Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).
Problems of state and municipal finance worsen. Governors announce new spending cuts at press conferences but inspire little confidence. The fury of emergency announcements leaves the listener (as well as the governors) in a daze. Research reports offer broad explanations but have left bondholders, as well as employees and local residents, unprepared for discontinuities. In other words, there will be instances when these constituencies will find themselves marched to the slaughterhouse without warning.
Following are corrections to the more common misunderstandings.
Claim #1: "General Obligation bonds do not default." Financial planners sometimes reassure retail clients with this claim. Following is a case study that shows how a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.
From a credit agency report: "Even in the event of default on [General Obligation] bonds, investors are likely to enjoy a full recovery of principal and interest because municipalities are required to levy additional taxes to repay debt backed by the general obligation pledge." The most significant word in that sentence is "likely." [Note: General obligation (GO) bonds are debt instruments issued by states and local governments to raise funds for public works. In contrast, revenue bonds are repaid from the revenue generated by the specific project that the bonds are issued to fund. Only GO bonds are addressed here.]
From a brokerage firm report: "General obligation debt is backed by a state municipal pledge to raise taxes to service debt if necessary." This is also true, but not the whole truth.
Courts have rebutted this pledge. A 1990 Missouri court ruled that "tax caps in effect when municipal debt was incurred cannot be overridden even if necessary to pay off the debt." (Kevin A. Kordana, "Tax Increases in Municipal Bankruptcy," Virginia Law Review) The court admonished the litigating bondholders: "[E]very purchaser of a municipal bond is chargeable with notice of the statute under which the bond is issued." (Missouri had a statutory tax rate cap.) In words the judge might have used: "Stop whining and wasting my time. Next time, read the bond offering."
Aside from a legal interpretation, raising taxes is often impractical. "At a certain point, raising taxes ceases to raise tax revenues." (McConnell and Picker, "When Cities Go Broke," University of Chicago Law Review).
The City of Vallejo, California may be an important precedent. It filed for bankruptcy in 2008. Both bondholders and city employees agreed to receive less money. The decision is before an appeals court.
Claim #2: "General Obligation default rate is 0.01%." This calculation is used to prove Claim #1. From a brokerage firm report: "The default rate on general obligation municipal bonds since 1970 is 0.01%." The calculation is correct. The brokerage firm used the default rate of Moodys-rated GO bonds since 1970.
Although true, this is misleading. It seems like yesterday when all - and it was all - the certified experts bellowed: "House prices never go down nationally." Just as mortgage payments had risen to uncollectible heights, municipal costs have risen to unsustainable levels. This is a different world than the period addressed by the Moodys study.
Even though money rained on municipalities during the salad days (sales tax revenue increased 46% between 2003 and 2007), it was only by playing games with the books and issuing a record amount of bonds that municipal spending grew so extravagantly over the past decade. States and municipalities issued $442 billion of bonds over the five years from 1998-2002. They issued $804 billion over the next five years, 2003-2007. The growth rate was not quite as steep, but, not dissimilar to mortgage securitizations and private-equity LBOs. The downward slope may not look that different, either.
Claim #3: "Most states are required by law to balance their budgets." This implies the restriction on revenues diverging from spending reduces the possibility of default. Municipal finance is often a shell game, shifting capital-project funds to meet today's burgeoning payrolls and benefits. [See Miami's Municipal Woes (Again): Exiting Before the Tide Goes Out].
Claim #4: "States cannot declare bankruptcy." This is a conclusion drawn by statements such as the following from a brokerage firm report: "The state is not permitted to file for Chapter 9 bankruptcy. Such filings are permitted only for 'municipalities' (e.g., levels of government below the state) under certain conditions." This is true. Bankruptcy law in the United States does not address the states. This does not mean states will not default. They might be in limbo according to the bankruptcy code, but still bankrupt according to the dictionary: "Any person unable to pay his creditors in full." Bondholders should take heed of the dictionary instead of waiting for the law to codify state bankruptcy.
Claim #5: "There has never been greater demand for municipal bonds." This is a sales pitch that implies "buy now, or you'll regret it later." Evidence for this claim is the willingness of retail investors to buy California municipal debt that yields 2% (for debt maturing in 2012; 5.8% for debt maturing in 2030). Another "get 'em while they're hot" argument is an initiative in Congress that would end the tax deductibility on interest from municipal bonds issued in 2011 and after.
First, the possibility of Congress passing such legislation is remote. Second, the "safe" asset classification by financial advisers is the real energy propelling retail investors into municipal issues. It was only two years ago when money market funds were thought of as "safe." They were often classified as "risk-free." (Beware of investment categories and classifications. Labels are often applied after their characteristics have been deemed predictable. By the time the predictable has been awarded a classification, the category has probably attracted too much attention and mindless buying.) After panic selling in September 2008, the federal government guaranteed the net asset value of money market funds.
Municipal appetite is also strong because Federal Reserve Chairman Ben Bernanke has chased savers out of short-term investments. His monetary policy (zero percent fed funds rate) is designed to refloat too-big-to-fail banks (that invest at zero percent and buy 3% Treasury notes) while leaving savers in the poor house. Municipal bonds produce some income, so are the new "cash" option.
Individuals are the only remaining net buyers. In 1975, commercial banks, savings banks, life insurers, and casualty insurers were municipal bond buyers. Only the individual is left today. This is a lonely outpost.
Tuesday, April 27, 2010
Monday, April 12, 2010
The Best and Brightest Protect Greenspan and Betray the American People
Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).
Alan Greenspan's reputation has a whiff of terminal decline after his appearance on April 7, 2010, before the Financial Crisis Inquiry Commission (FCIC). Prudence is warranted though, before taking a short position on the former Federal Reserve chairman. The celebrated central banker has spent a lifetime pouring his deep reservoirs of energy and ambition into his own advancement, and now, his legacy.
The pillars of respectability find common ground with Greenspan. Not having foreseen the meltdown of the western world, of what use are they? So, the universities and think tanks offer Greenspan a podium to play the part of scholar even though he makes less sense than Crazy Guggenheim.
Three weeks before his FCIC appearance, Alan Greenspan addressed the Brookings Institute (on March 19, 2010). He presented a 48-page paper, "The Crisis." The title was one of the few honest statements of the day. Greenspan exonerated himself from any blame for The Crisis. It would serve little purpose to address his misstatements, most of which are either absurd or had already been shown to be self-serving fabrications. [See Panderer to Power]
It is worth reviewing the process by which preposterous ideas drain through the establishment sieve and calcify. Greenspan's most glorious success in this respect was on June 17, 1999, when he told Congress: "[B]ubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." For that hallucination, the economics profession (such as it is) awarded him the Greenspan Doctrine. [For a review of this episode, See February 11, 2010, blog Alan Greenspan: Party Boy
Times have changed. His audience's net worth is no longer tethered to Greenspan's serial bubbles. He could be dismissed, as should be the case, as an unctuous failure. He should be denied a distinguished podium that confers respectability. The Brookings Institute, a prestigious think tank, lent its valuable brand name to the man most responsible for the housing wreckage and who has demonstrated his incapacity to tell the truth since the denouement. The authority of established institutions is in steep decline and stronger moral fiber is required for those that survive.
Greenspan told Brookings' invited guests, who should chide themselves for contributing to the speaker's credibility, that short-term interest rates did not contribute to the housing bubble. The man-who-should-be-too-ashamed-to-appear-in-public stated the absurd: "To my knowledge, the lowering of the federal funds rate nearly a decade ago was not considered a key factor in the housing bubble." (The federal funds rate was cut from 6.5% in 2001 to 1.0% in 2003.)
What was not absurd was deceitful: "[I]t appears the decision to buy homes preceded the decision of how to finance the purchase. I suspect (but cannot definitively prove) that a large majority of home buyers financing with ARMs [adjustable-rate mortgages] were ARMs not being offered (during that period of euphoria), would have instead funded their purchases with 30-year fixed rate mortgages. How else can one explain the peaking of originations of ARMs two years prior to the peak in house prices (exhibit 18). Market demand obviously did not need ARM financing to elevate home prices during the last two years of the expanding bubble."
If the Brookings Institute graded papers, Greenspan deserved the dunce cap. Exhibit 18 conforms to his claim. The chart shows adjustable-rate mortgages peaking at a volume of $250 billion per quarter in early 2004 (data from the Mortgage Bankers Association). It does not show, nor does the Old Pretender mention, that in today's Dust Bowl sections of the country, the volume of adjustable-rate mortgages climbed after 2004. ARMs rose from 2% of mortgages in California in 2002 to 47% in 2004 to 61% in 2005.
It was Greenspan's speech on February 23, 2004, that stripped him of trustworthiness when discussing housing. On that date, he sounded like a shill for the National Association of Homebuilders when he claimed "[m]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade."
The reason adjustable-rate mortgage growth slowed in 2005 was a matter of affordability. By 2005, over 20% of Californians who bought houses in the previous two years had devoted over one half of their earnings to mortgage payments. Adjustable rates no longer affordable, the interest-only (IO) and negative amortization (NegAm) share of total U.S. mortgage originations rose from 6% in 2003 to 29% in 2005. (Negative amortization mortgages allow the borrower to decide whether or not to make a payment each month. If no payment is made, the principal rises.) Exhibit 18 does not show IOs or NegAms (the line would have looked like a rocket launch), nor, are the terms "interest-only" or "negative amortization" used in the 48-page paper.
Not that Greenspan was unaware of them. Adjustable-rate mortgages in decline, Greenspan pitched these new innovations in a September 2005 speech before the American Bankers Association Annual Convention: "The menu [!!! - Editor's note], as you know, now features a long list of novel mortgage products, not only interest-only mortgages but also mortgages with forty-year amortization schedules and option ARMs, which allow for a limited amount of negative amortization." The consequences of Alan Greenspan cling to us like barnyard odor: $134 billion of Greenspan-sanctioned NegAm loans will be reset this year, and 93% of NegAm borrowers have only made the "minimum payment," meaning, the mortgages will be reset at higher than 100% of the original principal. (Standard & Poor's Research, November 2009)
In this speech he also praised piggyback mortgages and HELOCs [home equity lines of credit] used as piggyback loans: "Highly leveraged home purchasers tend to use so-called piggyback mortgages; that is, second liens originated at the time of purchase." In the next sentence, Greenspan showed he was as familiar with current mortgage subtleties as the highest producers at Countrywide Credit: "These loans are popular, in significant part, because they avoid the non-deductible private mortgage insurance payments required on larger, single loans." Greenspan then told his listeners he was not "worr[ied] that homebuyers are especially exposed to reversals in house prices." If any banker present had doubts about making zero-equity home loans, the nation's top banking regulator had just expressed approval.
