Category Archives: Monetary Issues

A Real Bailout For The Banking Industry

Only a week ago, I was claiming that the Bush “plan” to streamline the mortgage-modification process wasn’t a bailout. A bailout is when the government actually spends money or drastically changes regulation in order to give an industry a helping hand. That plan wasn’t a bailout, for many reasons.

But the financial markets weren’t quite happy with this non-action. And today, the Federal Reserve and European central banks chose to cow to their demands, by injecting inflation liquidity into the system:

A day after the Federal Reserve disappointed investors with a modest cut in interest rates, central banks in North America and Europe on Wednesday announced the most aggressive infusion of capital into the banking system since the terrorist attacks of September 2001.

Economists and market specialists say policy makers are trying to reassure bankers that they will stand firm as the lenders of last resort. The coordinated action is being led by the Fed, which will lend $40 billion this month. The European Central Bank, the Bank of England, the Swiss National Bank and the Bank of Canada will lend $50.2 billion this month and next.

“This is basically a reinsurance policy,” said William H. Gross, chief investment officer of the bond management firm Pimco. Central bankers “are saying, ‘We will stand behind you.’ ”

The market is reeling because the rapid expansion of credit is starting to come to an end, and the [necessary] resulting credit crunch will be nearly as painful as the heady days of credit expansion were joyful. The problem is, pain takes the form of recession, and central banks don’t want to stand idly by and let recessions occur, even if necessary. So they’re going to throw money into the system until lenders realize that a contraction won’t occur.

The Fed created this credit bubble. Now when it’s in danger of popping, they’re going to try to patch it up. Like many government actions, it might achieve its goal in the short term, but the long-term consequences will be far more damaging than allowing the system to correct today. Stocks may have rebounded today, but so did gold, an indication that this is a sign of future inflation, adding another story to the house of cards built upon a foundation of sand.

The Mortgage Bailout — Isn’t

The plan coming out of the administration and treasury to prop up the mortgage industry has caused quite an uproar. In particular, there’s been a big debate even within the ranks of contributors to this blog about exactly how smart of an idea this is.

The problem, however, is that we were largely arguing in a vacuum. The particulars of the plan were largely unknown (or not fully understood), even last night as I was writing my own post on the subject. Thus, in a vacuum people are throwing out terms like “bail-out”, and voluntary vs. forced renegotiation (hereafter I will use the term “modify”, as that appears to be the agreed-upon industry term). In general, we were arguing the rhetorical point about government intervention in the market, without really having a handle on what the government was proposing.

Enter a post by Tanta over at Calculated Risk. First, before you continue reading this post, click on the link and read it. Then come back.

As far as I can understand, it boils down to a few key points:

1. Due to the regulatory/contractual structure, lenders did not know whether they could modify loans without violating the contract of the debt instruments they’ve sold to investors.
2. Investor contracts (Pool & Servicing Agreements, or PSA’s) are not uniform, but most are designed such that loans can only be modified under certain circumstances (when in danger of foreclosure). This is due to the fact that the investments are tax-advantaged, and there are very specific rules within the tax code regarding the regulation of such instruments.
3. Lenders and investors wanted a way to modify loans (instead of foreclosing), but they weren’t sure if they could do so, as the typical language in a PSA says “you can follow agreed-upon practices that don’t violate REMIC standards or jeopardize the investment’s Q-status.”
4. The government decided to clarify the meaning of their tax regs and say that such modifications would not violate said standards.

That’s basically it. It looks like lenders and investors were very confused about whether the actions they wanted to take (modifying loans to avoid foreclosures) could legally be done without violating their current contracts. When they’re confused, they often simply don’t act. The government came out and said “yes, what you want to do is legal”, and now the lenders feel more comfortable going forward.

This is why there are three classes of borrowers, and that borrowers capable of refinancing are not eligible for the rate freeze. Those who are capable of refinancing their loan are not considered “in danger of foreclosure”, so they cannot be legally modified within the bounds of the PSA. Their only hope is refinancing. For those with low FICO scores, or other conditions that make refinancing impossible, but are in danger of foreclosure, this gives lenders the ability to modify their loans without fear of legal action under the PSA.

But this isn’t really all about helping borrowers, it’s about letting lenders find a way out of this mess without going belly-up. Which, if you think about it, is entirely consistent with a Bush administration proposal: help the corporations, whether it improves the economy, the housing market, or not. It appears this is a lot more complicated than what fits into a 2-minute sound bite on MSNBC. And like most government actions, between a thin veneer of “public interest”, it’s really about helping out the lenders and investors, not the borrowers.

Of course, the Administration is selling this to the public as if it’s all about helping borrowers. They’re politicians, and they want the public to believe they’re “doing something”. The media isn’t interested in in-depth analysis of the situation, and your average newspaper reader isn’t very interested in getting knee-deep in PSA, REMICs, Q-status, and the like. So only out in the blogosphere does anyone have an incentive to actually call this a non-action, which is what it is.

