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Guest Blog Post-All Systems Go

April 29, 2013

Wayne Heine has been a long time friend of mine and as scary as it might sound, he has some very similar concerns to mine about our economic, political and monetary policies. I asked Wayne if he might occasionally like to write for this blog and here is his first piece. I think it is a good history lesson. If we cannot learn from our past mistakes, we cannot learn.

Numerous articles espouse different theories about who is responsible for the housing bubble and why it was able to grow so large without detection from the Federal Reserve, numerous and redundant government agencies, legislative committees or private rating bureaus that watch-dog the financial system. We have all read and listened to never ending political spin, finger pointing and disingenuous conjecture — if not outright lies — concocted to deflect any possibility of wrong doing arriving at someone’s door step. One thing for sure, no mea culpas are in the wind — past, present or future. So it is clear that to understand the making of the real estate bubble we must conduct investigation on our own.

I suppose we could start with the advent of the Federal Reserve; or perhaps Keynesian economics adopted during the Great Depression; or leaving the gold standard which ultimately led to the creation of a credit standard and subsequent fiat currency. All of these and many other factors may or may not have been responsible, individually or in aggregate, for what has followed. But it is clear that a sequence of events, either by design or accident, has caused the greatest economic collapse of my life time to date. As I began to look closer at the real estate bubble and subsequent collapse, I realized there were some pivotal pieces of legislation and clear manipulation of interest rates that seem to have played a leading role in the creation, expansion and ultimate popping of the infamous real estate bubble of 2008.

The story begins with the Housing and Community Development Act, 1977. This act was intended to stop discriminatory lending practices against low income neighborhoods. This practice was known at the time as “redlining.” From 1977 on, the act was amended numerous times by both Democrat and Republican Presidents. (I am not trying to place blame — merely trying to connect the dots.) In response to the Savings and Loan debacle of the 1980s President Bush (senior) signed an amendment to the act which allowed for greater government oversight of banks to assure that the community’s credit needs were being met, including low and moderate income families. Additionally, the Act required that banks be examined and rated according to four criteria ranging from “Outstanding” to “Substantial Noncompliance.’ Amendments in 1991 and 1992 did not significantly change the original intent of the Act. The focus was still on providing credit to worthy borrowers, regardless of where they lived. In 1994, a portion of the Act was repealed which had placed restrictions on interstate banking.

However, in 1995 President Bill Clinton, at the advice of Robert Ruben, Assistant to the President for Economic Policy and Lloyd Bentsen, Secretary of the Treasury, successfully amended the Act to further expand government oversight of lending practices to assure that those who had the ability to pay back loans were not punished because of where they lived It was argued that the amendments made it easier for lenders to comply with the Act by reducing burdensome paper work and costs to small business.

At that time, there were a substantial number of critics to these amendments who argued that too much government regulation and micromanagement of the banking industry would cause them to operate at a loss to achieve compliance. The argued further that the long term effect would contract the banking system, affecting economic growth and prosperity.

Ultimately, the Act was amended and the final regulations adopted replaced the existing regulations in their entirety.

This brings us to 1999, when President Bill Clinton signed the Gramm-Leach-Bliley Act repealing part of the Glass-Steagall Act of 1933. That Act, in part, separated commercial banking (checking and savings accounts, mortgage and business lending) from the more speculative investment banking operations. It was recognized that one of the major factors causing bank failures during the Great Depression was commercial banks extending funds into high risk speculative investments. Thus, Glass-Steagall separated the functions and prohibited investment banks from engaging in commercial banking matters and commercial banks from becoming involved in investment banking matters. Since investment banking is much riskier than commercial banking ,it makes sense to separate the two functions. By repealing this portion of the Glass-Steagall Act, large banks were able to combine their operations and invent new products from bonds formulated out of non-performing mortgages. These bonds became known as Collateralized Debt Obligations (CDOs). CDOs were packaged and sold all over the world. It is at this point that I believe the problem began.

Additionally, to stimulate the housing market, President Clinton enacted legislation that allowed a capital gains tax exemption on the first $250,000 of a home sale for a single tax payer and $500,000 for a married couple. Prior to this change, capital gains realized from the sale from a home were treated as either short-term (less than 12 months) ordinary income or long-term (more than 12 months) capital gains. Or, if the capital gains were invested in another home of greater value, no taxes were due. This accounting change changed the way ordinary people valued and experienced their home/house. Initially, this change had very little impact on the housing market, but a few years later it played a dramatic role in expanding the bubble. Clearly, houses no longer were viewed as a home, but they were seen as either an ATM or commodity to be bought, sold and traded no differently than any other asset class on the exchange. However, homes received preferential tax treatment, making housing the ideal and leading asset class at the time.

Enter the Federal Reserve.

The Federal Reserve was established in 1913 by the Federal Reserve Act. The Congress has established three specific objectives for the Federal Reserve: maximum employment, stable prices and moderate long term-interest rates. Clearly, the role of the Federal Reserve has expanded beyond its original mandate given the monetary policy adopted by the Federal Reserve to replace the lack of fiscal policy emanating from the Congress and White House. Given this expanded role of the Federal Reserve, as we click back in time to the 1990s under the Chairmanship of Alan Greenspan, a “lose” interest rate policy began to appear. In other words, interest rates began to decline and declined for one of the longest periods in Fed history. As interest rates fell, more people became eligible to buy a home without necessarily increasing their monthly income. That’s because, as interest rates fell the interest rate charged for a mortgage decreased. Consequently the cost of servicing a mortgage loan was reduced. These Fed interest rate reductions were in response to the Dot-com bubble popping in 1999. However, as the housing bubble expanded, wages did increase, allowing for people to buy bigger and bigger homes with the hope of cashing in when they retired or making a quick million. Interest rates continued to remain low and the Housing and Community Development Act made it easier for individuals to qualify for a loan. These factors, coupled with large banks being able to participate as both commercial and investment arms of the credit market, set the stage, and it was only a matter of time before the race to own a home was on and the balloon was fully inflated. As with all balloons, they eventually deflate, sometimes with a hiss and sometimes a loud pop.

In this case the pop was heard around the world with much hand wringing….Congressional hearings….Federal Reserve denial…World-wide economic collapse…Continued bailouts and stimulus….High unemployment…Reduced GDP…Large deficits…Uncontrollable debt….Unprecedented low interest rates….Housing Repos…Liquidity, liquidity, liquidity, …QE, QE, and more QE.

The rest of the story is yet to be written.

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