Monday, July 28, 2008

Notes on the Sub-Prime Credit Crisis

The recent news that Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Corporation), the two giant quasi-private, government-created companies, are in need of a Federal bailout is the latest in a series of financial catastrophes that has led to widespread calls for new government regulatory powers over the banking industry. At the same time, a general consensus across the political spectrum (there are exceptions) has developed that holds that the crisis was caused by certain “deregulatory” actions in recent years. As a consequence, free-market capitalism is once again being blamed for a crisis clearly caused and exacerbated by government intervention into the economy.

Clearly, that is, if one takes a broad, historical perspective, which is sorely lacking today. Instead, the crisis is being looked at in snapshot fashion, seeing only the current banking and government set-up with all of its laws, institutions, programs, and regulations as a given. If one were to look at a mighty river, one would know that it did not just begin as what you are observing. Its beginnings trace back to thousands of trickles, which merge into hundreds of creeks, then streams and still larger streams, then tributary rivers, which finally merge into the mighty river you are observing.

But what is being observed in the banking and credit crisis today is only the mighty river at midstream. As a result, all that is seen is some relatively miniscule deregulation, while the whole labyrinth of ever-increasing government interventions dating back decades…the trickles, creeks, streams, and tributaries…are ignored. What is also being observed is that on the surface most of the players in this fiasco are private bankers, mortgage brokers, investment houses, and so on. This gives plausibility to the claim that the free market is to blame. The fallacy being employed, though, is to conflate capitalists with capitalism. Capitalists certainly do exist. But Capitalism, the system of laissez-faire (non-government intervention in private individual economic affairs) is nowhere to be seen.

Yet, it is Capitalism that is being tried, convicted, and sentenced without a hearing. For example, in an article repleat with evasion, Al Meyerhoff writes that "Without regulation, the invisible hand of the market is robbing us blind." (Read my response to Mr. Meyerhoff.) But the fact is that, in a classic scenario that has been repeated across many industries, the private financial industry has been progressively shackled and smothered under governmental controls and statist policies over the past 100 years, resulting in the almost total elimination of anything even remotely resembling a free market. The result has been predictable…one financial crisis after another. From the runaway inflation and soaring interest rates of the 1970s, to the savings & loan collapse of the 1980s, to the current sub-prime debacle that is still unfolding. Each time, the free market is blamed amid calls for more laws and controls.

But the “free market” that allegedly needs fixing is a mirage, having long ago disappeared. Consider:

*The Federal Reserve Board, America’s central bank, controls the value and quantity of money, the raw material of banking. It holds a coercive monopoly on the issuance of currency, which is fiat paper backed not by gold but only by the force of legal tender laws. Private banking institutions are forbidden from holding gold reserves and issuing notes (private money) backed by those reserves, as they were able to do prior to the creation of the Federal Reserve System in 1913, when the era of (almost) truly free banking ended. Private citizens are also forbidden from using privately minted gold and silver currency.

*The “Fed” controls short-term interest rates, expands and contracts credit through its discount window, establishes reserve requirements and capital to assets ratios, and regulates mergers and acquistions, bank ownership rules, and a whole host of other items. The Fed’s inflationary interest rate and credit (i.e., monetary) policies of the last eight to ten years are a big part of the equation in the current crisis.

* Banks are immune to the bankruptcy laws. Instead, when a bank begins to fail, the Fed steps in and “arranges” for a buyer to take over the failing bank’s assets. In other words, rather than face the objective oversight of a bankruptcy judge, as any business would in a free market, the failed bank is embraced by a paternalistic Fed. Depositors and customers are bailed out without even knowing it, helping to feed the illusion in the minds of people that the quality of the banking institution into which they place their savings is irrelevant, short-circuiting a key disciplinary feature of the market. The bankers know this too, which encourages excessive risk-taking and quick-buck artists.

(The Federal Reserve System was created allegedly in response to the “failures” of free, private banking and the gold standard, such as the supposed “confusion” caused by the issuance of multiple bank notes and occasional bank panics. But this phony argument ignores the fact that the US constitution defines American currency in specific weights of gold and silver [Article 1, Section 8], meaning a deviation by any private bank from those standards constitutes illegal fraud. Thus, the Federal Reserve System, having abandoned the gold standard, is itself an unconstitutional fraud. For more on this, consider what Ron Paul has to say. Also, for a detailed history of America’s free banking era, see Richard M. Salsman’s book Gold and Liberty

*Sound, prudent banking is penalized while risky, reckless lending is rewarded by Federal deposit insurance. Prior to deposit insurance (enacted in 1933 and expanded repeatedly since), an imprudent bank quickly saw its deposit base dry up, with the money gravitating toward sounder institutions. Deposit insurance subverts this natural market process, enabling banks with lax credit policies to proliferate at the expense of more cautious ones. Depositors run to banks offering the highest yields without regard to the soundness of the institution or its credit policies, knowing that the government (i.e., the taxpayers), will bail them out. Good banks lose, bad ones win, leading to more bad banks and fewer good ones. The increase in deposit insurance limits from $20,000 to $100,000 in 1980 is the prime reason for the 1980s savings and loan collapse. (For a detailed presentation on the history, practice, and failures of Federal deposit insurance, see Richard M. Salsman’s pamphlet, The Collapse of Deposit Insurance. Also note that money market mutual funds are not insured, yet are highly trusted and popular.)

