, two permanent seats on the FOMAC and that reflects the importance of its influence.
The Regional Federal Reserves operate under the supervision of the Federal Reserve Board of Governors. Their primary role is to collect and provide information to FOMAC in order assist in forming policy, and especially to influence the setting of interest rates, provision of credit and so on.
Members of Regional Federal Reserves are private banks, credit institutions etc. They appoint the members of the Regional Federal Reserves.
Many believe, including the perennial presidential candidate Ralph Nader, the Federal Reserve has become manipulated by the big banks and is now an abomination. It is often claimed it stole from Congress the power of printing money. This power is expressly given to Congress by the US Constitution. The Federal Reserve has used its power to create credit to distort growth in the economy, especially during and since former Chairman Alan Greenspan’s and President Bill Clinton’s time. It is believed to have linked money supply to the value of shares and property … and in the current crisis the real crunch is coming, when inflation must eventually soar through the roof, simply because of the oversupply of money, and interest rates will rise.
It has abdicated its role in overseeing the operation of the banking system. This occurred initially in the 1990s when Greenspan warned of the impending problems with Fanny Mae’s lending policies – and the Federal Reserve did nothing. I believe it did nothing because the large banks saw massive profits for themselves. The Federal Reserve sat on the sidelines and merely watched when Clinton and a bipartisan Congress changed the Glass Steagall Act in 1998 and allowed what had been previously outlawed – trading in mortgages.
I believe both Greenspan and current Chairman Bernanke are greatly influenced by the larger New York based banks.
Similarly, the current Secretary of Treasury Henry Paulson is bathed in the New York cronyism. He worked for Goldman Sachs until a year or so ago. He was once the member of the Federal Reserve Board of Governors from New York.
I believe Benanke’s and Paulson’s proposed US$800 billion bailout was originally intended to be distributed to those New York banks. I believe the Republican revolt where Congress initially refused to pass the bailout, absolutely prevented that course. Later changes to the package have resulted in Treasury and the Federal Reserve having to deal responsibly with taxpayers’ funds.
Clinton, in 1998, did away with the Glass Steagall Act. During this process the re-enforcement of President Jimmy Carter’s Community Reinvestment Act was included. The Glass-Steagall Act was enacted after the Great Depression of the 1930s. Among other things, it prevented investment banks from trading in mortgages: that same law also prevented trading banks from selling and parcelling mortgages. And that’s exactly where the big banks of the Federal Reserve recognised the possibility of future massive profits.
I opine they encouraged Greenspan to do nothing. Carter’s Community Reinvestment Act was an utter stupidity. Its purpose was to encourage lending organisations to lend to the poor and disadvantaged so they could enter the home ownership market. They, I believe, never had a hope of repaying any loans in the longer-term. These two rather simple acts were where the corruption of the system began.
The mechanic’s of the melt-down were complex. Fannie Mae and the two abovementioned Acts was at its heart. Fannie Mae was formed to only buy mortgages that had been executed between banks and borrowers. The repeal of the Steagall-Glass was a Republican proposal; bi-partisan approval was gained in Congress and was followed by Clinton’s approval. As a trade off the Democrats gained a strengthening of the Community Reinvestment Act, that included punitive clauses. This proposed that financial institutions provide loans to people who wouldn’t ordinarily gain home loan approval. It was directed towards minorities and the poor. Clinton also approved this Act.
The specific effects were: Clinton pressured the banks to initiate these altruistic CRA loans and Fannie Mae accommodated them. Fannie Mae under Franklin Raines was the first financial institution to parcel and on sell them as derivatives. That enabled refinancing as the loans defaulted. As the banks realised they had no liability for these bad loans naturally they embraced the process with gusto. They were getting great fees with no liability.
Daniel Mudd, Franklin Raines successor at Fannie Mae, oversaw the massive expansion of the parcelling and selling of the derivatives and naturally trading in them on Wall Street was raised to a fine art and exploded across the world.
The mortgage brokers’ role was simple, for they presented very plausible reasons for people to enter into agreements for the low start loans. They were not dealing with idiots. The two reasons were, first, repayments initially for the first two years were lower than rents and, second, as the market values of houses increased many loans were refinanced, with the increased equity as deposit, or they were sold before the bust with windfall profits to the buyer.
In 2006 and 2007 The Federal Reserve increased interest rates. What followed was a stall in the housing market, housing prices fell and the inevitable happened. When values and sales prospects fell, refinancing became a huge obstacle. This, coupled with the incremental interest and end of the low-start period (after two years) of non-repayment of principal, made it stupid for most sub-prime borrowers to keep their house.
In the US mortgage liability ends with the mortgaged house and any short fall in debt at the repossession sale is carried as a loss by the bank (in most early cases it was Fanny Mae). This is why almost all sub-prime, Alt-A and Jumbo loans are suspect.
