Cannibals on the Street?

Sometimes the things that are under the surface take a long time to finish growing and finally come up to show off their real faces. The American people are about to get a peek at what they have been growing under the rug for the past century or so.

The first little fungus to erupt is the Federal Reserve Banking System. Most Americans are under the impression that the Federal Reserve is a part of the government -- an extension, if you will, of the Treasury Department. They do not realize that it is a private bank for bankers, given special privileges by the government. It has a monopoly position on the issuance of currency, and can "create" money at its whim.

Part of the lure of the Federal Reserve System has been the ability of the Fed to loan money to its member banks, and to set the interest rate privately. Thus, while the politicians pride themselves in having maintained a "free market" in our economy, the roots of the market have been captivated by the governors of the Federal Reserve. To control the level of public confidence in the currency printed by the Fed (you know, those green things in your wallet that say "Federal Reserve Note"?), interest rates have been manipulated outside the market.

Thus, to slow inflation, the Fed has traditionally raised interest rates to its member banks, and since they are bound to the Fed (they own shares), they will not borrow money in the world market at interest rates that actually reflect the value (buying power) of the little green certificates. To spur the economy, the Fed would lower interest rates, making it easier for consumers to borrow -- the member banks set the rates for mortgage and credit card loans -- regardless what the open market would say about the money supply.

It was all an elaborate shell game, and worked quite well, as long as people continued to believe in the Tooth Fairy, and ignored the impact of social engineering on spending.

The Great Depression provided the first opportunity for the Fed to exercise its muscle. Under the policies of FDR, the national banking system coalesced around the idea that the government would guarantee the safety of private depositors; the FDIC was born. Further, the national currency was divorced from the "gold standard"; gold became an illegal substance for private citizens, and the dollar bill began to bear the words "Silver Certificate". Fort Knox, however, remained the repository of the nation's wealth, as the gold stored there encouraged the world citizen to have confidence that if they accepted payment in US dollars, at least their government could in some way collect in gold what was owed them. The rest of the world never left the "gold standard", even if Americans believed the fairy tale.

As a result of a World War from which the US emerged victorious with its industrial capacity intact, the fiction was sustainable. Americans grew to expect the prosperity that came from being the only (for a while) provider of industrial goods for the world market. In the decade following World War 2, as the German and Japanese economies began to recover, there was little competitive pressure on American industry. The German industrial heartland had been given to the Soviets to rule, and under their socialist regime, there was no danger of a resurgence to compete with the US. Western Germany was forced to rebuild what little industrial capacity it had, and develop new industries. Japan had never had a consumer-oriented industrial base -- most of its industrial production had been at the command of its imperialists and warlords -- and as it went through its new metamorphosis, the standard joke in the US was "Made in Japan".

In the second decade following World War 2, the emerging manufacturies of Japan and Germany began to address their weaknesses in the American market. Japan attacked quality control, and Germany worked at luxury market share. The Germans had a slight advantage, since they had been known for high-quality goods prior to their defeat and division, but the Japanese quietly mimicked the best German designs and undersold their American competitors, since their labor costs were substantially less. The American worker had enjoyed a monopolistic advantage for almost a generation, and demanded from the capitalist bosses ever larger wages and benefits. Had the increase in costs been re-spent on domestic production, the "trickle-down" might have been more uniform, but with American markets opening to the much less expensive foreign products, the increased American wages and benefits tended to trickle down to foreign economies.

Toward the end of the 1960's, America became preoccupied with long-overdue social justice issues. Not only was racial equality pushed to the front of the domestic political agenda, but the industrial heartland felt the guilt of rural poverty -- the hardscrabble farmers and miners who had provided the raw materials for the industrial growth had been left behind in the race to national prosperity. In addition, the plight of the urban poor, largely at that time Black Americans who had suffered discrimination in so many ways, was exposed to the national conscience.

