Jan212014

How Washington enables Wall Street to ransack Main Street

By encouraging asset bubbles and permitting Wall Street to extract undue gains from the volatility, policymakers in Washington encourage bad behavior on a large scale.

I recently opined that quantitative easing and mortgage interest rate stimulus bail out Wall Street, not Main Street. Quantitative easing serves to inflate house prices, and although homeowners benefit from this policy, the banks benefit even more; in fact, it’s necessary for their survival. However, inflating asset values through quantitative easing is not the only way decisions made in Washington help Wall Street over Main Street. No, the problem goes deeper than that.

Who benefits from bubbles?

In an ideal world, asset prices would rise and fall gently based on the productive value of the asset; volatility would be minimal; entrepreneurs and corporations would create businesses with viable, long-term prospects; businessmen would be honest and fear punishment for bad deeds; and investors would carefully evaluate the risks and returns of stable and predictable investments. This ideal world would have no asset bubbles. However, that isn’t the world we live in; it’s slow, it’s boring; you can’t make a quick fortune, retire on your yacht, and sail the sea of greed. So we create unnecessary volatility so those who understand the movements of financial markets can profit from those who don’t.

There are two main types of Wall Street desperadoes who profit from financial bubbles: (1) those who serve to inflate asset prices and cash out at the top, and (2) those who recognize value and buy at the bottom. The natural reaction of ordinary citizens and investors is the opposite of those who profit from asset bubbles; ordinary people buy with enthusiasm at the top of asset bubbles, and they sell in despair at the bottom. In both cases, the professional investor takes the other side of the trade.

Who desires bubbles?

The shocking part of this folly is that ordinary people — the people most hurt by these unnecessary gyrations — clamor loudest for its perpetuation. Who most wanted to reflate the housing bubble? Underwater homeowners. Who benefited the most? Wall Street and bankers. Economists on the political left lobby for more government spending and more quantitative easing, ostensibly to put people back to work and benefit the ordinary man. But that isn’t who wins out.

Larry Summers, Obama’s former economic advisor, made the following observations in a recent interview:

EK: So one interpretation … is that the economy can’t generate even sufficient demand without bubbles. The interpretation you take, though, is that it requires an extended period of expansionary policy that, in a more normal kind of economy, would be unwise. What makes you confident that policy can correct the problem?

LS: First, I never intended to suggest, and I don’t think I did suggest, that it should be the objective of policy to create bubbles. It does stand to reason that in a world where natural interest rates are lower there will be a greater tendency towards bubbles. Whenever you have interest rates lower than growth rates it’s easy to make ponzi schemes of various kinds work. When investors can make only very low returns being prudent they become less prudent. So an environment of secular stagnation is likely to be bubble-prone, but that isn’t the something to be welcomed or sought after. …

Apparently, it’s considered more desirable than the alternative, or we wouldn’t stay on this course.

Second, there is the question of financial stability. As Fed governor Jeremy Stein, among many others, has pointed out, lower real and nominal rates achieved either through quantitative easing or forward guidance raise the risk of bubbles as investors increase their risk-taking and the attractiveness of leverage is increased….

EK: That second strategy is pretty much what the Fed has been doing, correct?

LS: Exactly, yes. I am not being critical of the Fed here. There orientation to doing what they can to increase demand has in my view been entirely appropriate, and the economy would be in much worse shape without their efforts. But I am convinced it would be still better to raise demand in the economy in ways that do not work through reduced interest rates but operate at any given level of rates.

It may not be the federal reserve’s intention to inflate bubbles; it may not be liberal economist’s intention to inflate bubbles; it certainly isn’t the intention of ordinary citizens to lose their money in asset bubbles, but the policies enacted in Washington, the policies desired by everyone involved, do create asset bubbles, and these policies will continue to do so until changed.

13CorporateClubHorseyCartoon

How can Wall Street profit from future bubbles?

The model for pillaging the US economy was clearly demonstrated during the 00s; it isn’t something a genius needs to invent, and even a layperson can recognize it. Think back to how New Century and Countrywide Financial operated, particularly New Century, with it’s model of get in, get out, and take the money with you, leaving behind only an empty shell to contain the liabilities you couldn’t possibly pay off. Anthony Mozilo at Countrywide turned to the same model toward the end of his career.

If an entrepreneur knows an asset bubble is forming – or better yet, if that entrepreneur can manufacture the bubble — then establishing a company to siphon off as much of the graft as possible while the bubble inflates is a sound strategy. It’s just like the legions of Ponzi borrowers during the bubble who refinanced their home each year to harvest the year’s bounty of appreciation.

Why can’t we stop it?

First, nothing about what I describe above is illegal, in the mind’s of Wall Street players, it isn’t even unethical. But for the sake of argument, let’s say it carries some kind of civil penalty. Banks have already proven they can make far more through unethical behavior than they pay out in fines. (See: Which bank paid the most for past mortgage sins?) At this point, getting slapped on the wrist is merely looked upon as the cost of doing business — and most evil doers don’t get caught.

Not long ago, Attorney General Eric Holder noted that some firms are too-big-to-jail. So even if executives of some big company completely cross the line — which is tough to do when the line continually gets pushed back — even in that circumstance, they have no fear of criminal repercussions. Further, most executives at these firms have contract provisions where the company must defend them in any kind of legal proceeding resulting from their behavior while in the company’s employ, further emboldening bad behavior.