Alan Greenspan told the FCIC on April 7 that he warned about the housing bubble in 2002. (This is the same man who has been saying nobody could have predicted the housing bubble.) To prove his point, the worst equivocator since Pinocchio quoted from a Federal Open Market Committee (FOMC) meeting that year. From page 5 of his prepared Statement to the FCIC: "our extraordinary housing boom...financed by very large increases in mortgage debt, cannot continue indefinitely."
First, Greenspan uses ellipses rather than include the most compromising phrase of that sentence: "and its carryover into very large extractions of equity". Second, Greenspan completely misrepresents his intent. He was pleased in 2002 that Americans were cashing out home equity and spending it, but was worried this boost to the economy might be coming to an end. For full, compromising statements made by Greenspan at 2002 FOMC meetings, see April 8, 2010, blog: Greenspan Came Not to Save Consumers but to Bury Them.
We would all benefit if "The Crisis" had received a hostile rebuke from economists. The Great Collapse mystifies the American people. The characters involved and characterizations of their contribution are debated without resolution. But in the case of Alan Greenspan, not only his contribution but also his methods of deception have been catalogued and published. His continued presence as after-dinner speaker, television guest, and party-circuit celebrity in Washington is an affront and insults the American people. "The Crisis" was an opportune time for economists to make amends for their silence during the housing bubble. Maybe the FCIC undressing is the beginning of the end, but a sustained effort is required to quash Greenspan's attempts to upgrade his tattered legacy.
Instead, the most respected academics grovel before their betters and demonstrate their submissive loyalty. Greg Mankiw, Professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and author of internationally acclaimed college textbooks, opened his review of "The Crisis" with the official interpretation: "This is a great paper...."
Alan Greenspan's reputation has a whiff of terminal decline after his appearance on April 7, 2010, before the Financial Crisis Inquiry Commission (FCIC). Prudence is warranted though, before taking a short position on the former Federal Reserve chairman. The celebrated central banker has spent a lifetime pouring his deep reservoirs of energy and ambition into his own advancement, and now, his legacy.
The pillars of respectability find common ground with Greenspan. Not having foreseen the meltdown of the western world, of what use are they? So, the universities and think tanks offer Greenspan a podium to play the part of scholar even though he makes less sense than Crazy Guggenheim.
Three weeks before his FCIC appearance, Alan Greenspan addressed the Brookings Institute (on March 19, 2010). He presented a 48-page paper, "The Crisis." The title was one of the few honest statements of the day. Greenspan exonerated himself from any blame for The Crisis. It would serve little purpose to address his misstatements, most of which are either absurd or had already been shown to be self-serving fabrications. [See Panderer to Power]
It is worth reviewing the process by which preposterous ideas drain through the establishment sieve and calcify. Greenspan's most glorious success in this respect was on June 17, 1999, when he told Congress: "[B]ubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best." For that hallucination, the economics profession (such as it is) awarded him the Greenspan Doctrine. [For a review of this episode, See February 11, 2010, blog Alan Greenspan: Party Boy
Times have changed. His audience's net worth is no longer tethered to Greenspan's serial bubbles. He could be dismissed, as should be the case, as an unctuous failure. He should be denied a distinguished podium that confers respectability. The Brookings Institute, a prestigious think tank, lent its valuable brand name to the man most responsible for the housing wreckage and who has demonstrated his incapacity to tell the truth since the denouement. The authority of established institutions is in steep decline and stronger moral fiber is required for those that survive.
Greenspan told Brookings' invited guests, who should chide themselves for contributing to the speaker's credibility, that short-term interest rates did not contribute to the housing bubble. The man-who-should-be-too-ashamed-to-appear-in-public stated the absurd: "To my knowledge, the lowering of the federal funds rate nearly a decade ago was not considered a key factor in the housing bubble." (The federal funds rate was cut from 6.5% in 2001 to 1.0% in 2003.)
What was not absurd was deceitful: "[I]t appears the decision to buy homes preceded the decision of how to finance the purchase. I suspect (but cannot definitively prove) that a large majority of home buyers financing with ARMs [adjustable-rate mortgages] were ARMs not being offered (during that period of euphoria), would have instead funded their purchases with 30-year fixed rate mortgages. How else can one explain the peaking of originations of ARMs two years prior to the peak in house prices (exhibit 18). Market demand obviously did not need ARM financing to elevate home prices during the last two years of the expanding bubble."
If the Brookings Institute graded papers, Greenspan deserved the dunce cap. Exhibit 18 conforms to his claim. The chart shows adjustable-rate mortgages peaking at a volume of $250 billion per quarter in early 2004 (data from the Mortgage Bankers Association). It does not show, nor does the Old Pretender mention, that in today's Dust Bowl sections of the country, the volume of adjustable-rate mortgages climbed after 2004. ARMs rose from 2% of mortgages in California in 2002 to 47% in 2004 to 61% in 2005.
It was Greenspan's speech on February 23, 2004, that stripped him of trustworthiness when discussing housing. On that date, he sounded like a shill for the National Association of Homebuilders when he claimed "[m]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade."
The reason adjustable-rate mortgage growth slowed in 2005 was a matter of affordability. By 2005, over 20% of Californians who bought houses in the previous two years had devoted over one half of their earnings to mortgage payments. Adjustable rates no longer affordable, the interest-only (IO) and negative amortization (NegAm) share of total U.S. mortgage originations rose from 6% in 2003 to 29% in 2005. (Negative amortization mortgages allow the borrower to decide whether or not to make a payment each month. If no payment is made, the principal rises.) Exhibit 18 does not show IOs or NegAms (the line would have looked like a rocket launch), nor, are the terms "interest-only" or "negative amortization" used in the 48-page paper.
Not that Greenspan was unaware of them. Adjustable-rate mortgages in decline, Greenspan pitched these new innovations in a September 2005 speech before the American Bankers Association Annual Convention: "The menu [!!! - Editor's note], as you know, now features a long list of novel mortgage products, not only interest-only mortgages but also mortgages with forty-year amortization schedules and option ARMs, which allow for a limited amount of negative amortization." The consequences of Alan Greenspan cling to us like barnyard odor: $134 billion of Greenspan-sanctioned NegAm loans will be reset this year, and 93% of NegAm borrowers have only made the "minimum payment," meaning, the mortgages will be reset at higher than 100% of the original principal. (Standard & Poor's Research, November 2009)
In this speech he also praised piggyback mortgages and HELOCs [home equity lines of credit] used as piggyback loans: "Highly leveraged home purchasers tend to use so-called piggyback mortgages; that is, second liens originated at the time of purchase." In the next sentence, Greenspan showed he was as familiar with current mortgage subtleties as the highest producers at Countrywide Credit: "These loans are popular, in significant part, because they avoid the non-deductible private mortgage insurance payments required on larger, single loans." Greenspan then told his listeners he was not "worr[ied] that homebuyers are especially exposed to reversals in house prices." If any banker present had doubts about making zero-equity home loans, the nation's top banking regulator had just expressed approval.
Alan Greenspan told the FCIC on April 7 that he warned about the housing bubble in 2002. (This is the same man who has been saying nobody could have predicted the housing bubble.) To prove his point, the worst equivocator since Pinocchio quoted from a Federal Open Market Committee (FOMC) meeting that year. From page 5 of his prepared Statement to the FCIC: "our extraordinary housing boom...financed by very large increases in mortgage debt, cannot continue indefinitely."
First, Greenspan uses ellipses rather than include the most compromising phrase of that sentence: "and its carryover into very large extractions of equity". Second, Greenspan completely misrepresents his intent. He was pleased in 2002 that Americans were cashing out home equity and spending it, but was worried this boost to the economy might be coming to an end. For full, compromising statements made by Greenspan at 2002 FOMC meetings, see April 8, 2010, blog: Greenspan Came Not to Save Consumers but to Bury Them.
We would all benefit if "The Crisis" had received a hostile rebuke from economists. The Great Collapse mystifies the American people. The characters involved and characterizations of their contribution are debated without resolution. But in the case of Alan Greenspan, not only his contribution but also his methods of deception have been catalogued and published. His continued presence as after-dinner speaker, television guest, and party-circuit celebrity in Washington is an affront and insults the American people. "The Crisis" was an opportune time for economists to make amends for their silence during the housing bubble. Maybe the FCIC undressing is the beginning of the end, but a sustained effort is required to quash Greenspan's attempts to upgrade his tattered legacy.
Instead, the most respected academics grovel before their betters and demonstrate their submissive loyalty. Greg Mankiw, Professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and author of internationally acclaimed college textbooks, opened his review of "The Crisis" with the official interpretation: "This is a great paper...."
Thursday, April 8, 2010
Greenspan Came Not to Save Consumers but to Bury Them
April 7 (Bloomberg) -- Former Federal Reserve Chairman Alan Greenspan defended the central bank’s record on consumer protection in the years before the financial crisis…. “The Federal Reserve, often in partnership with the other federal banking agencies, was quite active in pursuing consumer protections for mortgage borrowers,” Greenspan said in testimony for a hearing today of the Financial Crisis Inquiry Commission in Washington.
April 7 (Bloomberg) -- “There’s a lot of amnesia that’s emerging,” Greenspan said.
The attention Alan Greenspan devoted to consumer protection on April 7, 2010, was a strange diversion, which is what it was. The Financial Crisis Inquiry Commission had penetrated, to an uncomfortable degree, the shallow defenses Greenspan has dreamt up to justify his indefensible behavior. For instance, he offered a ridiculous response when asked if monetary policy was one failure during his tenure. Greenspan changed the subject, only – one suspects to Greenspan’s surprise – to be asked the same question again. He again ran off on a tangent. Maybe even Greenspan understood the emperor who wore no clothes had been exposed.
To those not suffering a bout of amnesia, his fidelity to the consumer was a surprise. That is, to those who have read the Greenspan Papers. We need only review transcripts of Federal Reserve Open Market Committee (FOMC) meetings in 2002. The man who built his reputation as a disciple of Ayn Rand (to be sure, a false claim) dearly wanted to drain the consumer of economic self-sufficiency. He succeeded.