This isn’t a giveaway to borrowers.
This isn’t a violation of investors’ contracts with lenders.
This isn’t costing the taxpayer money.

This isn’t a bailout.

Are Exports Good?

Now, I know this is a question that most people will answer with a resounding “YES!” After all, exports are the sign of a strong economy, right? And the reason that we’re so pissed off at China is because they keep sending us goods and we’re not sending them nearly as much in return, right?

Well, if you believe in 18th-century mercantilist theory, as I believe the Chinese do, you’d say yes. I don’t know that it is the right answer, though.

Let’s look at your personal lives for a moment. In order to live and be comfortable, you must buy food and goods, pay for shelter, etc. These are imports. There are shipping services such as Plexus Freight ( that bring these imports into the country, making them available to the public. Unfortunately, you need to pay for these imports, and to do so you must trade your labor, your chief export, for dollars that allow you to buy the imports. And don’t forget you also need to hire jonble or another quality assurance company to make sure that quality is maintained from manufacturing the imported product to shipping it. Yet with these costs, it is still profitable for companies to import than export.

What’s the ideal situation? Well, outside of the personal accomplishment many of us feel from working, the ideal situation would be to not work at all, and only receive imports. If you really want to be rich, you would import constantly and never export anything! Of course, that’s not possible for us. We as individuals cannot print money that people will accept for those imports they’re selling, so we must exchange something of value for them. Granted, in the world of voluntary transactions and division of labor, we are both being made richer through this trading process, but we are still forced to export labor in exchange for those imports.

Now, step outside of this situation for a moment, and look at the wider national picture. Should America find exporting to be beneficial? Is an export the sign of a rich populace? I would say that it is not. It may be a productive economy, and there may be low unemployment, but we are working to send stuff away to other people, rather than to be consumed here. A nation which exports constantly without importing an equal number of goods is sending away the fruits of their labor to other nations. They’re becoming poorer in the process!

Ahh, but there’s a conundrum here. That nation is not just sending those exports out as a charitable act, they’re doing so in exchange for money. But what is money? Is money a tangible store of wealth? If money is a tangible store of wealth, they are simply deferring consumption, and not becoming poorer. This is like the individual who wants to save to buy a house, so he defers consumption and lets his bank balance increase to save a down payment. He is not becoming poorer by saving. But what if money isn’t a tangible store of wealth? What if money, due to printing, is a constantly depreciating asset? Well, then the exporting nation does not benefit from the exports. They may have full employment, but they are not making their society richer. (Note that this is a general statement, and the productivity gains and economies of scale generated from such production may– and usually will– have side benefits for their society).

So what is the ideal for a nation? Well, for a nation, the ideal is to fool the world into believing that you’re sending them something of value in exchange for their exports, when you’re really just sending them an empty promise. They take that promise and store it in a “reserve”, where it slowly rots. As we pointed out here and here, America has been taxing the rest of the world in the form of their imports for the last 40 or so years (the time during which the dollar was the world’s reserve currency). America has been getting something for nothing from the world, and thus it’s silly for us to export goods to them instead of using those productive resources to satisfy ever-greater internal demands.

America may see exports as a good thing, but all they really are is a way for other countries to exchange their dollar reserves for durable goods. This is not something we want. We want other countries to hide their dollar reserves in a locked vault and never let them out, because if they use these reserves to start buying goods, the prices rise and we see the inflation that’s been hiding for the last 40 years. As long as those dollars leave our shores and never come back, we’re getting a free lunch. When the world decides they actually want to redeem those dollars for goods, we’ll all be working our butts off and sending the product of that work overseas. Sure, you’ll be making plenty of money by doing all that work, but everything you buy will have risen in price to the point that you’re not better off.

Just like an individual cannot borrow forever, the dollar hegemony won’t last forever. It will come crashing to a halt, and eventually result in crippling inflation and probable war. After all, if the world ever learns that mercantilism doesn’t apply when fiat currencies reign, they might become very upset with America. And rightly so, as they’ve held these dollars expecting us to keep our promises (and keep the dollar stable), and we’ve reneged on that promise. In the process, we’ve gotten a lot of something for nothing, but someday the bill will come due. When the bill comes due, it’s your butt in the factory seat that will be paying it.

The Road To Recession

The American economy, fueled by the mortgage market, has soared over the last few years. What remains to be seen is whether there is a crash, as myself and others are predicting, or a “soft landing”, as many economists predict. Of course, The Economist magazine explains just what those predictions are usually worth:

IN 1929, days after the stockmarket crash, the Harvard Economic Society reassured its subscribers: “A severe depression is outside the range of probability”. In a survey in March 2001, 95% of American economists said there would not be a recession, even though one had already started. Today, most economists do not forecast a recession in America, but the profession’s pitiful forecasting record offers little comfort. Our latest assessment (see article) suggests that the United States may well be heading for recession.