Had the equality sought by Martin Luther King, Jr. sufficed, the Civil Rights Movement would have triumphed, since there was a large and relatively prosperous Black middle class that had grown up within that segregated society. Guilt, however. is a powerful motivator, and LBJ, with his Great Society, was able to sell to Middle America the socialism that would create central government entitlement programs which would ultimately dwarf all other government costs. That would create a permanent underclass, with no respect to race, color, or national origin, depending on government handouts and market manipulation.

Nixon restored to the American citizen the right to own gold, but the "Silver Certificate" had gone out of print in 1963, under JFK, and redemption of the certificates for silver ended in 1968 under LBJ. Inflation had caused the price of silver to exceed the official backing price of the dollar because the total outflows of dollars to other countries, partly due to trade, and partly due to foreign aid, had exceeded the inflows. In short, America was buying more foreign made goods than it was selling back to foreign markets. Nixon recognized the problem, saw the rift between China and the Soviet Union as a tool, and opened China to US trade as a means of correcting the imbalance.

The rise of OPEC, however, caught the American economy off-guard. Never before had a cartel been large enough to impact the cost of American living overall. With the sudden rise in energy costs, inflation jumped, and the political answer seemed to lie in wage and price controls. The Fed raised interest rates to try to control inflation, and the economy staggered. By 1980, under Carter, the prime rate had been raised to over 21%. The Savings and Loan portion of the banking industry suffered severely, and under Carter the caps that had hindered S&L mortgage lending were lifted.

With the Reagan presidency, the economy recovered through the stimulation that was provided investment via the Reagan tax cuts. However, the S&Ls were also allowed to begin borrowing from the Federal Reserve to augment their deposit income. Because they were not under the same kind of regulatory oversight as the Federally chartered banks, risky and imprudent lending brought about the S&L collapse. It was at this time, also, that the S&Ls were allowed to sell their mortgages and have them transformed into securities.

Under GHW Bush, FIRREA was passed, and Fannie Mae and Freddie Mac were encouraged to increase the availability of low-cost mortgages to lower income families. Because the S&Ls had declined in number, there were competitive openings for other private lenders to get involved. Mortgage brokerage became a very viable alternative to traditional mortgage lending, since a pool of mortgages could be combined and sold as securities by GNMA. During most of the Clinton presidency, interest rates remained relatively high -- above 8% -- as the Fed worked to keep inflation down under the growing ability of private mortgage companies to "create" money.

After September 11, 2001, the US economy stumbled, and the Fed was called upon to reduce interest rates in order to raise confidence in the economy. The lowered interest rates made it attractive to refinance existing mortgages, and, in the refinancing, to extend the debt. This worked to further the social engineering aspect; a primary focus of "compassionate conservatism" was affordable housing, and the boast of increased homeownership was heard. Unfortunately, the effects of supply and demand were ignored; growth was fueled by new construction and in many areas of the country, the supply of housing was greater than the number of households to occupy it.

Also, in order to enlarge the pool of new homeowners, requirements for down payments were reduced; whereas normal lending practice in more conservative times called for a 10%-20% down payment, with mortgage insurance required to underwrite any down payment of less than 20% (FHA mortgages are mortgages with the lower down payment insured by HUD). Private mortgage insurers became very profitable businesses.

It became apparent to some participants in the market that the cost of PMI was a hindrance to the mortgage boom. There appeared to be a rise in mean sales prices (a factor which was probably a result of the higher prices of new homes rather than an actual increase in the value of the existing stock, since the supply was outpacing the demand), and an unregulated cottage industry arose in which mortgage brokers encouraged refinancing to eliminate the PMI premium on the mortgages which had little homeowner equity behind them.

