What Caused This Mess?Bad Laws Built Up Over Time

1930s—Law put risk of default on the government through Fannie Mae and Freddie Mac. Banks sold mortgages they made to those “public corporations” which insulated banks from some risk.

1977—Community Reinvestment Act—banks forced to expand loans to higher-risk areas.

1990s—Government pressures banks to increase risky mortgages. Government agency rules: “Lack of credit history should not be seen as a negative factor.”

Congress at Work

1992—Congress sets targets for Fannie and Freddie to meet for share of mortgages to go to low income buyers.1995—HUD sets quota for low- and moderate-income buyers to be 42% of mortgages by 1997.The result?By 2006, 20% of all mortgages were subprime (up from 4.5% in 1994) — and 81% of the subprimes were securitized. Not so in Canada or EU.

Some Lenders Greatly Expand Loans

• Countrywide and other lenders focused on loans to people who could not traditionally qualify.

• Fannie & Freddie back $1 trillion subprime loans. This has not changed, so may happen again.

• Many people buy homes who could not before (ownership rises from 65% up to 70% of families); and existing owners trade up; high demand pushes prices up; builders happy to build more homes; lenders happy to make loans and collect a fee.

Easy Money• Government forces lenders to make risky loans,

but government “guarantees” loans.• Mortgage brokers encourage people to buy

houses or trade up to more expensive house. No down payment needed!

• Bush Admin had easy money policy—low interest rates—housing bid up 65% from 2001-2006.

• Adjustable rate mortgages—ARMs—first year or two, very low rate, then rises to market. People thought they would cash out before then.

• When prices drop & owner can’t afford higher payment—default.

Then Reality – and Fear – Sets In

By 2006, the problem becoming clear and prices begin to fall in summer. Weakest markets fall hardest and fastest—

Average fall—30% (‘06-09)

10 million+ badmortgages

Less Trouble in Texas

Where Are the Mortgages Now?Few banks keep mortgages—most are bundled together

and sold as “Special Investment Vehicles” (SIVs) to creditors all over the world. Mortgages backed by Fannie Mae—so why worry? China holds $375 billion worth of Fannie Mae backed loans.

Insurance companies, AIG, insure the purchase of the SIVs. No loss possible!

What is in an SIV? A jumble of good and bad mortgages.Hedge funds take positions on mortgages—derivatives.

Those on the wrong side took huge losses.No one really knows who has what in detail.

What Next?No one really sure except fortune tellers.Most important is liquidity in banking sector—keep

credit flowing to strong businesses or they must contract and make recession far worse.

[Personal view—banks & AIG should have been let go—insure the deposits but kill the worst institutions—their buddies in D.C. saved them]

Get cash into banks for lending purposes, not to guarantee their weak assets—that is just a bailout, not a solution to liquidity problem. None of the bad laws behind all this have been changed.

Who will cover this mess?

TARP then the “Stimulus”

A Guess About Near Term

• Economy will continue to grow slowly.• BUT—The longer term is disturbing. We are

becoming Euro-Japanese in policies. Massive debt. Budget deficits impossible to deal with and made worse by health care “reform.”

• How do you finance massive federal deficits?1.Raise taxes—kill incentives; capital flees.2.Sell bonds? Market cannot absorb.3.Treasury borrows more from Fed—Inflation.

Stimulus

Administration says cost of new job “created” in 2009 was $92,000. Other estimates much more.

No “multiplier” effect—that is, $1 of government spending does not generate $2 private sector spending. It is $1 for $1—but less efficient than $1 of private spending, so a negative.

Where does the money come from?Our children, grandchildren, great grandchildren.

Great Grandpa Did Fine with No Stimulus

In the recession of 1921, real GDP fell 4.25% compared to 1920.

In 1922, real GDP rose by 7% - the recession lasted less than a year.

In 1922, federal non-defense spending fell 44%.The “stimulus” was less government spending. The

national debt was reduced.In 2009, the federal deficit tripled—”stimulus”2010-11 continue to be bad.

What Causes Economic (and job) Growth? Private Investment

What Does Investment Mean?Worker Productivity and Wages Rise