The economy was emerging from recession, though imperceptibly. The mean household income declined in the United States every year from 2000 through 2004. To the Fed, consumer spending leads the economy. Since income from jobs was not boosting the GDP, innovative consumer finance was an FOMC obsession.
The Federal Reserve chairman spent the year not trying to protect consumers, but to bury them. At the March 2002 meeting, he stated: “[I]f the mortgage rate goes up, we will get some restraining effects on personal consumption expenditures because a goodly part of PCE has been financed by equity extraction from the appreciation in housing values.”
At 2002 meetings, Greenspan spent a good deal of time talking about consumers cashing out home equity from their houses and – it would only boost the GDP with the and – spending it. At the September FOMC meeting, Greenspan reported on the rising level of consumer cash from home sales and from cash-out refinancing.
First, from home sales: “We know, for example, that the current level of existing home turnover is quite brisk and that the average extraction of an existing home is well over $50,000. A substantial part of the equity extraction related to home sales, which is running at an annual rate close to $200 billion, is expended on personal consumption and home modernization, two components, of course, of GDP.” GDP growth, of course, is the Federal Reserve chairman’s popularity barometer.
Second, from refinancing extractions: “[A]pplications reported by the Mortgage Bankers Association [are showing] a very large increase in cash-outs. We estimate that they, too, are running in the $200 billion range at an annual rate, up very significantly from where they were a year or eighteen months ago.”
This was good news: “I think it’s fairly evident the unprecedented levels of equity extractions from homes have exerted a strong impetus on household spending.”
Also at the September meeting: “[T]here is no question that a goodly part of the robustness of household expenditures stems from [home equity cash outs]. Cars and light trucks which have been quite strong, are examples of large ticket items that are disproportionately purchased when equity is extracted from the sale of a home….”
In November, he thought “it’s hard to escape the conclusion that at some point our extraordinary housing boom and its carryover into very large extractions of equity, financed by very large increases in mortgage debt, cannot continue indefinitely into the future.” [Author’s italics.]
All to the good, as Edward Gramlich was told at the August meeting:
GRAMLICH: “I am just uncomfortable that the refinancing of housing should be the source of so much of the support for our recovery.”
GREENSPAN: “You sound like a true conservative.” So said the head banking regulator, responsible for the solvency of the banking system.
At the August 2002 meeting, Greenspan unrolled a theory, one that may actually work in the real world: the decline of interest rates plays an important role in trading, extracting and spending. (The Federal Reserve staff believed only the level of interest rates matter.) The chairman declared the “decline [in the 10-year Treasury yield] has had a major impact on thirty-year mortgage rates…. [W]e are seeing very significant churning in the mortgage markets, and as I have indicated previously, the increase in home equity is cumulative over a period of years because the prices of houses very rarely turn negative. What we are observing at this point is a very high rate of house turnover. Existing home sales are very high….”
This churning was as important as rising prices. A faster rate of house trading, multiplied by profits from house sales, prompted greater cash-out consumer spending.
At the November meeting, Greenspan once again pushed his decline-in-interest-rate theory: “In sum it strikes me that we are looking at an economy that potentially has significant upside momentum if it can get through the current soft spot. [M]y suggestion would be to lower the funds rate by 50 basis points – it is possible that such a move may be a mistake. But it’s a mistake that does not have very significant consequences.” The FOMC voted to cut the funds rate.
It might seem extraordinary, if we were not discussing Alan Greenspan, that the Federal Reserve chairman actively engaged in financial shenanigans with the specific intention of encumbering Americans with more debt at a time their incomes were falling.
The consequences today are most visible in Las Vegas, California’s Inland Empire and in southern Florida. As for Greenspan, the Fed had cut the funds rate 12 times in 2001 and 2002, from 6.5% to 1.25%. His theory was running out of ammunition. Greenspan’s manipulation of thirty-year fixed mortgage rates was nearly spent. (How does his 2002 theory square with his 2010 theory that short-term interest rates set by the Fed had no influence on the mortgage bubble?) By 2004 and 2005, he gave speeches exhorting Americans to buy adjustable-rate, interest-only and negative-amortizing mortgages.
The man never stops trying .
April 7 (Bloomberg) -- “There’s a lot of amnesia that’s emerging,” Greenspan said.
The attention Alan Greenspan devoted to consumer protection on April 7, 2010, was a strange diversion, which is what it was. The Financial Crisis Inquiry Commission had penetrated, to an uncomfortable degree, the shallow defenses Greenspan has dreamt up to justify his indefensible behavior. For instance, he offered a ridiculous response when asked if monetary policy was one failure during his tenure. Greenspan changed the subject, only – one suspects to Greenspan’s surprise – to be asked the same question again. He again ran off on a tangent. Maybe even Greenspan understood the emperor who wore no clothes had been exposed.
To those not suffering a bout of amnesia, his fidelity to the consumer was a surprise. That is, to those who have read the Greenspan Papers. We need only review transcripts of Federal Reserve Open Market Committee (FOMC) meetings in 2002. The man who built his reputation as a disciple of Ayn Rand (to be sure, a false claim) dearly wanted to drain the consumer of economic self-sufficiency. He succeeded.
The economy was emerging from recession, though imperceptibly. The mean household income declined in the United States every year from 2000 through 2004. To the Fed, consumer spending leads the economy. Since income from jobs was not boosting the GDP, innovative consumer finance was an FOMC obsession.
The Federal Reserve chairman spent the year not trying to protect consumers, but to bury them. At the March 2002 meeting, he stated: “[I]f the mortgage rate goes up, we will get some restraining effects on personal consumption expenditures because a goodly part of PCE has been financed by equity extraction from the appreciation in housing values.”
At 2002 meetings, Greenspan spent a good deal of time talking about consumers cashing out home equity from their houses and – it would only boost the GDP with the and – spending it. At the September FOMC meeting, Greenspan reported on the rising level of consumer cash from home sales and from cash-out refinancing.
First, from home sales: “We know, for example, that the current level of existing home turnover is quite brisk and that the average extraction of an existing home is well over $50,000. A substantial part of the equity extraction related to home sales, which is running at an annual rate close to $200 billion, is expended on personal consumption and home modernization, two components, of course, of GDP.” GDP growth, of course, is the Federal Reserve chairman’s popularity barometer.
Second, from refinancing extractions: “[A]pplications reported by the Mortgage Bankers Association [are showing] a very large increase in cash-outs. We estimate that they, too, are running in the $200 billion range at an annual rate, up very significantly from where they were a year or eighteen months ago.”
This was good news: “I think it’s fairly evident the unprecedented levels of equity extractions from homes have exerted a strong impetus on household spending.”
Also at the September meeting: “[T]here is no question that a goodly part of the robustness of household expenditures stems from [home equity cash outs]. Cars and light trucks which have been quite strong, are examples of large ticket items that are disproportionately purchased when equity is extracted from the sale of a home….”
In November, he thought “it’s hard to escape the conclusion that at some point our extraordinary housing boom and its carryover into very large extractions of equity, financed by very large increases in mortgage debt, cannot continue indefinitely into the future.” [Author’s italics.]
All to the good, as Edward Gramlich was told at the August meeting:
GRAMLICH: “I am just uncomfortable that the refinancing of housing should be the source of so much of the support for our recovery.”
GREENSPAN: “You sound like a true conservative.” So said the head banking regulator, responsible for the solvency of the banking system.
At the August 2002 meeting, Greenspan unrolled a theory, one that may actually work in the real world: the decline of interest rates plays an important role in trading, extracting and spending. (The Federal Reserve staff believed only the level of interest rates matter.) The chairman declared the “decline [in the 10-year Treasury yield] has had a major impact on thirty-year mortgage rates…. [W]e are seeing very significant churning in the mortgage markets, and as I have indicated previously, the increase in home equity is cumulative over a period of years because the prices of houses very rarely turn negative. What we are observing at this point is a very high rate of house turnover. Existing home sales are very high….”
This churning was as important as rising prices. A faster rate of house trading, multiplied by profits from house sales, prompted greater cash-out consumer spending.
At the November meeting, Greenspan once again pushed his decline-in-interest-rate theory: “In sum it strikes me that we are looking at an economy that potentially has significant upside momentum if it can get through the current soft spot. [M]y suggestion would be to lower the funds rate by 50 basis points – it is possible that such a move may be a mistake. But it’s a mistake that does not have very significant consequences.” The FOMC voted to cut the funds rate.
It might seem extraordinary, if we were not discussing Alan Greenspan, that the Federal Reserve chairman actively engaged in financial shenanigans with the specific intention of encumbering Americans with more debt at a time their incomes were falling.
The consequences today are most visible in Las Vegas, California’s Inland Empire and in southern Florida. As for Greenspan, the Fed had cut the funds rate 12 times in 2001 and 2002, from 6.5% to 1.25%. His theory was running out of ammunition. Greenspan’s manipulation of thirty-year fixed mortgage rates was nearly spent. (How does his 2002 theory square with his 2010 theory that short-term interest rates set by the Fed had no influence on the mortgage bubble?) By 2004 and 2005, he gave speeches exhorting Americans to buy adjustable-rate, interest-only and negative-amortizing mortgages.
The man never stops trying .
Monday, April 5, 2010
Advice to the Financial Crisis Inquiry Commission: How to Question Alan Greenspan on April 7.
Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).
The Financial Crisis Inquiry Commission is holding a public hearing from April 7-9, 2010. The topic is "Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs)."
The Commission subpoenaed former Federal Reserve Chairman Alan Greenspan, among others. He is scheduled to appear on Wednesday April 7, 2010, at 9 AM. (The FCIC website has a notice of all those scheduled to appear.)
Frederick Sheehan sent a letter to each of the ten members of the Commission along with his book, [Panderer to Power]. As the letter (more or less) states, Chapter 22 names the smorgasbord of parties who profited from the subprime crisis and how they were connected to each other. Round 'em up.
The letter below is to the chairman of the committee, Mr. Phil Angelides.
The other nine members are:
Hon. Bill Thomas, Commission Vice Chairman
Brooksley Born, Commissioner
Byron S. Georgiou, Commissioner
Senator Bob Graham, Commissioner
Keith Hennessey, Commissioner
Douglas Holtz-Eakin, Commissioner
Heather H. Murren, CFA, Commissioner
John W. Thompson, Commissioner
Peter J. Wallison, Commissioner
___________________________________________
Frederick J. Sheehan
Fsheehan@aucontrarian.com
The Financial Crisis Inquiry Commission is holding a public hearing from April 7-9, 2010. The topic is "Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs)."
