Protect the rich and make them richer; Repub solution to the credit crisis and economic problems

Now that we know that the Bush administration is going to bail out Fanny Mae and Freddy Mac, something that as late as last Friday they were saying they would not do, let's look at how they are going about it. Dean Baker has a lot to say:

Bush and Congress Want to Raise Your Taxes to Help out Fannie and Freddie's Management and Shareholders
By Dean Baker - July 13, 2008, 11:27PM

That's the word from the press reports. Apparently the government is going to hand Fannie and Freddie bucket loads of taxpayer dollars, no questions asked. The NYT reports that they will be given access to $300 billion of government loans at below market interest. [Snip]

Some people say that we had to hand tens of billions of dollars to the country's richest people to prevent a financial collapse. This is simply not true.

We had to keep Fannie and Freddie in business, but we could have done this by putting conditions on the bailout. The government uses conditions all the time when it offers help to low and moderate income people. Unemployment insurance, TANF, food stamps, and even student loans come with all sorts of conditions.

It is only when it comes to giving money to extremely rich people that we find it impossible to impose conditions. Again, we could have told Fannie and Freddie that no executives will get more than $2 million a year in total compensation. We could have told their shareholders that they are out of luck, because that is what is supposed to happen when you invest in a bankrupt company.

Instead, we told the people who work as truck drivers, school teachers, and fire fighters that they will have to pay more in taxes to help some of the richest people in the country escape the consequences of their own stupidity. While kicking the poor is always fun for politicians, neither the Bush administration nor Congress are prepared to tell the very rich that they are on their own.

Congress and the administration have no interest in protecting the people who are losing their homes to foreclosure, often because they were put into mortgages they could not pay. This had the effect of forcing real estate prices up while allowing mortgage brokers and lenders to reap huge commissions before the mortgages were sold to investors as parts of collateralized debt obligations or similar arcane and not understood financial instruments.

The result was Alan Greenspan's housing bubble and a lot of very wealthy mortgage brokers knocking down commissions of as much as a million dollars a year, all at the cost of a lot of people spending a lot of money on homes that would inevitably be in foreclosure as soon as the bubble broke and investors who found that the "secure" investments they were sold a AAA instruments suddenly were worth much less than they paid for them.

IndyMac Bancorp, which failed and was taken over by the federal government last Friday existed to accept deposits from people who wanted to save their money and to make loans to people who wanted to buy homes. According to Mish's Global Economic Trend Analysis:

The Pasadena, California-based bank specialized in so-called Alt-A mortgages, which didn't require borrowers to provide documentation on their incomes. Its home state has been among the hardest hit by foreclosures.

"Given their focus on Alt-A and a heavy concentration in California, they would have suffered meaningful losses in almost any scenario...

Alt-A loans are often called "Liar Loans.")

IndyMac's big profits came from making more loans, so they did the logical thing - they stopped verifying income. Whatever the customer said his income was they accepted without question.

Of course, the mortgage broker trying to get the loan accepted by IndyMac Bankcorp would not get a commission unless the loan was accepted, and they got a bigger commission if the loan was bigger, so the mortgage brokers encouraged the home buyers to inflate their income. This was almost required in area where home prices were highly inflated, but when the loan was accepted, it added to the inflation of home prices. That was a major contributor to the housing bubble.

IndyMac is often described as a bank closely associated with CountryWide Mortgage Company, previously the nation's largest mortgage broker. So CountryWide was making the mortgage loans and making its money from the commissions, while IndyMac was lending the money that was used to buy the homes, and taking its commissions. IndyMac was then bundling the mortgages into CDO's and selling them to investors.

The investors, like Freddy Mac and Fannie Mae, would buy the CDO's, which would give IndyMac more money to loan. The investors would look at the CDO's and see investments that were backed by mortgages. Homeowners generally pay their mortgage first before they pay other bills, and if they stop paying, the home can be sold in foreclosure to recover the investment.