So are we on the road to recession*? A lot of that depends on inflation (see the postscript at the end of this article), which means a lot of it depends on the dollar. I have contended that a lot of our inflation is being hidden by other countries hoarding dollars as a reserve currency, which acts as a sinkhole where those dollars are removed from the general economy. It’s possible, though, that this may be changing:

The enfeebled dollar—lately in sight of $1.50 to the euro—would be weaker still without enormous purchases by central banks in emerging economies. This support is now waning. China and others are putting a smaller share of increases in reserves into the American currency. And Asian and Middle Eastern countries with currencies linked to the dollar are facing rising inflation, but falling American interest rates make it harder to tighten their own monetary policy. They may have to let their currencies rise against the sickly greenback, meaning they will need to buy fewer dollars. More important, as international investors wake up to the relative weakening of America’s economic power, they will surely question why they hold the bulk of their wealth in dollars. The dollar’s decline already amounts to the biggest default in history, having wiped far more off the value of foreigners’ assets than any emerging market has ever done.

The vigour of emerging economies is good news for the world economy: for its growth, it has much less need of a strong America. The bad news for America is that this, in turn, may mean that the world also has less need of the dollar.

Good news for the world… From the emphasized portion of the excerpt above, our inflationary policies continually devalue the reserves of dollars that other nations hold. If they can find a reserve with more stable value than the dollar, they might escape from dollar hegemony. But that’s bad news for America, as we may have to earn our imports, instead of sending newly-printed bills overseas to obtain them.

» Read more

And The Bubble Goes POP!

What happens in an inflationary economic expansion? Credit comes into a market, getting sucked into ever-larger speculative ventures, driving up pricing in an asset class to the point where people check their good sense at the door in exchange for a shot glass full of hysteria. But unfortunately, growth fueled by speculation requires ever-more speculation to sustain it, and eventually the level-headed start to grow in number. When that happens, those holding the bag look for somebody, anybody to sell it to, but nobody’s buying, and the bubble bursts.

A lesson that Countrywide is learning all too quickly:

Countrywide Financial Corp. survived the first phase of the mortgage meltdown this summer thanks in part to a $2-billion investment from Bank of America.

But the Calabasas-based lender suffered a major new setback Tuesday when mortgage giant Freddie Mac posted a big loss and said it needed new capital — which could curb Countrywide’s ability to make loans.

When the mortgage crisis began last summer, Countrywide said it would cut back making higher-risk loans to concentrate on the safer loans it could sell to Freddie Mac and Fannie Mae, the government-chartered buyers of home loans.

That approach is now looking dicey in the wake of Freddie Mac’s surprising $2-billion loss and its announcement that it must raise more capital before its regulator will allow it to step up purchases of loans from lenders such as Countrywide, said Fox-Pitt Kelton analyst Howard Shapiro, who downgraded Countrywide shares.

“Countrywide’s survival strategy has depended on access to the secondary markets” — the companies that, like Fannie Mae and Freddie Mac, buy loans and bundle them into securities for sale, Shapiro wrote. The approach won’t work so well when Freddie Mac and Fannie Mae “are capital-constrained and may need to shrink.”

The merry-go-round has stopped, but Countrywide can’t get off.

In a world with real money, this doesn’t seem to be a problem. If you have to actually hold real money to loan it to somebody else, there is not enough fuel for the speculative fire to burn. In our current world, though, money is effectively free. It can be created out of thin air, and cannot bear to sit in a lake. Much like a river, it needs to flow, and it flows downhill to whoever is offering the greatest returns. Our housing crisis was created by cheap money. When prime lending wasn’t enough to lure the money, subprime and alt-A offered the returns it needed. The money kept flowing until it had saturated the market, and nobody was left to buy. And now it’s flowing elsewhere (perhaps commodities), leaving empty shells of former worth in its wake.

What’s the only way to hide the destruction? More money! And that’s what the traders are clamoring for. Ease the credit crunch! Lower interest rates! Bail-out! But all they’re asking for is air to pump a bubble that’s got a hole in it. They can’t repair the hole, so they desperately hope that if they blow enough air into the bubble, it might remain inflated.

The blame will go far and wide on this one. Unscrupulous lenders. Uninformed consumers. Not enough government regulation. There will be congressional investigations, maybe even some indictments and perp walks.

But only those of us in a tiny minority understand the truth: When money is free, it must expand and remain in motion to survive. It flows from asset class to asset class, but can never stay in one place long enough to be a store of value. Those who understand this– get rich. Those who don’t– get foreclosed.

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