The Commission subpoenaed former Federal Reserve Chairman Alan Greenspan, among others. He is scheduled to appear on Wednesday April 7, 2010, at 9 AM. (The FCIC website has a notice of all those scheduled to appear.)
Frederick Sheehan sent a letter to each of the ten members of the Commission along with his book, [Panderer to Power]. As the letter (more or less) states, Chapter 22 names the smorgasbord of parties who profited from the subprime crisis and how they were connected to each other. Round 'em up.
The letter below is to the chairman of the committee, Mr. Phil Angelides.
The other nine members are:
Hon. Bill Thomas, Commission Vice Chairman
Brooksley Born, Commissioner
Byron S. Georgiou, Commissioner
Senator Bob Graham, Commissioner
Keith Hennessey, Commissioner
Douglas Holtz-Eakin, Commissioner
Heather H. Murren, CFA, Commissioner
John W. Thompson, Commissioner
Peter J. Wallison, Commissioner
___________________________________________
Frederick J. Sheehan
Fsheehan@aucontrarian.com
Website: AuContrarian.com
April 1, 2010
Mr. Phil Angelides, Commission Chairman
Financial Crisis Inquiry Commission
1717 Pennsylvania Avenue, NW
Suite 800
Washington, DC 20006-4614
Dear Chairman Angelides:
I am writing in regard to the Financial Crisis Inquiry Commission’s April 7-9, 2010, public hearing, “Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs).” Specifically, the following is written to help you examine Alan Greenspan.
Enclosed please find a copy of my book, Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession. I am also co-author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.
In preparation for writing these books, I read ten years of Federal Reserve Open Market Committee (FOMC) transcripts, Congressional and Senate testimony over the same period, and Chairman Greenspan’s speeches, interviews and articles that he wrote back to 1959 (New York Times, Wall Street Journal, Fortune, U.S. News and World Report, Newsweek, Time and others). I have followed much of his public self-vindication since his retirement from the Federal Reserve Board.
This letter addresses three areas. First, Alan Greenspan and the Government-Sponsored Enterprises (GSEs). This includes how the GSEs changed the American economy. Second, Alan Greenspan’s promotion of toxic mortgage products. Third, the Federal Reserve’s influence on the topics you are addressing on April 7-9. Although the role of the Federal Reserve is not, per se, the subject of the April 7-9 hearing, the Fed prints the nation’s money and, for the most part, has the ability to limit the amount of credit in the economy.
1 – Alan Greenspan and the Government-Sponsored Enterprises
Alan Greenspan deserves recognition for his attempts to harness Fannie Mae and Freddie Mac. His first warning about the GSEs explosive growth was on February 24, 2004, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs. He also urged reform at a conference sponsored by the Federal Reserve Bank of Atlanta on May 19, 2005. I quote and discuss the importance and timing of these warnings on pages 266-270 of my book Panderer to Power.
I think Alan Greenspan should explain to you why he waited until 2004 before issuing his first warning. If he is asked this question directly, Greenspan will state you are incorrect. He may cite a previous occasion or occasions when he issued such advice. If so, the speech or testimony should be read. This advice applies to any topic.
Chapter 22 of Panderer to Power lays out the reason I would ask why he waited until 2004. Without GSE expansion, the home mortgage market could not have grown to dominate the U.S. economy. (Northern Trust estimated that, between 2001 and 2006, 40% of new jobs were related to housing.) Fannie and Freddie were vacuum cleaners for the nation’s mortgage finance growth. In 1995, home mortgage debt increased by $153 billion; in 2000, by $380 billion; in 2005, by $1.1 trillion.
In 1990, the value of Fannie Mae’s and Freddie Mac’s combined mortgage portfolio was $132 billion. In April 2003 – a single month – Fannie Mae (alone) bought $139 billion of mortgages. The mutation of Fannie and Freddie played a large role in the mutation of the U.S. economy.
Chapter 22, “The Mortgage Machine,” integrates the parties who contributed to the housing wreckage: the non-bank mortgage companies, the commercial banks (writing and selling mortgages) the investment banks (securitizing mortgages and funding the growth of the non-bank mortgage companies), the GSEs (packaging mortgage securities and funding subprime lenders, banks and non-banks), the Office of Federal Housing Enterprise Oversight (which mishandled its role as GSE supervisor), members of Congress (who prevented OFHEO from performing its function), the Securities and Exchange Commission (which removed the 12:1 leverage limit on brokerage houses and allowed Lehman Brothers – among others – to expand their mortgage and mortgage-security holdings to a leverage ratio of over 30:1), technology (derivatives, accounting, and the ability to process loan requests in 12 seconds) and the negligence of all of the government agencies with authority over financial institutions (widespread fraud was front page news in the Wall Street Journal in 2001.) This is only a partial list of the parties discussed in Chapter 22.
In Panderer to Power, my exploration of the housing bubble veers towards the earlier years, 2001-2003. I did this to show that someone in a position of authority who picked up the morning newspaper had to know the Mortgage Machine should be reined in. Aside from fraud, the terms of loans and the incapacity of home buyers to pay their mortgages was a common newspaper topic by 2002. (I quote some of these in my book.)
I chose this emphasis after hearing Alan Greenspan state on 60 Minutes (October 3, 2007): “While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late. I really didn't get it until very late in 2005 and 2006.”
You might expect this sort of answer on April 7. It is not credible.
The absurdities in the housing market were already a source of laughter at FOMC meetings in 2002. On November 2, 2002, Atlanta Federal Reserve President Jack Guynn told the FOMC: “The south Florida housing market would have to be characterized as red hot. One director reported that when a moderately priced development on the west coast of Florida opened, demand was so great that sales had to be limited to three homes per customer. That’s a semi-true story. [Laughter]”
2 – Alan Greenspan Used his Position to Sell Toxic Mortgage Products
More important than his knowledge was how Greenspan used his testimony and speeches to sell the mortgage bubble. I will restrict my discussion to two of his sales talks.
On February 23, 2004, Greenspan spoke to the National Association of Homebuilders. He claimed the “traditional fixed-rate mortgage may be an expensive method of financing a home” and “[m]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade.”
Greenspan will deny this speech influenced the mortgage market. It did. He was still a demigod to a large part of America. The title of an article in the February 24th Wall Street Journal read: “Fed Chief Questions Loan Choices.” Quoting the first sentence of the story: “In a rare evaluation of the interest rate options that households face, Federal Reserve Chairman Alan Greenspan questioned whether homeowners are well-served by popular fixed-rate long-term mortgages.” Realtors quoted Greenspan in their sales materials. Adjustable-rate mortgages rose from 2% of mortgages in California in 2002 to 47% in 2004 to 61% in 2005. It is a fair though unanswerable question how much Greenspan contributed to the current fiscal problems in California.
Alan Greenspan has run away from this speech since retirement. Here is an excellent example of how he will dodge responsibility when he appears before the Financial Crisis Inquiry Commission.
An interviewer questioned Alan Greenspan about his February 23, 2004 speech at a January 2008 conference in Canada. Greenspan told the interviewer “I strongly clarified my remarks” regarding adjustable-rate mortgages in a speech on March 2, 2004 and “[s]o I plead not guilty.” The transcript of the March 2, 2004, speech to the Economic Club of New York shows no mention of mortgages. He may have discussed adjustable-rate mortgages after the speech, but this certainly did not clarify his remarks to the public.
Greenspan made another attempt to extricate himself in February 2008. Greenspan told an audience in Sweden his warning (or retraction or however he planned to style it) was not in New York but in Chicago on May 6, 2004. This trail was not worth pursuing.
When he responds to your questions in like fashion, the transcript of his original remarks should be read.
Another of Greenspan’s speeches worth reviewing is an address to the American Bankers Association on September 26, 2005. By this late date, it was not enough to encourage adjustable-rate mortgages. To sell mortgages, and feed the Mortgage Machine, Chairman Greenspan discussed “a long list of novel mortgage products” such as 40-year loans, option ARMs, piggyback mortgages and HELOCS used as piggyback loans. Greenspan told his listeners he was not “worr[ied] that homebuyers are especially exposed to reversals in house prices.”
This was quite a conclusion since he also told the American Bankers Association: “We can have little doubt that the exceptionally low level of home mortgage interest rates has been a major driver of the recent surge of home building and home turnover and the steep climb of home prices.”
It seems likely that the nation’s leading banking regulator made these speeches before the National Association of Homebuilders and the American Bankers Association for a reason. Builders and bankers received Greenspan’s implicit encouragement to continue to build and to lend.
3 – The Federal Reserve is Cause, Not Effect, for Abuses in Subprime Lending
There would have been no lending of any sort without the Federal Reserve. The Fed prints the money that enters the economy. It has a monopoly. Counterfeiters know that.
Credit springs from money. The commercial banking system produces credit, by and large. The Federal Reserve sets reserve requirements on commercial bank credit growth. If the Fed sets the bank reserve ratio at 10:1, a bank cannot lend more than $10 for every $1 on deposit. That effectively limits the growth of credit.
The Federal Reserve has the authority to increase or decrease bank reserve requirements at any time. During Alan Greenspan’s chairmanship, the Fed reduced bank reserve requirements several ways; it never increased them. The result of the Greenspan Fed’s money and credit expansion: commercial banks, having run out of proper projects to fund, lent to investment banks, hedge funds, private-equity funds, subprime mortgage lenders, and commercial property speculators. (An investment bank may have lent to a non-bank mortgage company, but it first had to borrow from the commercial banking system.)
The Federal Reserve, under Alan Greenspan, both printed every dollar that entered the economy and had sole authority to set bank reserve requirements. If the Fed had reduced reserve requirements, this would have restricted the lending that proved so destructive.
I would anticipate a rebuttal from Alan Greenspan. He spent his Federal Reserve chairmanship distracting committees by turning money and credit into a quagmire of confusion. There is, of course, much more than I have written above for a full understanding of money and credit, but Alan Greenspan will not attempt to enlighten the commission. The paper he recently presented at the Brookings Institute was a grab bag of unrelated hypotheses that never mentioned the relationship between the Federal Reserve, money and credit. The role and influence of the Federal Reserve can be explained in plain English.