As long as home prices were rising, this seemed like a safe investment, so the bond rating agencies would quickly stamp them AAA quality, which meant that more investors could bid to buy them. (Many large investors are limited to buying only certified very safe investments by the people who give them money to invest.) We now know that the bond rating agencies were competing with each other by promising security sellers (like IndyMac) higher ratings as long as they got the job of issuing the rating. Since the bond rating agencies did not get paid unless they got the rating job, they were bidding the ratings up higher.

All of this was exaggerated by the Ayn Rand acolyte and Libertarian Alan Greemspan's Federal Reserve. He lowered interest rates to pump more money into the economy and avoid Recession prior to Bush's reelection in 2004, and then encouraged the use of exotic mortgages like Adjustable Rate Mortgages (ARM) so that more people could qualify for home mortgages. In addition, he refused to use the power the Federal Reserve has to set lending standards for lenders or to require mortgage brokers to provide comprehensible information to the borrowers on the risks to the loans they were issuing.

Finally, there was no regulator that any of the participants had to provide honest information about their loans or their own financial stability to. Investment banks (like Bear Stearns) have never been regulated and Congress, led by the Austro-Libertarian Senator Phil Gramm, repealed the Glass Steagall Act, removing most regulation from banks like IndyMac.

It is now clear in hindsight that this (lack of) system could not survive long. The question was not if it would collapse, but when.

So why did the credit crisis occur when it did? The answer is "Alan Greenspan." As noted in my previous post Politics of the federal Fund Rate, Greenspan lowered the interest rate to keep the economy out of recession prior to the 2004 Presidential election. The rate reached 1.75$, a rate so low that there was literally no incentive to save or invest in fixed rate securities. A major reason why large investors were investing in Collateralized Debt Obligations was that bank savings rates and federal bonds were so low that after inflation there was no effective return, and the rating agencies were saying that the higher paying CDO's were safe (see the rating agency discussion above.)

Even Alan Greenspan knew that the interest rate he had established was too low, so starting in November 2004 (immediately after it would effect the Presidential election) he started raising the interest rate 1/4% per month. This went on until the Summer of 2006. The first publicly announced warning of the impending mortgage market collapse was when CountryWide Mortgage Company warned in early 2007 that foreclosures were sharply increased. The rest has been a long, slow collapse of the credit markets, now to be followed by the collapse of more banks. Here's Jim Cramer:

We all know that Citigroup (NYSE: C) (Cramer's Take), Wachovia (NYSE: WB) (Cramer's Take), Washington Mutual (NYSE: WM) (Cramer's Take) and National City (NYSE: NCC) (Cramer's Take) are in trouble. Bank of America (NYSE: BAC) (Cramer's Take) says it isn't in trouble, but obviously the market doesn't believe management because the stock failed to rally when it said its dividend was safe.

The current economic problems are going to continue until the inflated prices of homes bought during the housing bubble are cleaned out of the system, and as they do get cleaned out, the banks that have those old over-priced mortgages on their books as assets are going to be losing money. That's what just killed IndyMac, and It's what the Federal Reserve is trying to head off by lending money to Freddy Mac and Fanny Mae. The fear is that as the losses mount, the investors/lenders/Depositors may decided that they have to remove their money first, because those who wait will find no money there to pay them. The race to be first to try to get your money back is called a run on the bank. The fed is promising that they will pump in taxpayer money to Freddy and Fannie to prevent that.

The financial managers who have been running this mess have the knowledge to recognize the ponzi scheme that our American investment and commercial banks had become, but they were staying in long enough to get their millions and move them to safer investments. They've lobbied Congress and the administration to head off the regulation that would have stopped their personal wealth-generating activities before they got out. Now the fed is bailing them out using taxpayer money, while letting the individuals who bought homes take the hit.

Note also that nothing in the bail-out adds any regulation to the system, so that the same thing is going to happen again as soon as this economic collapse finishes. And they guys who caused it have their wealth in safe places so that they can wait out the economic time of troubles and start a new boom as soon as it's over.

This is the logical working out of the Reagan Revolution and the conservative movement with its free market banking policies. It will always work this way, every time you allow bankers to operate without regulation and close, effective oversight.