Previous to this Fanny Mae had, on occasion, experienced severe liquidity problems. To overcome this Fanny Mae used Clinton’s law changes to parcel and on sell the now defaulting and predicted future toxic loans. This enabled Fanny Mae to liquefy the loans and continue in business lending more and more and of course on selling more and more.
Therein lay the original hive, drones and Queen Bees of the current crises.
The Carter Administration and the Clinton Administration planted the seeds. The Republican controlled Congress proposed the legislation enacted by Clinton. It was passed in Congress with bi-partisan support. The Democrats support was conditional upon reinforcement of Carter’s folly. As an aside Fanny Mae was and still is widely recognised as an arm of the Democrat party.
Wikipedia gives a comprehensive synopsis of the legislation and processes here.
John Montgomery in The Australian recently gave a very good, albeit a bit partisan, explanation of this part of the mess.
An article “They Warned Us About the Mortgage Crisis” in Business Week published last week gives a grand account of the details of what was occurring across the US and is easily read.
It gives a detailed account of the extent of the problem and how it spread to the “Main Street” and “Wall Street” banks.
The Bush Administration and Republican Congress oversaw this spread from the original corruption in Fanny Mae. What happened from there was plain stupidity and raw greed.
These institutions, watched by the well aware Federal Reserve and Federal Government Overseers, jumped aboard the out-of-control sub-prime express. They were well aware of the “profits” earned by Fanny May and its management, well aware of the loans toxicity risks, but fearful of missing the massive profits available, and hoping to have “passed the parcel” before the current inevitable wreck occurred. They were enthusiastic participants and made the corruption a fine art.
They were somewhat successful at “parcel passing” and that’s why many banks across the world are failing.
The most recent Democrat controlled Congress prevented re-regulation and curtailment of the abominable lending practices as little as three years ago. The cheer leader in this monstrosity is Barney Franks, Chairman of the House Financial Services Committee. Up until March of this year he was spruiking the great financial standing of Fanny Mae and encouraging continued investment in this lender. Again Wikipedia is good for background.
The irresponsible actions and inactions Franks, along with all the major shareholders of the banks of the Federal Reserve – especially those of the New York Regional Fed Res, as well as Greenspan, Benanke, Bush, Clinton, Carter, Paulson and Raines have wrecked a finance and banking system that had served us well for nearly 80 years through times of war, social dislocation and massive social and economic growth and change.
The banks should be allowed to fail, for I opine that eventuality cannot be avoided.
The extent of these toxic loans is given in the Business Week article. The authors estimate US$7 trillion. I am on record as estimating it to be nearer US$8 trillion. The proposed bailout was for US$0.8 of a trillion and on the basis of that figure the world has gone into recession.
Contemplate the impact of 10 times that amount.
As a further perspective the US GDP is US$13 trillion per annum. I have seen two figures for the number of empty or repossessed houses in the US. One is five million the other is 10 million. I think the truth is closer to the lower figure and at an average loan of US$200,000 that’s about US$10 trillion. The US has built, during the last 10 years and throughout the Fanny Mae fiasco, roughly one million houses a year. The US economy is likely to be in recession or depression until the building industry recovers.
Locally, PM Kevin Rudd in his speech to the Press Club on October 15, 2008 stated the extent of the US toxic debt is estimated at $1.3 trillion. If his AUD$10 billion, bailout is predicated on that basis it is a case of “spitting into a hurricane”.
There is only one other dreadful fact. It is well known the sub-prime loans were loans made to people with no assets, no income and often bad or no credit rating. They had a low-start period of two years and were reported as up to an estimated 15 per cent of the loans market. They were on sold as sub-prime loans. It is acknowledged we were thought to be through that glitch by March of this year.
Now here is the real ugliness.
The next level of mortgage loans are Alt-A loans. These loans comprise a reported 40 per cent of the US housing loans market. These loans differ from sub-prime loans in that they were given to people with no assets, no income but with a credit rating. They had a low-start period of five years. They are about due to start making their appearance … everywhere. They were on sold as prime loans and it is these that, I believe, caused the collapse of Lehmann Bros.
No one knows how many of these Alt-A loans are parcelled with “fair dinkum” prime loans so all such “assets” held by businesses, banks , financial institutions, city councils, universities, government bodies and governments across the world are suspect. And that’s the cause of the non-lending by the banks.
In the current climate uncertainty is creating and driving fear. If certainty was encouraged and all the facts generally well and widely known that fear would be replaced by a dreadful terror.
Everybody owns some of the truth, but often bits and pieces of the truth obscure the whole truth. This article covers the history of this thing as I’ve watched it unfold over roughly the past eight years.
Politically it won’t matter who the Americans elect at the next election for they’ll get a right wing government which supports the status quo. The Republicans are the representatives of Southern rich elites and the Democrats are the representatives of Northern rich elites … both are beholden to their respective bankers.
Keith Kennelly 21 October 2008