He may attempt to respond to questions of money and credit with another argument, which could be phrased as follows: “We live in a global economy with a global financial system. The Federal Reserve does not have as much control as you claim.” This is a specious argument. In reality the dollar is still the world’s reserve currency. As the world’s reserve currency, it is only the United States that can print money in any quantity it so desires.
Greenspan has attempted to dodge his responsibility as Fed chairman by talking about housing bubbles in twenty different countries. No, there was a housing bubble in the United States that we exported by printing money that was then shipped overseas to pay for goods. When these dollars were converted into local currencies, the excess credit led to the twenty housing bubbles.
I hope my letter is of service. Please let me know if I can offer instruction or advice, either for the current or later hearings.
Sincerely,
Frederick J. Sheehan
April 1, 2010
Mr. Phil Angelides, Commission Chairman
Financial Crisis Inquiry Commission
1717 Pennsylvania Avenue, NW
Suite 800
Washington, DC 20006-4614
Dear Chairman Angelides:
I am writing in regard to the Financial Crisis Inquiry Commission’s April 7-9, 2010, public hearing, “Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs).” Specifically, the following is written to help you examine Alan Greenspan.
Enclosed please find a copy of my book, Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession. I am also co-author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.
In preparation for writing these books, I read ten years of Federal Reserve Open Market Committee (FOMC) transcripts, Congressional and Senate testimony over the same period, and Chairman Greenspan’s speeches, interviews and articles that he wrote back to 1959 (New York Times, Wall Street Journal, Fortune, U.S. News and World Report, Newsweek, Time and others). I have followed much of his public self-vindication since his retirement from the Federal Reserve Board.
This letter addresses three areas. First, Alan Greenspan and the Government-Sponsored Enterprises (GSEs). This includes how the GSEs changed the American economy. Second, Alan Greenspan’s promotion of toxic mortgage products. Third, the Federal Reserve’s influence on the topics you are addressing on April 7-9. Although the role of the Federal Reserve is not, per se, the subject of the April 7-9 hearing, the Fed prints the nation’s money and, for the most part, has the ability to limit the amount of credit in the economy.
1 – Alan Greenspan and the Government-Sponsored Enterprises
Alan Greenspan deserves recognition for his attempts to harness Fannie Mae and Freddie Mac. His first warning about the GSEs explosive growth was on February 24, 2004, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs. He also urged reform at a conference sponsored by the Federal Reserve Bank of Atlanta on May 19, 2005. I quote and discuss the importance and timing of these warnings on pages 266-270 of my book Panderer to Power.
I think Alan Greenspan should explain to you why he waited until 2004 before issuing his first warning. If he is asked this question directly, Greenspan will state you are incorrect. He may cite a previous occasion or occasions when he issued such advice. If so, the speech or testimony should be read. This advice applies to any topic.
Chapter 22 of Panderer to Power lays out the reason I would ask why he waited until 2004. Without GSE expansion, the home mortgage market could not have grown to dominate the U.S. economy. (Northern Trust estimated that, between 2001 and 2006, 40% of new jobs were related to housing.) Fannie and Freddie were vacuum cleaners for the nation’s mortgage finance growth. In 1995, home mortgage debt increased by $153 billion; in 2000, by $380 billion; in 2005, by $1.1 trillion.
In 1990, the value of Fannie Mae’s and Freddie Mac’s combined mortgage portfolio was $132 billion. In April 2003 – a single month – Fannie Mae (alone) bought $139 billion of mortgages. The mutation of Fannie and Freddie played a large role in the mutation of the U.S. economy.
Chapter 22, “The Mortgage Machine,” integrates the parties who contributed to the housing wreckage: the non-bank mortgage companies, the commercial banks (writing and selling mortgages) the investment banks (securitizing mortgages and funding the growth of the non-bank mortgage companies), the GSEs (packaging mortgage securities and funding subprime lenders, banks and non-banks), the Office of Federal Housing Enterprise Oversight (which mishandled its role as GSE supervisor), members of Congress (who prevented OFHEO from performing its function), the Securities and Exchange Commission (which removed the 12:1 leverage limit on brokerage houses and allowed Lehman Brothers – among others – to expand their mortgage and mortgage-security holdings to a leverage ratio of over 30:1), technology (derivatives, accounting, and the ability to process loan requests in 12 seconds) and the negligence of all of the government agencies with authority over financial institutions (widespread fraud was front page news in the Wall Street Journal in 2001.) This is only a partial list of the parties discussed in Chapter 22.
In Panderer to Power, my exploration of the housing bubble veers towards the earlier years, 2001-2003. I did this to show that someone in a position of authority who picked up the morning newspaper had to know the Mortgage Machine should be reined in. Aside from fraud, the terms of loans and the incapacity of home buyers to pay their mortgages was a common newspaper topic by 2002. (I quote some of these in my book.)
I chose this emphasis after hearing Alan Greenspan state on 60 Minutes (October 3, 2007): “While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late. I really didn't get it until very late in 2005 and 2006.”
You might expect this sort of answer on April 7. It is not credible.
The absurdities in the housing market were already a source of laughter at FOMC meetings in 2002. On November 2, 2002, Atlanta Federal Reserve President Jack Guynn told the FOMC: “The south Florida housing market would have to be characterized as red hot. One director reported that when a moderately priced development on the west coast of Florida opened, demand was so great that sales had to be limited to three homes per customer. That’s a semi-true story. [Laughter]”
2 – Alan Greenspan Used his Position to Sell Toxic Mortgage Products
More important than his knowledge was how Greenspan used his testimony and speeches to sell the mortgage bubble. I will restrict my discussion to two of his sales talks.
On February 23, 2004, Greenspan spoke to the National Association of Homebuilders. He claimed the “traditional fixed-rate mortgage may be an expensive method of financing a home” and “[m]any homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages over the past decade.”
Greenspan will deny this speech influenced the mortgage market. It did. He was still a demigod to a large part of America. The title of an article in the February 24th Wall Street Journal read: “Fed Chief Questions Loan Choices.” Quoting the first sentence of the story: “In a rare evaluation of the interest rate options that households face, Federal Reserve Chairman Alan Greenspan questioned whether homeowners are well-served by popular fixed-rate long-term mortgages.” Realtors quoted Greenspan in their sales materials. Adjustable-rate mortgages rose from 2% of mortgages in California in 2002 to 47% in 2004 to 61% in 2005. It is a fair though unanswerable question how much Greenspan contributed to the current fiscal problems in California.
Alan Greenspan has run away from this speech since retirement. Here is an excellent example of how he will dodge responsibility when he appears before the Financial Crisis Inquiry Commission.
An interviewer questioned Alan Greenspan about his February 23, 2004 speech at a January 2008 conference in Canada. Greenspan told the interviewer “I strongly clarified my remarks” regarding adjustable-rate mortgages in a speech on March 2, 2004 and “[s]o I plead not guilty.” The transcript of the March 2, 2004, speech to the Economic Club of New York shows no mention of mortgages. He may have discussed adjustable-rate mortgages after the speech, but this certainly did not clarify his remarks to the public.
Greenspan made another attempt to extricate himself in February 2008. Greenspan told an audience in Sweden his warning (or retraction or however he planned to style it) was not in New York but in Chicago on May 6, 2004. This trail was not worth pursuing.
When he responds to your questions in like fashion, the transcript of his original remarks should be read.
Another of Greenspan’s speeches worth reviewing is an address to the American Bankers Association on September 26, 2005. By this late date, it was not enough to encourage adjustable-rate mortgages. To sell mortgages, and feed the Mortgage Machine, Chairman Greenspan discussed “a long list of novel mortgage products” such as 40-year loans, option ARMs, piggyback mortgages and HELOCS used as piggyback loans. Greenspan told his listeners he was not “worr[ied] that homebuyers are especially exposed to reversals in house prices.”
This was quite a conclusion since he also told the American Bankers Association: “We can have little doubt that the exceptionally low level of home mortgage interest rates has been a major driver of the recent surge of home building and home turnover and the steep climb of home prices.”
It seems likely that the nation’s leading banking regulator made these speeches before the National Association of Homebuilders and the American Bankers Association for a reason. Builders and bankers received Greenspan’s implicit encouragement to continue to build and to lend.
3 – The Federal Reserve is Cause, Not Effect, for Abuses in Subprime Lending
There would have been no lending of any sort without the Federal Reserve. The Fed prints the money that enters the economy. It has a monopoly. Counterfeiters know that.
Credit springs from money. The commercial banking system produces credit, by and large. The Federal Reserve sets reserve requirements on commercial bank credit growth. If the Fed sets the bank reserve ratio at 10:1, a bank cannot lend more than $10 for every $1 on deposit. That effectively limits the growth of credit.
The Federal Reserve has the authority to increase or decrease bank reserve requirements at any time. During Alan Greenspan’s chairmanship, the Fed reduced bank reserve requirements several ways; it never increased them. The result of the Greenspan Fed’s money and credit expansion: commercial banks, having run out of proper projects to fund, lent to investment banks, hedge funds, private-equity funds, subprime mortgage lenders, and commercial property speculators. (An investment bank may have lent to a non-bank mortgage company, but it first had to borrow from the commercial banking system.)
The Federal Reserve, under Alan Greenspan, both printed every dollar that entered the economy and had sole authority to set bank reserve requirements. If the Fed had reduced reserve requirements, this would have restricted the lending that proved so destructive.
I would anticipate a rebuttal from Alan Greenspan. He spent his Federal Reserve chairmanship distracting committees by turning money and credit into a quagmire of confusion. There is, of course, much more than I have written above for a full understanding of money and credit, but Alan Greenspan will not attempt to enlighten the commission. The paper he recently presented at the Brookings Institute was a grab bag of unrelated hypotheses that never mentioned the relationship between the Federal Reserve, money and credit. The role and influence of the Federal Reserve can be explained in plain English.
He may attempt to respond to questions of money and credit with another argument, which could be phrased as follows: “We live in a global economy with a global financial system. The Federal Reserve does not have as much control as you claim.” This is a specious argument. In reality the dollar is still the world’s reserve currency. As the world’s reserve currency, it is only the United States that can print money in any quantity it so desires.
Greenspan has attempted to dodge his responsibility as Fed chairman by talking about housing bubbles in twenty different countries. No, there was a housing bubble in the United States that we exported by printing money that was then shipped overseas to pay for goods. When these dollars were converted into local currencies, the excess credit led to the twenty housing bubbles.
