1/07/2009

Financial Arms of Mass Destruction (Part 2)

By Sean Hayes (Korea Times 01/08/09)

In last week's article I noted that ``Warren Buffett, who used to utilize credit-default swaps (CDS), called them financial weapons of mass destruction (WMDs). I love Warren Buffett and was a student of his every word during my pre-attorney stockbroker days, but blaming CDS for our present financial difficulties is as logical as blaming the Iraq War on oil or skin cancer on the sun."

The heart of our current difficulties was not `complex financial instruments but many governments the world over, particularly the American government, being hell-bent on distorting markets.

Their policies led to distorted interest rates and asset prices, loans to un-creditworthy borrowers and, eventually, the destruction of our markets.

The first culprit was Alan Greenspan and his serfs at the Federal Reserve. Since 2001, it has drastically increased the money supply while reducing the federal funds rate.

The drastic increase in the money supply led to the increased availability of credit, which overwhelmingly went into real estate. This Fed-induced, credit-fueled artificial demand led to an overheated real estate market and a drastic increase in the construction of new homes.

The dramatic decrease in the federal funds rate from 6.25 percent to 1.75 present led to a negative rate, in real terms. The interest rates were lower than the inflation rate, leading to more adjustable-rate mortgages (ARMs), since short-term interest rates were much lower than long-term interest rates.

The Fed-induced low short-term interest rates led to almost 40 percent of homebuyers choosing ARMs by 2004. When short-term rates began to climb and mortgages adjusted up, many of these new homeowners were unable to pay their mortgages.

The second culprit was a government that encouraged and even mandated the writing of risky mortgages. In 2006, over 23 percent of them were classified as ``nonprime.'' The vast majority included only a small down payment.

The culprits in the government include an administration that extended the Community Reinvestment Act and the Home Mortgage Disclosure Act, the Department of Housing and Urban Development, the Federal Housing Administration, and Fannie Mae and Freddie Mac.

The Community Reinvestment Act and related acts made it more difficult for lenders to receive acceptable bank ratings, which, after the amendments, were heavily influenced by how well a lender ``served'' low, moderate income and minority borrowers.

Without acceptable ratings, banks did not receive permission to merge or establish new branches.

Secondly, the Department of Housing and Urban Development (HUD) lowered payment requirements to only 3 percent. Many private lenders, in order to compete, followed suit. These low down payment mortgages were some of the first to fail.

The Department of Housing and Urban Development also strong-armed lenders to offer loans to ``nonprime'' borrowers by suing lenders who declined higher percentages of minority applicants, leading to many lenders not only evaluating credit risk but evaluating lawsuit risk.

Finally, Fannie and Freddie Mac grew to hold over half of the U.S. mortgage market. HUD set ``affordable housing'' goals; 52 percent of borrowers had to be below-median income earners.
Institutional investors were more than willing to feed these goliaths since they had the implicit guarantee of the U.S. government.

Many in D.C. tried to reign in on them but they had the strong backing of some of the most powerful people in Washington, including our usually regulation-friendly Barney Frank, chairman of the House Financial Services Committee, who strongly opposed plans to monitor Fannie and Freddie Mac, noting that the agencies ``are not facing any kind of financial crisis … The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.''

He added, in a House hearing, that ``there has been more alarm raised about potential unsafety and unsoundness than, in fact exists … I want to roll the dice a little bit more in this situation toward subsidized housing.''

Hopefully, we can give credit where credit is due and learn, as Professor Lawrence White has noted, that ``Cheap-money policies by the Federal Reserve system do not produce a sustainable prosperity. Hiding the cost of mortgage subsidies off-budget, as by imposing `affordable housing' regulatory mandates on banks and by providing implicit taxpayer guarantees on Fannie and Freddie Mac bonds, does not give us more housing at nobody's expense.''

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SeanHayes@ipglegal.com