The broker-based subprime model was thus an offspring of the Fed’s bull market in housing and, in fact, was guaranteed to fail the minute the housing price spiral stopped. The founder of Guardian Savings, for example, famously insisted that borrower ability to make the monthly payment had nothing to do with his new-style subprime lending. “If they have a house, if the owner has a pulse,” quipped Russell Jedinak, “we’ll give them a loan.”
Sometime later, one of Jedinak’s disillusioned collaborators completed the picture with respect to Guardian’s business model: “They were banking on a model of an ever rising housing market.”
Needless to say, rising housing prices and serial refinancings did wonders for reported default rates. Before failing loans could hit the default statistics, subprime lenders kicked the can down the road, converting imminent or actual defaults into new originations. Bearish evidence of stress and underwriting failure was thereby transformed into bullish signs of growth in lending volumes.
Not surprisingly, nearly 85 percent of these early vintage subprime mortgages were refinancings. Often these were of the “cash-out” variety, meaning that borrowers were given enough extra cash to meet the monthly payments until the next refinancing. In this manner, such borrowers remained “current.”
This kind of “churn” was an old trick of scam artists in traditional securities markets. But prior to the 1990s there had never been a strong, chronic inflation of residential housing prices in the context of deregulated financial institutions. Accordingly, even one of the astute founders of the government mortgage-backed securities business, Larry Fink, could not imagine a market for privately securitized subprime loans.
Asked by a congressional committee in the late 1980s whether Wall Street might try to securitize risky mortgages, Fink dispatched the notion cleanly: “I can’t even fathom what kind of mortgage that is … but if there is such an animal, the marketplace … may just price that security out [of existence].”
In short, the subprime mortgage industry was not a natural product of the free market. Instead, it was a deformed by-product of the financial asset inflation the Fed persistently fostered after its October 1987 Black Monday panic. Larry Fink failed to imagine that highly risky mortgages could be economically securitized because he had not yet realized that cheap mortgage debt and rising housing prices would converge in a hidden default cycle of rinse and repeat.
CHURN AND BURN: HOW THE HOUSING PRICE SPIRAL FOSTERED THE MORTGAGE BROKER PLAGUE
The financial innovation labs of Wall Street did, in fact, invent the estimable mechanisms of credit enhancement such as overcollateralization and senior-subordinated tranching of subprime mortgage pools. But all the razzmatazz of structured finance did not make subprime lending safer or more financially viable.
Securitization just shuffled around among the various investor classes the drastically underestimated default loss projections cranked out by subprime underwriters. Not only did these projections suffer from the inherent refinancing bias of a bull market in housing, but this contamination of the performance data actually became more severe as the housing price spiral accelerated.
This pernicious feedback loop was crucial to the final explosion of the subprime mortgage market in 2004–2006. It was not coincidental that the single most nefarious operator among the rogue’s gallery of subprime entrepreneurs, Roland Arnall of Long Beach Savings and Ameriquest fame, ceremoniously ditched his thrift charter in 1994. This was a smoking gun. Just as the subprime party was getting started, its most important figure elected to go the pure mortgage banker and broker route—funding his originations with warehouse credit lines and wholesaling the resulting mortgages to the incipient Wall Street securitization machine.
Here, then, was one of the great financial deformations which emerged from the age of bubble finance. A multi-trillion business in dodgy housing loans was eventually built by mortgage brokers who could not actually raise capital or funding on the free market and, indeed, not even in the state-supported market for insured deposits. At the end of the day, it was only when the Fed flooded Wall Street with liquidity after December 2000 that Larry Fink’s “impossible” market achieved liftoff.
Indeed, absent the rise of the mortgage banker and broker industry and the GSE and Wall Street financing channels on which they were wholly dependent, the next decade’s disastrous breakdown of mortgage credit quality might never have happened. The data show that the stiff-necked loan officers who populated the Main Street banks and thrifts which survived the savings and loan meltdown gave subprime mortgages a wide birth, putting up less than 1 percent of their balance sheets for these risky assets.