I hope my letter is of service. Please let me know if I can offer instruction or advice, either for the current or later hearings.
Sincerely,
Frederick J. Sheehan
Thursday, March 25, 2010
Government Authorities are Looking Out for Themselves – As Should Everyone
Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).
"China in Midst of 'Greatest Bubble in History'", Bloomberg told readers on March 17, 2010. That was the opinion of certain experts interviewed by the news service. One expert held the opposite view: "'People making comments about bubbles possibly don't have all the facts,' HSBC Holdings Plc Chief Executive Officer Michael Georghegan said in Shanghai today. Regulators are in control of the banking industry, and have the ability to curb lending as needed, he said."
Aside from the bubble question (which the experts answered), it is the rationale behind Georghegan's chipper comment that deserves attention. "Regulators are in control" seems low on the list to assure clientele. Even though Georghegan is persuaded, investors should be skeptical. What follows is a review of instances when trusted regulators were a good reason to panic.
On September 4, 1929, Roger Babson advised a gathering in Wellesley, Massachusetts to "pay up their loans and avoid margin speculation at this time because a 'crash' of the stock market was inevitable." This was the New York Times summary in its September 6 edition under the headline "Babson Predicts 'Crash' in Stocks."
Forever known as the "Babson Break," stocks fell 3% after the ticker relayed Babson's warning. This was two days after the Dow Jones Industrial Average peaked at 381, which would remain the top until 1954. The Times quoted the most celebrated economist of the time, Irving Fisher: "Stock prices are not too high and Wall Street will not experience anything in the nature of a crash." The persistence of celebrated economists to miss monumental shifts is, or should be, expected.
Alexander D. Noyes, sometimes called the "dean of American financial journalism," cautioned Times' readers that Babson's counsel might be outdated. There are "numerous other considerations now which must nowadays modify ideas about the future. One is the power and protective resources of the Federal Reserve."
There were some inside the Fed who thought differently. In 1928, Carl Snyder of the New York Fed wrote: "Owing to the abundance of credit, in excess of what appears to be about the maximum possible growth of trade, there came a heavy expansion of bank investment.... [P]artly in consequence of the abundant credit, [we have seen what] appears to be the greatest building boom which this country has known in 60 years..."
By the fall of 1929, plans were or had been drawn for five buildings ranging in height from 80 to 150 stories in New York. The "protective resources of the Fed" were no better (or worse) in 1929 than in 2008.
Investors are better off trusting their own judgment than the motivations of government authorities. In the same September 6, 1929, "Babson Break" edition of the Times, a column with the title "Action by Board Doubted" reported the "total of broker's loans by member banks of the Federal Reserve System took another jump... [to] a new peak of $6,354,000,000. Treasury officials indicated that they did not expect any radical step by the Federal Reserve Board at this time to curb the speculative movement."
This instance of an inflated stock market accompanied by a blank stare from the government is known, in contemporary parlance, as the "Greenspan Put," now superseded by the "Bernanke Put." Speculators, in 2010, as in 1929, must decide whether the "power and protective resources of the Federal Reserve" have put a floor on the stock market's price even though it was (and is) floating on borrowed money.
Such calculations aside, there was another story in the Times' "Babson Break" issue that warned the mind of the market was that of the village idiot. The article, "Brokerage Office Set Up On Pebble Beach Golf Course," reported: "Golf enthusiasts who are following the course of the national amateur championship at Pebble Beach, Cal., may watch the stock market while keeping up with the play. A temporary brokerage office, housed in a tent...has been established by the firm of E.F. Hutton & Co.... The temporary office has had a lively bit of business from the crowd following the players and from some of the players, too, many of whom are ardent followers of market quotations."
In 1966, when the Federal Reserve was ceding monetary policy to the Johnson administration, the business editor of the New York Times calmed readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as has happened recently in other countries." The inflation rate was 3.3% at the time and rose to 6.1% in 1969. The Times, in its high-minded trust of Washington, did not stoop to consider the authorities might be looking after their own interests. Secretary of Defense Robert McNamara was lying about the financial burden of Vietnam, where the troops deployed were to double (from 184,000) in 1966. The Johnson administration would not consider a major tax increase and the budget deficit rose from $1 billion in 1965 to $25 billion in 1968.
As every schoolchild knows, political independence of the Federal Reserve does not include its unstated mandate to plug Treasury deficits. In late 1965, Federal Reserve Chairman William McChesney Martin had told the Federal Reserve Open Market Committee "I cannot believe that all periods of prosperity float on constantly rising levels of credit or that one can ignore credit quality." Martin's intentions may have been parsimonious, but McNamara's War demanded expansion. Bank credit rose at a 7.2% rate in December 1965 and by 15% in April 1966. At Martin's 1970 White House farewell dinner, he told the assembled: "We are in the wildest inflation since the Civil War."
As goes inflation, so go bonds. Americans who trusted the "ability and wisdom" of the Federal Reserve were scarred. In 1969, Institutional Investor published a front cover story, "The Death of Bonds." Prices of long-term Treasuries fell 14% from the end of 1966 to 1969. Stock investors wished they hadn't. After rising for 17 years, the Dow Jones Industrial Average reached a peak of 995 on February 9, 1966. The Dow was 777 on August 12, 1982. These numbers do not reflect inflation's toll on purchasing power. Consumer prices tripled over the 16-year period.
This brings us to the present and to a regular columnist in the New York Times, Greg Mankiw, professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and so on. On December 23, 2007, Mankiw outdid Irving Fisher: "The truth is the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team, as we are ever likely to see.... The best Congress can do now is to let the Bernanke bunch do its job."
The Federal Reserve governors had spent 2007 in a daze; 2008 would show their policy was to panic, overreact to meltdowns the Fed had fostered, and disguise their market manipulations.
Anti-authoritarianism is often simple common sense. Returning to China, the country suffered one of the worst inflations of the twentieth century during the 1930s and 1940s. (In good measure, this was inflicted by the United States. See "America's Beggar-Thy-Neighbor Policy" under "Articles" on the Aucontrarian.com website.)
The Chinese press, controlled by Chinese Communists in 1949, blamed inflation on "Kuomintang agents" and "unscrupulous speculators." (It never changes.) Prices for necessities - rice, bean oil, firewood, soap - were rising daily when the Communists demanded trade be conducted in the new People's Bank note. In June 1949, a New York Times correspondent spoke to a merchant in Nanking who would not touch the paper currency: "Communist currency may be backed by rice, but you can't hold rice. It spoils. A gold bar is always a gold bar."
Frederick Sheehan writes a blog at www.aucontrarian.com
"China in Midst of 'Greatest Bubble in History'", Bloomberg told readers on March 17, 2010. That was the opinion of certain experts interviewed by the news service. One expert held the opposite view: "'People making comments about bubbles possibly don't have all the facts,' HSBC Holdings Plc Chief Executive Officer Michael Georghegan said in Shanghai today. Regulators are in control of the banking industry, and have the ability to curb lending as needed, he said."
Aside from the bubble question (which the experts answered), it is the rationale behind Georghegan's chipper comment that deserves attention. "Regulators are in control" seems low on the list to assure clientele. Even though Georghegan is persuaded, investors should be skeptical. What follows is a review of instances when trusted regulators were a good reason to panic.
On September 4, 1929, Roger Babson advised a gathering in Wellesley, Massachusetts to "pay up their loans and avoid margin speculation at this time because a 'crash' of the stock market was inevitable." This was the New York Times summary in its September 6 edition under the headline "Babson Predicts 'Crash' in Stocks."
Forever known as the "Babson Break," stocks fell 3% after the ticker relayed Babson's warning. This was two days after the Dow Jones Industrial Average peaked at 381, which would remain the top until 1954. The Times quoted the most celebrated economist of the time, Irving Fisher: "Stock prices are not too high and Wall Street will not experience anything in the nature of a crash." The persistence of celebrated economists to miss monumental shifts is, or should be, expected.
Alexander D. Noyes, sometimes called the "dean of American financial journalism," cautioned Times' readers that Babson's counsel might be outdated. There are "numerous other considerations now which must nowadays modify ideas about the future. One is the power and protective resources of the Federal Reserve."
There were some inside the Fed who thought differently. In 1928, Carl Snyder of the New York Fed wrote: "Owing to the abundance of credit, in excess of what appears to be about the maximum possible growth of trade, there came a heavy expansion of bank investment.... [P]artly in consequence of the abundant credit, [we have seen what] appears to be the greatest building boom which this country has known in 60 years..."
By the fall of 1929, plans were or had been drawn for five buildings ranging in height from 80 to 150 stories in New York. The "protective resources of the Fed" were no better (or worse) in 1929 than in 2008.
Investors are better off trusting their own judgment than the motivations of government authorities. In the same September 6, 1929, "Babson Break" edition of the Times, a column with the title "Action by Board Doubted" reported the "total of broker's loans by member banks of the Federal Reserve System took another jump... [to] a new peak of $6,354,000,000. Treasury officials indicated that they did not expect any radical step by the Federal Reserve Board at this time to curb the speculative movement."
This instance of an inflated stock market accompanied by a blank stare from the government is known, in contemporary parlance, as the "Greenspan Put," now superseded by the "Bernanke Put." Speculators, in 2010, as in 1929, must decide whether the "power and protective resources of the Federal Reserve" have put a floor on the stock market's price even though it was (and is) floating on borrowed money.
Such calculations aside, there was another story in the Times' "Babson Break" issue that warned the mind of the market was that of the village idiot. The article, "Brokerage Office Set Up On Pebble Beach Golf Course," reported: "Golf enthusiasts who are following the course of the national amateur championship at Pebble Beach, Cal., may watch the stock market while keeping up with the play. A temporary brokerage office, housed in a tent...has been established by the firm of E.F. Hutton & Co.... The temporary office has had a lively bit of business from the crowd following the players and from some of the players, too, many of whom are ardent followers of market quotations."
In 1966, when the Federal Reserve was ceding monetary policy to the Johnson administration, the business editor of the New York Times calmed readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as has happened recently in other countries." The inflation rate was 3.3% at the time and rose to 6.1% in 1969. The Times, in its high-minded trust of Washington, did not stoop to consider the authorities might be looking after their own interests. Secretary of Defense Robert McNamara was lying about the financial burden of Vietnam, where the troops deployed were to double (from 184,000) in 1966. The Johnson administration would not consider a major tax increase and the budget deficit rose from $1 billion in 1965 to $25 billion in 1968.