*Unsound banking is encouraged in other ways as well. The Fed acts as “lender of last resort”, meaning banks know that big daddy will always be there to create money out of thin air…literally. A bank with an over-extended loan portfolio can turn to the Fed’s discount window for below-market, dirt-cheap credit. On top of that, the government’s "too big to fail” policy of bailing out financial institutions has rolled into an enormous snowball. Both of these activities lead to less disciplined and excessively risky credit practices. (Keep in mind that these government operations are financed by artificial money and/or credit creation [inflation], which robs the purchasing power of money held by the country’s productive citizens.)

*An enabling factor in the sub-prime crisis is the fact that the major bond-rating agencies completely missed the impending disaster. Being private companies, they are pointed at as another example of failed capitalism. But even here, the government’s intrusive hand can be found as the culprit. Steve Forbes explains in Cart This Cartel to the Dumpster (Forbes, 5/19/08)

For more than 30 years the SEC [Securities and Exchange Commission] has taken upon itself the task of deciding who should rate debt instruments and who shouldn't. Thus, the industry has been dominated primarily by three firms: Standard & Poor's, Moody’s and, at a distant third, Fitch. Competitors are hobbled in the credit-rating field without the SEC's regulatory blessing.

This cartel is further aided by government laws and regulations that require, in various instances, insurance companies, money funds, banks and other institutions to hold only those debt securities rated by these agencies. In this way the feds not only keep out the competition but also require customers to buy the services of these select few. Investors are ill-served by this federally mandated oligarchy. (emphasis added)

The banking industry is so heavily controlled and regulated that it would be more accurate to call it a quasi-arm of the government. Super-impose on this government appendage the massive state intervention into the housing markets, and you have the still-expanding sub-prime credit crisis. For example, the Federal Home Loan Bank system (FHLBank) was set up to artificially supply banks with funds for home loans. There is the wildly popular home mortgage and property tax deduction. There are the aforementioned Fannie Mae and Freddie Mac behemoths that create an artificially inflated mortgage resale market for mortgage originators to sell into. The government’s attempts to “encourage” homeownership has led to a massive over-“investment” in housing…a bubble that is now deflating.

Super-impose on that the actions of the Federal Housing Administration (or FHA, which insures mortgages for people with poor credit histories and/or minimal home equity) and the politically-imposed Community Reinvestment Act, which forces on lenders low mortgage underwriting standards to help the “poor” afford homes. Writes Jerry Bowyer, in the NY Sun:

The government compels banks to make loans in poor neighborhoods even if the applicants are not considered prime borrowers. You may not know about that because the Community Reinvestment Act is not exactly a household (excuse the pun) name.

But the commercial banks do know about it. They have a CRA department. They get a CRA rating. They know that the way to get a high CRA rating is to make loans to poor applicants or in poor urban neighborhoods regardless of the financial prudence of the loans.

They know that if they don't do this, they will be punished severely by the regulators when they try to make any major change which is dependent on regulatory approval. And they know that pretty much every major change a traditional bank makes is, in fact, subject to regulatory approval. So, they grit their teeth and stamp a big inky "yes" on an application which they know, according to traditional financial standards, deserves a "no."

Add it all up, and you have the witches brew now bubbling over and spreading everywhere, including overseas.

In classic form, rather than look upstream to the tributaries that contributed to this mighty river of financial turmoil, the government will now trample further the underpinnings of the remnants of the free market by abrogating contracts on a massive scale…the very contracts that it is the government’s proper role to enforce and honor. A massive bailout of homeowners and lenders is now underway, paid for with massive money creation (inflation) that is now beginning to manifest itself as it always does…in a general and accelerating spiral of prices.

Bad loans and lending practices can always occur in the free market. But in a free market, where there is no central bank or coercive governmental money monopoly, bank failures are localized and contained. Only government, which today controls the banking industry, can cause such a system-wide failure. The sub-prime crisis has a made-by-government label written all over it. Government, to which the entire banking industry is tied, is the common denominator. Rather than blame the non-existent free market or the pseudo-deregulation of recent years, what’s needed is a thorough examination of the government’s policies, regulations, and programs…including all “sacred cows.” Today’s crisis is only the latest in a series of financial calamities that may only be symptoms of an approaching apocalypse. There will be more. Ultimately, only a return to some form of gold-convertible money will restore financial sanity. As Edmund Contoski writes in Liberty magazine, “…there has never been a paper money unredeemable in a material asset that did not eventually become worthless.” ( Housing Bubble and Bust, Liberty Magazine, July, 2008, page 24)

These brief notes are just that…brief notes…and should not be construed as an exhaustive analysis. They are intended to focus attention on the banking system as it actually is. Everywhere one looks, one finds the distorting hand of government intrusion. As in the case of healthcare, the root of the problem is in the fact that free market capitalism in the financial industry is conspicuous by its absence. The road to recovery begins not in blaming capitalism, but in discovering it.

Post Reference 33

Cart This Cartel to the Dumpster

Ron Paul

Gold and Liberty

The Collapse of Deposit Insurance-and the Case for Abolition

money market mutual funds are not insured

Research & Commentary: Privatization of Fannie and Freddie

Central Planning-Housing Bubble and Bust

Legal Tender Laws and fractional-Reserve Banking

Too Big to Bail

The Government Did It


Don't Blame the Markets

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