The nation’s epic housing disaster was thus not inevitable, but was spawned by Washington policy makers who adopted serial measures that put housing and mortgage finance squarely in harm’s way. So doing, they brought the gambling mania to America’s neighborhoods, and, in the end, to the most economically vulnerable among them.
CHAPTER 21
THE GREAT FINANCIAL
ENGINEERING BINGE
THE MENACE POSED BY THE TOTTERING MEGA-BANKS, THE MASSIVE housing bubble, and the household consumption binge, among others, was definitely not noticed in the Eccles Building. Instead, the Fed went all-in on the Great Moderation, and after January 2006 was led by the theory’s own self-deluded proponent. Wall Street had christened this alleged combination of low inflation and moderate growth as the “Goldilocks economy” and, believing Bernanke could perpetuate it indefinitely, drove the stock averages back to their dot-com bubble highs and beyond.
There was no Goldilocks economy, however, and the stock indices were being artificially levitated by a spree of destructive financial engineering fostered by the Fed. The real numbers showed that the American economy was failing: inflation was being temporarily repressed by the export factories of China, not by the deft maneuvers of the Fed. And real GDP was actually just limping along at its worst rate since the 1930s, notwithstanding the wholly unsustainable growth of household debt.
So the nation’s monetary politburo should have been focused on quashing the debt-fueled outbreak of corporate financial engineering, that is, leveraged buyouts, M&A takeovers, and stock buybacks. That these true dangers were completely ignored was in large measure attributable to the fact that the Fed was now in the hands of a timorous academic who didn’t have a trace of Volcker in him—who wouldn’t even dream of facing down the Wall Street gamblers, looters, and empire builders who were taking the financial system over the edge.
BERNANKE’S DEFLATION HOBGOBLIN AND MORGAN STANLEY BAILOUT II
The reason that Bernanke could not do his job and bring Wall Street’s speculative furies to heel was not merely personal weakness. He was obsessed by theoretical hobgoblins of deflation and depression. As detailed in chapter 8 and explicated further in chapter 29, these were not remotely relevant to the actual circumstances of the American economy. So when the destructive Greenspan bubble began to deflate, the Fed did not permit the markets to liquidate what remained of the Wall Street train wreck it had fostered.
Instead it retreated into headlong panic, pulling out every imaginable stop to reflate these dying financial behemoths. The Bernanke worldview thus engendered a level of desperation in the Eccles Building that knew no bounds. Falsely believing that the US economy was heading for a Great Depression 2.0, the Fed not only expanded its balance sheet by $1.3 trillion in thirteen weeks—that is, by $600 million per hour—but did so in a manner that was utterly indiscriminate and without principle or plan.
As detailed in part 1, the Fed’s alphabet soup of cash-pumping programs effectively nationalized the entire $2 trillion commercial paper market, guaranteed the checking accounts of everyone including Exxon, Microsoft, and Warren Buffet, and wantonly handed AAA-rated General Electric $30 billion of loan guarantees. It even artificially propped up the ABCP market so that the likes of Citigroup could continuing booking profits the very nanosecond customers swiped their credit cards.
These cash-pumping actions were so reckless that even the outrageous anecdotes to which they gave rise can scarcely capture the lunacy rampant in the Eccles Building. In one ludicrous case, therefore, the nation’s central bank actually guaranteed upward of $200 million that had been borrowed by two New York housewives to start a new business. Amazingly, the purpose was to enable this intrepid duo to purchase large volumes of securitized auto loans about which they knew nothing.
Even in November 2008, the American economy did not need two amateurs to make car loans. The Main Street banks were flush with cash and willing to make such loans to any creditworthy buyer. Likewise, these two housewives most especially did not need a bailout from the Fed: their husbands were the top executives of Morgan Stanley, a firm that by then had already received its own bailout.