As every schoolchild knows, political independence of the Federal Reserve does not include its unstated mandate to plug Treasury deficits. In late 1965, Federal Reserve Chairman William McChesney Martin had told the Federal Reserve Open Market Committee "I cannot believe that all periods of prosperity float on constantly rising levels of credit or that one can ignore credit quality." Martin's intentions may have been parsimonious, but McNamara's War demanded expansion. Bank credit rose at a 7.2% rate in December 1965 and by 15% in April 1966. At Martin's 1970 White House farewell dinner, he told the assembled: "We are in the wildest inflation since the Civil War."
As goes inflation, so go bonds. Americans who trusted the "ability and wisdom" of the Federal Reserve were scarred. In 1969, Institutional Investor published a front cover story, "The Death of Bonds." Prices of long-term Treasuries fell 14% from the end of 1966 to 1969. Stock investors wished they hadn't. After rising for 17 years, the Dow Jones Industrial Average reached a peak of 995 on February 9, 1966. The Dow was 777 on August 12, 1982. These numbers do not reflect inflation's toll on purchasing power. Consumer prices tripled over the 16-year period.
This brings us to the present and to a regular columnist in the New York Times, Greg Mankiw, professor of Economics at Harvard University, past chairman of President George W. Bush's Counsel of Economic Advisers, and so on. On December 23, 2007, Mankiw outdid Irving Fisher: "The truth is the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team, as we are ever likely to see.... The best Congress can do now is to let the Bernanke bunch do its job."
The Federal Reserve governors had spent 2007 in a daze; 2008 would show their policy was to panic, overreact to meltdowns the Fed had fostered, and disguise their market manipulations.
Anti-authoritarianism is often simple common sense. Returning to China, the country suffered one of the worst inflations of the twentieth century during the 1930s and 1940s. (In good measure, this was inflicted by the United States. See "America's Beggar-Thy-Neighbor Policy" under "Articles" on the Aucontrarian.com website.)
The Chinese press, controlled by Chinese Communists in 1949, blamed inflation on "Kuomintang agents" and "unscrupulous speculators." (It never changes.) Prices for necessities - rice, bean oil, firewood, soap - were rising daily when the Communists demanded trade be conducted in the new People's Bank note. In June 1949, a New York Times correspondent spoke to a merchant in Nanking who would not touch the paper currency: "Communist currency may be backed by rice, but you can't hold rice. It spoils. A gold bar is always a gold bar."
Frederick Sheehan writes a blog at www.aucontrarian.com
Friday, March 12, 2010
Municipal Deflation: Consequences of the Greatest Speculation
Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009).
"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate...."
-Herbert D. Simpson, Meeting of the American Economic Association, 1933
On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."
To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead. A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities - cities and towns - receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.)
The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."
Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability.... In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster's Club of New York. (Novelists shy from such parody.)
Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."
This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate 'speculation' carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."
In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction...." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%.
With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007. One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008.
Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms.... The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.
At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest.... The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."
Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse. First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.
At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.
"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate...."
-Herbert D. Simpson, Meeting of the American Economic Association, 1933
On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."
To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead. A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities - cities and towns - receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.)
The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."
Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability.... In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster's Club of New York. (Novelists shy from such parody.)
Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."
This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate 'speculation' carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."
In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction...." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%.
With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007. One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008.
Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms.... The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.
At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest.... The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."
Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse. First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.
At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.
Tuesday, March 9, 2010
From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers
Federal Reserve Vice Chairman Donald Kohn announced his retirement on March 1, 2010. In his obligatory lament, Federal Reserve Chairman Ben S. Bernanke was half right: "The Federal Reserve and the country owe a tremendous debt of gratitude to Don Kohn." What is good for the Fed is generally not good for the country. The influence of Donald Kohn supports this view.
A rarity, Kohn rose through the ranks of the Federal Reserve System. After 32 years of grunt work, he was named a Federal Reserve governor in 2002 and assigned the vice chairmanship in 2006. He participated in Federal Reserve Open Market Committee (FOMC) meetings long before his governorship. He had been a staff economist (Director of Monetary Affairs) and Secretary at FOMC meetings.
Donald Kohn will be smothered in praise from now until his June retirement. The media will quote celebrity economists who will deify the celebrity vice chairman. Alan Greenspan was "the greatest central banker who ever lived," according to former Federal Reserve Vice Chairman Alan Blinder at a 2005 conference. These farewell hosannas are necessarily vague and meaningless, as was the March 6, 2010, appraisal of Kohn in the Economist: "Mr. Kohn is widely considered one of the most experienced and thoughtful central bankers in the world." Given the worldwide failure of central bankers, this may well be true, so a critique of Kohn's brilliance is necessarily specific.
October 15, 1998: Fanning the Greenspan Put
The FOMC held a conference call on October 15, 1998. This remains the most infamous FOMC discussion on record. It was held shortly after Wall Street paid over $3 billion to bail out Long-Term Capital Management (LTCM), a hedge fund. The Nasdaq Composite Index fell 20% from mid-July to mid-October. It had boomed for the past three-and-one-half years (a 160% return), but the Fed decided a hiatus would not do.
In the wake of the conference call, the Fed announced a surprise rate cut at 3:14 p.m. The bond market had already closed for the day, stock-option contracts expired the next day, and investors panicked. A frenzy of buying pushed the S&P 500 futures up 5% in five minutes. The Nasdaq Composite rose from 1,540 on October 14, 1998 to 4,069 on December 31, 1999.
Donald Kohn's contribution, as Secretary of the FOMC, was to announce at the meeting's conclusion: "We are not constrained by the practice followed after regularly scheduled FOMC meetings where the release time is set for 2:15 p.m. We will try to move through the process of preparing the press release as rapidly as possible."
It was after this surprise rate cut that the "Greenspan Put" came into common use. A put option is bought by investors to limit losses when the market falls. Now, instead of buying protection, the Greenspan Put inspired such confidence that speculators replicated the borrowing and leveraging of LTCM. Kohn's faux pas, if that is what it was, served the interests of the Fed but not those of the American people. Around $5 trillion was lost by investors after the Greenspan Stock-Market Put failed in 2000.
Joining the Inflation Targeting Team
The Fed's deflation team was beefed up on August 5, 2002. Both Ben Bernanke and Donald Kohn were appointed as Fed governors, and to the FOMC. Bernanke had devoted his adulthood to inflationary economics. His book, which he wrote with three other economists, Inflation Targeting: Lessons from the International Experience made clear that an economy should always be inflating.
At Bernanke's first FOMC meeting (August 13, 2002), it was the other newcomer, Donald Kohn who sounded as if he was reading from Bernanke's book: "I don't see a zero real rate as a natural bound for monetary policy." He not only was unconcerned about real rates below zero, Kohn stated the opposite case: [I]nflation is already as low as I would like to see it go." He intimated that real rates were already below zero (when inflation exceeds the borrowing rate), and stated a desire for even lower real rates.
This was an about face. At the May 2002, Donald Kohn, speaking as a staff economist, had warned the committee it would soon need to address a fed funds rate hike from "its currently unsustainably low level." He also told the FOMC the fed funds rate "will have to be tightened at some point to forestall increasing inflationary pressures."
Donald Kohn has been an asset inflator since his coming out party at the August 2002 meeting. Although (the current) Chairman Bernanke has led the charge against deflation at all costs, Donald Kohn has been a loyal sidekick.
The FOMC had started cutting the fed funds rate in 2001 and did so until 2003, when it stopped at 1.0%. There are few precedents to a 1.0% borrowing rate. When we sift through the wreckage in future years, the zero-percent school will deserve a healthy portion of the blame.
"[H]ouseholds Have Bought More and Larger Houses and Cars, Have Taken on More Debt..."
Ignorance will not be an excuse. Donald Kohn knew what he was doing. After the Greenspan Stock-Market Put had failed, the FOMC instituted the Greenspan Home-Equity, Cash-Out Put. On April 1, 2004, Kohn spoke at Widener College in Chester, Pennsylvania. He opened by reminding his audience of the gratitude it owed the Federal Reserve: "Starting in January of 2001, the Federal Reserve moved to counter [the weak economy] by lowering the funds rate.... This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record." Attendees among the cohort that had lost the $5 trillion may not have appreciated this P.R. stunt.
Kohn acknowledged there were dissenters to the Fed's current 1.0% fed funds rate: "[S]ome observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later." They were concerned "that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances - excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us."
Since the financial meltdown, the Fed has recited from its handbook: "No one saw it coming." The credit crash in 2007 had been widely anticipated and in all its severity. The question was not "if," but "when." The media quotes the Fed without correction, and so, Ben Bernanke was recently awarded another term as chairman.
Kohn dismissed concerns before the Pennsylvania college audience: "[H]ouseholds have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher.... [T]hese developments... are by-and-large the intended and logical consequences of the Federal Reserve's efforts to reduce economic slack through low interest rates."
Should there be credit "adjustments", Kohn assured his audience: "Commercial banks remain highly profitable and well capitalized...." They were only well capitalized as long as they remained highly profitable.
Of course, Kohn praised the Fed's regulatory vigilance: "Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee."
Regulation: "It's a Very Hard Sell to the Banks."
On March 4, 2008, Vice Chairman Kohn testified before the Senate Banking Committee about the "Condition of the U.S. Banking System." He made an honest admission: "I don't know that we fully appreciated all the risks out there." He also made a self-serving claim: "I'm not sure anybody did, to be perfectly honest."
Kohn was among the slow minded. In October 2007, Kohn had predicted that once "we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment."
At the March 2008 hearing, Kohn acknowledged that banks had not priced certain risks appropriately, but "It's a very hard sell to the banks." Senator Richard Shelby, a member of the committee, was not amused: "It's a hard sell to the banks, yes, but you are the supervisor of all the bank holding companies, and you are also the central bank.... So you have not just a little bit of power, but a lot of power." Shelby asked Kohn if the Fed "was afraid of the banks they regulate." Kohn responded in the negative. If this was true, a classroom of rookie bank tellers would have done - and would do - a better job supervising the banks.