Moral hazard

I wrote that Moral hazard is central issue in housing bust. It is. We now live under circumstances so laden with moral hazard that a major catastrophe, most likely engineered on Wall Street, is all but assured. And if it happens in housing, which it may, then the US taxpayer will have direct responsibility for cleaning up the mess by bailing out everyone who participated. The whole situation disheartens me; it also pisses me off.

bank_constitution

The Onion is known for its great satirical essays. The best satire has a touch of truth that screams for your attention, makes you think. The following article is from the Onion, but I challenge you to take it seriously because even though the article is supposed to make the idea of intentionally making bad loans look ludicrous, the idea isn’t ludicrous; it can and will work in today’s policy regime.

Wait, What If We Try Giving People Home Loans They Can’t Actually Afford To Pay Off?

By Michael Corbat, Citigroup CEO

There’s no doubt about it: Times are still tough for millions of Americans out there. The country is continuing to recover from the monumental economic downturn resulting from the 2008 financial crisis, and even though there are some recent reasons for optimism, things aren’t improving nearly as quickly as they need to be. As the Chief Executive Officer of Citigroup, I’m always looking for new, innovative ways to expand our business, and the current economy has certainly made that job tougher. However, with that in mind, I’ve been thinking, what if—and please bear with me, because I’m just spitballing here—but what if we were to approve home loans for people who can in no way actually afford to pay them off?

Now, I’m talking loans that homebuyers will never, ever be able to pay off in their lifetimes—not in 10 years, not in 20 years, not in 100 years. Loans that are so big and inflated by high compound interest rates that these people will have to win the goddamn lottery if they want any hope of affording their monthly payments.

Pretty smart, right? I’m telling you, I really think this can work!

It would be a profitable business model while the Ponzi scheme inflated. The lender with the backing to do this would rake in enormous fees, the CEO would don the cover of Fortune Magazine, and he would cash in millions in stock options as the share price skyrocketed.

I’ll give you an example to help better paint the picture of what I’m talking about, since I realize this is a pretty off-the-wall idea. Let’s say, just for argument’s sake, we come across somebody who’s looking to become a first-time homeowner—maybe a young married couple who have yet to solidify their careers, put away much in savings, or build strong credit. First, we relax our underwriting standards so they can qualify for a loan in the first place—and I’m talking about a pretty big loan here, something in the hundreds of thousands of dollars. It’ll be crystal clear to us that they can’t afford this in the long term, but instead of saying, “Look, this loan is very risky and could easily lead to early default, so this is not a sound investment for you,” we just say, “Thank you very much, and congratulations on your new home!”

Then—and this is where it gets really good—we just sit back and wait. Before that young, wide-eyed couple knows it, they’re up to their necks in debt, they can’t qualify to refinance the rapidly growing mortgage, and they’re driven into total insolvency, after which we seize the very house we gave them the loan for in the first place and then, when that alone doesn’t cover the accrual from the high interest rate we set, we seize all of their financial assets, leaving them with absolutely nothing and us with a nice, healthy profit margin.

The CEO of the company inflating the bubble would, at the height of the insanity, take all the money and invest it in an REO-to-rental company. Then as house prices collapsed due to the foreclosure processing from his collapsing, empty-shell of a lending firm, the CEO would order his REO-to-rental firm to start buying up properties — undoubtedly with sweetheart deals from the lending firm for as long as it lasted.

coming_going

It’s so simple. In fact, the more I think about it, the better it sounds. Hell, this could be just the kind of shot in the arm our economy needs!

I know this all sounds pretty outside-the-box, pretty ahead of its time, but aren’t the best ideas always like that? And you want to know the best part? This doesn’t have to just stop at home loans. We could do this with literally any loan: loans for college, loans to start a new business, loans for whatever! I don’t want to get too ambitious here, but we could even explore some kind of further option where we package all these loans together in some way and then sell these packages to investors, creating a sort of massive win-win situation. It sounds technical, I know. But trust me, it’ll work.

The cool thing is that it sounds kind of risky on the surface, but it actually isn’t at all! I’m telling you, I had some of my guys run the numbers on this and it’s essentially a can’t-miss.

It is a can’t miss if the firms are structured properly. The liabilities must be contained behind corporate entities while all profits are siphoned off by management before the crash. New Century did it, and Anthony Mozilo forfeited none of the money he made from Countrywide.

Now, I know what you’re thinking: C’mon, Mike, there’s an entire regulatory system in place to prevent us from doing this exact thing. That’s what the entire Dodd-Frank law is there for. Well, you’re right. But you know what? I have a feeling—just a hunch—that we can get around all that. In fact, that gives me another idea: Why don’t we just go through with this whole thing without any regard to the legal or ethical ramifications of our actions—especially the ethical ramifications—and then if things go south, we’ll just use the incredibly expensive, high-powered legal team we have on retainer to negotiate with SEC prosecutors so we can just pay a paltry nine-figure fine and be on our way.

Yes, that is exactly what to do if it even comes to that, but since it’s so common, it won’t come to that.

God, why didn’t anybody think of this before? Somebody call Mensa; I think I’m a fucking genius.

Now, if anyone has any doubts, or can think up any reasons why this could potentially be a bad idea, I’m all ears. But from where I’m sitting, it seems pretty damned foolproof. Hell, we might as well just try it and see how it goes, right? I mean, what’s the worst that could happen?

I can’t think of any reason this wouldn’t work; that’s what astonishes me.

onion_circle-of-hell