Foolish episodes like this one underscore the pathetic consequence of Bernanke’s doctrinal error. He was so desperate to prop up Wall Street that he approved a $200 million car loan to Christy Mack, the wife of John Mack of Morgan Stanley, and her social pal, Susan Karches.
In truth, the real problem facing the Fed was not another externally based industrial collapse like the Great Depression, but a long twilight of internal debt deflation. The tip-off was evident in two key economic variables with sharply divergent peak-to-peak growth rates during the alleged economic boom of this century’s first decade.
The first of these was nominal GDP, which grew at a modest annual rate of 5.1 percent over the seven-year business cycle ending in late 2007. The second measure was total credit market debt outstanding, which bounded upward at nearly double that rate, rising by 9.2 percent annually. It wasn’t a sensible or sustainable equation, a truth that is self-evident in the whole numbers.
Total debt outstanding surged by $23 trillion, rising from $27 to $50 trillion between 2000 and 2007. The nation’s nominal GDP, however, grew by only $4 trillion (from $10 to $14 trillion). During the second Greenspan bubble it thus took nearly $6 of new borrowings to generate another $1 of national income.
The Fed’s radical interest rate repression campaign, which fostered this unprecedented debt explosion, was thus an utterly misbegotten enterprise. The very notion that the central bank would deliberately peg the money market rate at 1 percent was just plain off the deep end; it defied all historical canons of sound finance.
The end result was a vicious financial bubble that exploded from its inner tensions and instabilities in September 2008. Yet the Fed couldn’t explain why the Wall Street meltdown happened owing to a singular reality: the stock market had been propped up all along by a financial engineering binge that had been enabled by the Fed’s own policies.
WHEN HELICOPTER BEN CRIED WOLF ABOUT DEFLATION
The unwinding of the massive Greenspan debt bubble implicated an extended deleveraging cycle in which the phony growth of the bubble years would be given back and there would be persistent downward pressure on consumer prices. But a modest reprieve from the relentless forty-year rise in the cost of living, which meant that a dollar saved in 1971 was now worth just twenty-five cents, would have been beneficial to much of society. Wage workers and retirees whose incomes had not even kept up with the understated CPI-U (consumer price index for all urban consumers) would have especially benefited.
This kind of slow, constructive deflation owing to the end of the American debt binge, however, would not have been even remotely comparable to the 30 percent drop in consumer prices after the 1929 crash, nor would it have triggered a depressionary collapse of output and employment (see chapter 29).
In truth, Professor Bernanke was exploiting his reputation as a Depression scholar to peddle the Keynesian canard that price stability—that is, zero inflation plus or minus—is a bad thing. Indeed, Bernanke had gone fully Orwellian: what “deflation” meant to the money printers at the Fed was the absence of 2 percent “inflation.” Through some economic alchemy that has never been proven, they insisted that the way to get more jobs and output growth was to debauch the money by 2 percent each year; that is, reduce the dollar’s purchasing power by 50 percent over a standard working lifetime.
This was the second time that Bernanke had played the “deflation” card. Back in 2002–2003, he had provided exactly the same rationale for the Fed’s first round of panicked interest rate cutting. Freshly appointed to the Fed, he had hinted darkly about a 1930s-style deflation. But the actual data soon proved that to be balderdash.
Goods and services inflation was still very much alive and kicking and remained so right through the last days of the Greenspan bubble. The aforementioned $4 trillion debt-swollen gain in nominal GDP during 2000–2007, for example, was rife with inflation. More than half of this figure, $2.2 trillion, did not represent real output gains; it simply quantified the impact of the very rising prices that Professor Bernanke had claimed would soon be smothered in a vortex of deflation.
Bernanke’s howling at the specter of deflation, in fact, proved to be loony: the CPI actually increased at a 2.7 percent annual rate during the five years through 2007, and that rate wasn’t benign. It meant that inflation would steal nearly 60 percent of the dollar’s purchasing power every thirty years. So there was a menace in the price trend: with the cost-of-living rising stoutly, it put “paid” to Bernanke’s “deflation” warnings.