Pressure was applied to appraisers to "hit the number" needed to make the loan. In many cases, this was as little as a 5%-10% increase in perceived value, which could be accomplished by skillfully manipulating comparable sales data. It was further assisted by published government and trade association statistics which made sweeping generalizations as to the rate of increase in "value". Appraisers who failed to go along with the program found their business volume declining. Hordes of new appraisers were trained, most often by the value-inflating appraisers who were swamped with business, and speed and low cost, rather than quality of analysis, became the hallmark of a successful appraisal practice. Such qualities were demanded by the clients. It was even argued by some appraisers that their upper end value opinions were justifiable, since the increases sought were so small, as a percentage, and, after all, government-supplied statistics backed their opinions.

The mortgages generated by such practices, sold as securities on the secondary mortgage market by such players as Bear Stearns, reached their peak volume in 2005. At that point, the Fed determined that inflation was beginning to increase, and minor moves upward were made in the Federal discount rate. This had the effect of slowing, almost imperceptibly, the refinance boom. The larger effect was on the lending products that had been pushed to the marginal borrowers. Many of those loans had been made as adjustable-rate mortgages, with low or no interest teaser periods. Some had been made as interest-only loans, also with adjustable rate structures.

These products had been sold to investors with the understanding that by making the loan now, at below-market rates, the returns later, after the resets, would cause the loans to be profitable in the long run. Because they were securities, traded on the world market, they were purchased by investors world-wide. Banks in Europe, in particular, found these securities attractive.

European investors, stymied by slow growth in their industrial sectors because they were also facing competition from emerging Third World producers, turned to American mortgage-backed securities rather than investing their money in the socialistically restrictive economies of their own countries. It would prove to be their undoing.

As the resets began to occur in 2005, the borrowers for those mortgages were faced with either accepting the higher payment amounts, refinancing at current rates (which had also increased), or defaulting. A small percentage began defaulting. As 2006 wore on, the volume of new construction sales declined, since it became harder to finance those homes under the liberal rates that had been available before. The decline in new construction sales, which had driven the upward trend of the market, caused the overall mean sales prices to begin to decline. As the mean sales prices began to decline in most markets, it became just a bit harder to obtain a loan at what was viewed as the upper end of the range; resale prices then began to decline a bit as existing stocks of housing on the market were enlarged. Because the comparable sales no longer existed to justify lending at the levels that previously existed, borrowers whose mortgages were resetting found it harder to refinance, even at the higher rates. The number of defaults began to climb precipitously.

By mid-2007 serious questions were being asked about the quality of collateral backing some of the securities handled by Bear Stearns and other financial houses. The ratings of such companies were reduced, and investors began to sell off their securities. In a climate of doubt over their value (and it should be remembered that value is a perception, not a fact), the values naturally declined. With a decline in the confidence in the backing of those securities, the entire credit marketplace underwent a transition. Creditors -- the major banks behind both mortgages and credit cards -- tightened their criteria and actually became punitive toward otherwise good credit risks (all the while continuing to try to lure borrowers with introductory "0%" interest rates). Industrial borrowers found it more difficult to borrow to meet ordinary operations, driving up their costs and reducing their profitability. The stock market has reacted accordingly, seeking investments that are either seen as "safer" or "more profitable".

Behind the scenes, the Federal Reserve has been manipulating the rates. We now see a situation in which a financial company, Bear Stearns, has been purchased by a Federal Reserve member bank, JP Morgan Chase, at a fraction of its book value, under direct duress from the Federal Reserve (a threat to the Bear Stearns management do the deal NOW, at an unrealistically low price, because the backing for it may not exist later). This smacks of cannibalism, one bank eating another, to the benefit of the Federal Reserve governors. The spring rains have brought the mushroom out in the open.

It is easy to blame the Federal Reserve. That bank, however, is doing what comes naturally. Big loan sharks eat little loan sharks. For the ordinary investor, the question now is, "Whenever the DOW rises, is that a fake come-on by the big players to encourage the less wary to buy their worthless assets? Are the big boys simply seeding the marketplace and pulling back once the less wary step in and buy their overpriced holdings?" If you are a little shark, be careful that your eyes are not bigger than your stomach.