Donald Kohn was talking through his hat on September 9, 2009. Again, selling the virtues of the Fed, he claimed the Fed's myriad bailouts (not his description) over the past year had followed the "precepts derived from the work of Walter Bagehot [author of Lombard Street, a central-banking blueprint from Queen Victoria's time.] Those precepts hold that central banks can and should ameliorate financial crises by providing ample credit to a wide set of borrowers, as long as the borrowers are solvent, the loans are provided against good collateral, and a penalty rate is charged." [Italics added]
Bagehot's precepts were stated correctly but Fed practices contradicted the Victorian author. Kohn betrayed a complete ignorance of what the Fed was doing. Kohn and Company had provided loans against collateral that was so damaged it was necessary for the Fed to buy it from the banks and hide it from the public on its own books. We still do not know what the Fed bought and this is probably the main reason the central bank is resisting an audit. As for charging a "penalty rate," the Fed has charged a negative real rate of interest (below the rate of inflation). A double-digit interest rate would meet Bagehot's requirement.
The Kohn Put: Inducing "Savers to Diversify into Riskier Assets"
This past fall, the Kohn Put was announced. Maybe because he was speaking to the choir - at a Federal Reserve conference - he explicitly stated the Fed's grand plan. "[R]ecently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."
In other words, the Federal Reserve is attempting to rescue itself as it did in 1998 and in 2002. Afraid the LTCM failure would cause financial institutions to freeze, the October 15 Greenspan Put inflated confidence and the stock market. In 2002, Federal Reserve governors, in speech after speech, terrorized Americans into believing it had to lift prices or the United States would suffer another Great Depression. This was the rationale for the 1% fed funds rate, the means by which the Fed inflated another asset bubble, the mortgage market, to compensate for its earlier mistake. And now, with the housing market and economy in despair, Kohn has announced the Fed's zero percent interest-rate policy will induce savers into the stock market and the already inflated municipal and federal government bond markets.
Presidential adviser Larry Summers and Secretary of the Treasury Tim Geithner are leading the search for Donald Kohn's replacement. We can be sure this pair of insiders will identify a candidate who will serve the Federal Reserve first and the American people last.
A rarity, Kohn rose through the ranks of the Federal Reserve System. After 32 years of grunt work, he was named a Federal Reserve governor in 2002 and assigned the vice chairmanship in 2006. He participated in Federal Reserve Open Market Committee (FOMC) meetings long before his governorship. He had been a staff economist (Director of Monetary Affairs) and Secretary at FOMC meetings.
Donald Kohn will be smothered in praise from now until his June retirement. The media will quote celebrity economists who will deify the celebrity vice chairman. Alan Greenspan was "the greatest central banker who ever lived," according to former Federal Reserve Vice Chairman Alan Blinder at a 2005 conference. These farewell hosannas are necessarily vague and meaningless, as was the March 6, 2010, appraisal of Kohn in the Economist: "Mr. Kohn is widely considered one of the most experienced and thoughtful central bankers in the world." Given the worldwide failure of central bankers, this may well be true, so a critique of Kohn's brilliance is necessarily specific.
October 15, 1998: Fanning the Greenspan Put
The FOMC held a conference call on October 15, 1998. This remains the most infamous FOMC discussion on record. It was held shortly after Wall Street paid over $3 billion to bail out Long-Term Capital Management (LTCM), a hedge fund. The Nasdaq Composite Index fell 20% from mid-July to mid-October. It had boomed for the past three-and-one-half years (a 160% return), but the Fed decided a hiatus would not do.
In the wake of the conference call, the Fed announced a surprise rate cut at 3:14 p.m. The bond market had already closed for the day, stock-option contracts expired the next day, and investors panicked. A frenzy of buying pushed the S&P 500 futures up 5% in five minutes. The Nasdaq Composite rose from 1,540 on October 14, 1998 to 4,069 on December 31, 1999.
Donald Kohn's contribution, as Secretary of the FOMC, was to announce at the meeting's conclusion: "We are not constrained by the practice followed after regularly scheduled FOMC meetings where the release time is set for 2:15 p.m. We will try to move through the process of preparing the press release as rapidly as possible."
It was after this surprise rate cut that the "Greenspan Put" came into common use. A put option is bought by investors to limit losses when the market falls. Now, instead of buying protection, the Greenspan Put inspired such confidence that speculators replicated the borrowing and leveraging of LTCM. Kohn's faux pas, if that is what it was, served the interests of the Fed but not those of the American people. Around $5 trillion was lost by investors after the Greenspan Stock-Market Put failed in 2000.
Joining the Inflation Targeting Team
The Fed's deflation team was beefed up on August 5, 2002. Both Ben Bernanke and Donald Kohn were appointed as Fed governors, and to the FOMC. Bernanke had devoted his adulthood to inflationary economics. His book, which he wrote with three other economists, Inflation Targeting: Lessons from the International Experience made clear that an economy should always be inflating.
At Bernanke's first FOMC meeting (August 13, 2002), it was the other newcomer, Donald Kohn who sounded as if he was reading from Bernanke's book: "I don't see a zero real rate as a natural bound for monetary policy." He not only was unconcerned about real rates below zero, Kohn stated the opposite case: [I]nflation is already as low as I would like to see it go." He intimated that real rates were already below zero (when inflation exceeds the borrowing rate), and stated a desire for even lower real rates.
This was an about face. At the May 2002, Donald Kohn, speaking as a staff economist, had warned the committee it would soon need to address a fed funds rate hike from "its currently unsustainably low level." He also told the FOMC the fed funds rate "will have to be tightened at some point to forestall increasing inflationary pressures."
Donald Kohn has been an asset inflator since his coming out party at the August 2002 meeting. Although (the current) Chairman Bernanke has led the charge against deflation at all costs, Donald Kohn has been a loyal sidekick.
The FOMC had started cutting the fed funds rate in 2001 and did so until 2003, when it stopped at 1.0%. There are few precedents to a 1.0% borrowing rate. When we sift through the wreckage in future years, the zero-percent school will deserve a healthy portion of the blame.
"[H]ouseholds Have Bought More and Larger Houses and Cars, Have Taken on More Debt..."
Ignorance will not be an excuse. Donald Kohn knew what he was doing. After the Greenspan Stock-Market Put had failed, the FOMC instituted the Greenspan Home-Equity, Cash-Out Put. On April 1, 2004, Kohn spoke at Widener College in Chester, Pennsylvania. He opened by reminding his audience of the gratitude it owed the Federal Reserve: "Starting in January of 2001, the Federal Reserve moved to counter [the weak economy] by lowering the funds rate.... This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record." Attendees among the cohort that had lost the $5 trillion may not have appreciated this P.R. stunt.
Kohn acknowledged there were dissenters to the Fed's current 1.0% fed funds rate: "[S]ome observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later." They were concerned "that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances - excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us."
Since the financial meltdown, the Fed has recited from its handbook: "No one saw it coming." The credit crash in 2007 had been widely anticipated and in all its severity. The question was not "if," but "when." The media quotes the Fed without correction, and so, Ben Bernanke was recently awarded another term as chairman.
Kohn dismissed concerns before the Pennsylvania college audience: "[H]ouseholds have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher.... [T]hese developments... are by-and-large the intended and logical consequences of the Federal Reserve's efforts to reduce economic slack through low interest rates."
Should there be credit "adjustments", Kohn assured his audience: "Commercial banks remain highly profitable and well capitalized...." They were only well capitalized as long as they remained highly profitable.
Of course, Kohn praised the Fed's regulatory vigilance: "Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee."
Regulation: "It's a Very Hard Sell to the Banks."
On March 4, 2008, Vice Chairman Kohn testified before the Senate Banking Committee about the "Condition of the U.S. Banking System." He made an honest admission: "I don't know that we fully appreciated all the risks out there." He also made a self-serving claim: "I'm not sure anybody did, to be perfectly honest."
Kohn was among the slow minded. In October 2007, Kohn had predicted that once "we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment."
At the March 2008 hearing, Kohn acknowledged that banks had not priced certain risks appropriately, but "It's a very hard sell to the banks." Senator Richard Shelby, a member of the committee, was not amused: "It's a hard sell to the banks, yes, but you are the supervisor of all the bank holding companies, and you are also the central bank.... So you have not just a little bit of power, but a lot of power." Shelby asked Kohn if the Fed "was afraid of the banks they regulate." Kohn responded in the negative. If this was true, a classroom of rookie bank tellers would have done - and would do - a better job supervising the banks.
Donald Kohn was talking through his hat on September 9, 2009. Again, selling the virtues of the Fed, he claimed the Fed's myriad bailouts (not his description) over the past year had followed the "precepts derived from the work of Walter Bagehot [author of Lombard Street, a central-banking blueprint from Queen Victoria's time.] Those precepts hold that central banks can and should ameliorate financial crises by providing ample credit to a wide set of borrowers, as long as the borrowers are solvent, the loans are provided against good collateral, and a penalty rate is charged." [Italics added]
Bagehot's precepts were stated correctly but Fed practices contradicted the Victorian author. Kohn betrayed a complete ignorance of what the Fed was doing. Kohn and Company had provided loans against collateral that was so damaged it was necessary for the Fed to buy it from the banks and hide it from the public on its own books. We still do not know what the Fed bought and this is probably the main reason the central bank is resisting an audit. As for charging a "penalty rate," the Fed has charged a negative real rate of interest (below the rate of inflation). A double-digit interest rate would meet Bagehot's requirement.
The Kohn Put: Inducing "Savers to Diversify into Riskier Assets"
This past fall, the Kohn Put was announced. Maybe because he was speaking to the choir - at a Federal Reserve conference - he explicitly stated the Fed's grand plan. "[R]ecently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."
In other words, the Federal Reserve is attempting to rescue itself as it did in 1998 and in 2002. Afraid the LTCM failure would cause financial institutions to freeze, the October 15 Greenspan Put inflated confidence and the stock market. In 2002, Federal Reserve governors, in speech after speech, terrorized Americans into believing it had to lift prices or the United States would suffer another Great Depression. This was the rationale for the 1% fed funds rate, the means by which the Fed inflated another asset bubble, the mortgage market, to compensate for its earlier mistake. And now, with the housing market and economy in despair, Kohn has announced the Fed's zero percent interest-rate policy will induce savers into the stock market and the already inflated municipal and federal government bond markets.
Presidential adviser Larry Summers and Secretary of the Treasury Tim Geithner are leading the search for Donald Kohn's replacement. We can be sure this pair of insiders will identify a candidate who will serve the Federal Reserve first and the American people last.
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