That should have also roundly discredited the Fed’s radical interest rate cutting campaign, which was predicated almost exclusively on Bernanke’s phony deflation scare. Instead, Professor Bernanke got promoted in 2005 to the top economic job in what was ostensibly a “sound money” Republican White House.
To their everlasting discredit, Karl Rove and the Bush apparatchiks around him could administer a litmus test on abortion to any schedule-C job seeker who came along. Yet they did not know they had brought a Keynesian money printer into their midst, an unabashed believer in Big Government who had publicly described exactly how to drop money out of a helicopter.
THE GREENSPAN-BERNANKE MONEY-PRINTING SPREE WAS A DUD: WEAKEST GROWTH IN HALF A CENTURY
All of the Fed’s money printing and interest rate repression during this period did not do much for the economy of Main Street, either. During the seven-year period through the 2007 peak, national output adjusted for inflation expanded at just 2.3 percent per year. That was the lowest seven-year rate of GDP growth since the 1930s, meaning that the Fed’s wild money printing produced a dud.
What it actually generated, instead, was a lot of spending from borrowed money and very little growth in real investment and earned incomes. In fact, the three consuming sectors of the American economy—personal consumption (PCE), residential housing, and government expenditures—accounted for virtually all of the growth. These sectors expanded by $4.1 trillion between 2000 and 2007, thereby accounting for a remarkable 98 percent of the entire gain in nominal GDP.
Debt growth in all three of these sectors was exceedingly robust. On the margin, therefore, much of the gain in the GDP “print” during the Greenspan boom was simply a feedback loop: the higher GDP “prints” embodied in roundabout fashion the debt being injected into the spending side of the economy by the central bank.
In contrast to the debt-funded spending side, growth on the investment and income side was punk. Real spending for fixed plant and equipment, for example, rose at only a 1.7 percent annual rate during these seven years and actually by less than 1 percent when the Great Recession period “payback” is averaged in. Likewise, real private wage and salary incomes grew at just 1.6 percent annually—a plodding rate which obviously begs the question of how real personal consumption spending managed to grow at nearly twice that rate, or by about 2.8 percent, during the same period.
There was really no mystery. The US economy was now getting deeply entangled in an accounting illusion. Part of the extra margin of household spending compared to private wages and salaries reflected cash that was being dispensed from home ATM machines and recorded in the drawdown of the savings rate. But there was also
a huge supplement to household consumption which came through the debt economy’s back door; that is, from the spend out of transfer payments and government payroll disbursements.
As detailed in chapter 29, most of the growth in these latter categories was not owing to the honest “repurposing” of national income that occurs when transfer payments are funded with taxes. Instead, it was derived from public sector borrowings; that is, new money supplied by foreigners and their central banks or from the printing-press-funded purchases of Treasury debt by the Fed.
Notwithstanding Republican White House cheerleading, therefore, it was transfer payments—which grew at double the rate of private wages—and government payrolls that comprised the fastest growing slice of the income pie. During the seven-year Greenspan bubble these disbursements rose from $1.8 trillion to $2.8 trillion, and accounted for nearly half of the nation’s entire pre-tax income gain. That was hardly an indicator of booming capitalist prosperity.
When government borrowing of this magnitude occurs on the free market, of course, there is an offset. Interest rates are forced up and interest-sensitive spending on capital goods and consumer durables soon buckles, thereby short-circuiting any tendency of legislators to imbibe in free lunch economics. As previously detailed, the trick that made the faux prosperity of the Greenspan era possible was the nation’s giant current account deficit with the rest of the world. The latter reached a peak of $750 billion and 6 percent of GDP in 2006, underscoring that the prosperity of the Greenspan bubble years was being imported on container ships from East Asia and funded by soaring indebtedness to the rest of the world.
The Great Deformation Page 61
