Whither, Federal Reserve? (1) Before Our Crash
The Federal Reserve seems to be a big black box, containing magic. In fact, its high-wire acrobatics must not be allowed to fail. Nevertheless, it may be time to consider revising or replacing it.
Banking Panic 2007-2009 (1)
Mankind hasn't learned how to control sudden wealth, whether in families, third-world countries, or the richest nation in history. The world banking crisis of 2007 is the biggest example yet.
Whither, Federal Reserve? (2)After Our Crash
Whither, Federal Reserve? (2)
Merrill Lynch admitted it lost a hundred billion dollars in 2008, maybe more. To read the news accounts, one would suppose the only news was it overpaid its executives. To put the matter in some sort of perspective, the really astonishing thing was they lost $100 billion -- and didn't go bankrupt. Just imagine how profitable a business must be to take losses like that, with maybe more to come, and remain standing. Securitization of debt may be hard to understand, but it's a gold mine. Mortgages are currently the biggest part of it, but securitization -- changing debts into bonds--can apply to any debt, so we are discussing a fundamental change in the definition of debt which generates enormous efficiencies. The government-subsidized variety held by Fannie Mae and Freddie Mac represents half of the mortgages in the country, some $5 trillion dollars worth, equal to the national debt. The other half was fast on its way to becoming involved in the private-sector variant, Collateralized Debt Obligations (CDO), when the markets nearly collapsed under the strain. Let's do some rough math.
The fundamental insight was that risk was overpriced in the market. Since sovereign governments can print money, their debts will always be paid; they are risk-free if you ignore inflation. Thirty-year government bonds pay 4.5% interest, so thirty-year private debts must pay more, because they contain some risk of default. The extra interest, which normally varies from one to thirteen percent, is called a risk premium. During inflationary times, the risk premium can be considerably more, but then it's an inflation-risk premium. Loan sharks often charge fifty percent on top of normal interest; call that the Mafia premium. Whatever. The central point which has only recently been recognized is that computers allow you to calculate the actual rate of default on risky mortgages. The going rate of the risk premium had long been priced considerably higher than the actual experience of default. The risk premium was bigger than the risk. Once you know that, you see that only one problem remains: how do you capture that extra interest rate, and pocket most of it yourself?
That's really all there is to this supposedly complicated business. The incentives are huge. If you could extract one percent from $10 trillion of American mortgages, you would extract what Merrill Lynch just lost, a hundred billion dollars. A conservative guess might be that the "un-earned" risk premium of American mortgages would come close to a quarter of a trillion dollars, every year. That's just home mortgages; there are plenty of debts with other kinds of collateral. So the gold rush was on. The influx of Far Eastern and Middle Eastern money drove down interest rates, so it became comparatively easy to borrow huge amounts of money to lend out at a premium that still looked pretty good to the home purchaser, but left plenty for the packager. The ingenuity of this packaging and the monumental task of organizing an international distribution network are not to be scoffed at. But it is not described here, because it distracts attention from the main points. This was a gold rush, it was quite complicated, and there were loose ends that nearly toppled it.
But the fact nevertheless remains that all economies for all time will be stimulated by a permanent reduction of interest rates in the debts of every nook and corner of life. More people everywhere will be able to afford things they couldn't afford, and it will be a legitimate part of commercial life, not a government hand-out.
Nevertheless, there are losers. Over a period of eighty years, Fannie and Freddie had gradually accumulated half of the mortgages in America, by enjoying an informal guarantee by the Federal Government with its printing presses. Their rates were lower than commercial rates, so why wouldn't a homeowner take advantage of the fact? However, these new Wall Street arrangements which nobody seemed to explain, might be cheaper still. Since the securities were effectively bundles of thousands of mortgages, everything depended on what proportion were held by sound honest people, and how many were held by, let us delicately say, subprime borrowers. In the hurry to get into the Gold Rush, inadequate information was collected, and some of it was just plain inaccurate. It would have been a straight forward administrative task to devise a safe system, but there was no time. The first to move into a new field, sweeps the field.
So now there remain only the Government Sponsored Entities, Fannie and Freddie, to re-insure home mortgages, because in the panic the market for CDOs pretty well dried up, and why not. The immediate problem is that years of political influence peddling has undermined the quality of these giant organizations, currently enjoying panicked protection by allied Congressmen up for election. The government has teams of accountants combing through their books to see if they are salvageable. The Secretary of the Treasury said ten times if he said it once, that by guaranteeing the debts of these agencies, he has doubled the national debt. It doesn't inspire confidence to hear that.
But even if Fannie Mae can be patched together for the short term, there is a long term concern. Eventually, Wall Street will get its shop in order, too. At that point, it will be possible to know if the efficiencies of securitizing debt result in lower rates to the customer -- than mortgages subsidized by the government. If it's anywhere near close, our government made a bad bet, worth $5 trillion dollars.