Mr. Moderate

Then I’ll get on my knees and pray
We don’t get fooled again
Don’t get fooled again
…

Meet the new boss
Same as the old boss
– Won’t Get Fooled Again by The Who

One of my favorite quotes of all time is by George Santayana (from The Life of Reason [1905 1906], Volume I, Reason in Common Sense, Chapter 12):

Progress, far from consisting in change, depends on retentiveness. . . . Those who cannot remember the past are condemned to repeat it.

Ronald Reagan came to power in 1981, and a large part of what he pledged to accomplish was to “get government off our backs” by deregulating various industries. One of the deregulated industries was the Savings and Loan industry which, I’m afraid, you need to be fairly old to understand how critical that industry used to be to the American economy. But in its zeal to eliminate government regulations that prevented businesses from seeking profits wherever they could be found, the Reagan administration convinced a Democratic Congress to vote away the governmental controls which ensured that industry remained healthy. However, they did not vote away, but actually increased, the guarantee of health provided by the US taxpayer through the Federal Savings and Loan Insurance Corporation (FSLIC). This was, of course, a recipe for disaster as the greedy owners and managers of savings and loan corporations sought vast personal wealth for themselves without one thought for the safety of the federally-insured funds they were using to create that wealth. This led to the Savings and Loan Crisis (or S&L Crisis) of the late 1980s, which was the precursor to the current subprime mortgage crisis. Apparently, we never did really learn our lessons from the S&L Crisis so I’m going to begin with a discussion of what went on with that mess.

The root cause of that mess began with the managers of S&Ls who were given incentives to produce loans in order to increase S&L profits. These incentives were usually given in the form of commissions or bonuses paid on top of an already-generous salary. The motivation for this was the usual motivation for any business: more loans, and particularly higher-interest (riskier) loans, were supposed to generate more interest income to the S&L. More interest income, particularly the higher the interest rate was “above the market” (in other words, the greater the risk-based interest rate spread was), the more profit the S&L would earn. The greater the profits, the more money would be paid to top managers and shareholders. One barrier to this system taking immediate hold is the fact that a lot of S&Ls were organized as cooperatives. These would be called “Mutual Savings and Loan” institutions as they were not owned by shareholders, but were rather owned by depositors. The deregulation of the 1980s caused most of these mutuals to disappear as the profit motive would be such that a private firm or a shareholder-owned firm could come in and offer to buy the existing institution from the depositors at a generous price, take the depositors’ money and invest it in higher-profit opportunities and still make a lot of money for the managers and shareholders of the new company. The keys to making a lot of money included underestimating the amount of risk involved in these high-profit loans, thereby not setting aside adequate reserves for loan losses, and when loans became “nonperforming” (or even worthless), finding ways to continue holding them on the books as “performing” (earning interest) through various refinancing techniques. So, the depositors in mutual associations made a lot of money by selling out to private companies. The shareholders in private S&Ls made money from large dividends paying out profits which should not have existed if proper accounting practices had been followed. The managers made a great deal of money in payments for originating loans that should never have been made by any careful banker. And while the money being lent was federally insured, deregulation meant that the federal regulators were often prohibited from verifying that the loans made were actually going to be paid back. They were more-or-less required to take the word of the bank for whether or not loans were “performing” and “adequately collateralized.”

The end result of the above process was the S&L crisis, referred to above. While it ultimately cost taxpayers only about $125 billion (see HERE), that was a large percentage (about 32%) of the $394 billion value of failed S&Ls that were taken over by the government and turned over to the Resolution Trust Corporation (RTC) for liquidation. That percentage clearly indicates that the money being lent out on bad loans wasn’t anywhere near limited to the risk capital of the institution, but the managers were taking large risks with the federally-guaranteed deposits of ordinary people in order to pad their own bank accounts with commissions and bonuses. What isn’t even tracked in these statistics is the large number of institutions which were sold to or merged into larger institutions because they were about to fall into the category of S&Ls that would be taken over by the RTC. News articles printed at the time the legislation creating the RTC was working its way through Congress indicated that the total size of the S&Ls that needed to be resolved, one way or another, was well over $1 trillion.

As we look back at the winners and losers from the S&L crisis, we can see that the winners include a large number of land speculators who received loan money from S&Ls in return for property they had purchased for a fraction of the loan amount. We can also see that the managers of these institutions, along with various brokers and dealers that they dealt with, all received huge salary, commission, and bonus payments almost right up until the day their own particular S&L finally collapsed and they were booted out of their jobs. However, many of those managers made so much money during the good years that being out of a job wasn’t much of a burden. The shareholders and debt holders got good returns for as long as the S&L lasted, but eventually they lost some or all of their investment when the institution was forced to be sold or just collapsed into RTC receivership. The costs to pay for the winnings described herein were paid by the federal taxpayer (about $125 billion), by insurance payments made by surviving institutions (a cost eventually paid by the shareholders and/or depositors of the paying institutions), by the uninsured depositors in failed institutions, and by the shareholders and other debt holders of any failed institutions.

So, if you want to understand what is going on with the current subprime mortgage crisis, all you need to do is look at the above description of the S&L crisis. Land speculators made out once again by purchasing and selling properties at prices the market couldn’t sustain. They get to keep all their profits. It is only the last purchaser in the chain (the so-called “greater fool“) who gets stuck owning the overvalued property. However, unless they have signed loan papers which give the lender personal recourse to their other assets, that person loses only the amount of cash they actually put into the property, minus whatever income they can receive pending foreclosure. Many speculators are managing to rent out their properties while not paying their mortgage payments, and that can allow them to recover a large percentage of their investment, if not even make them a profit. The managers in the chain of making mortgage loans on overvalued properties again make out with large salaries, commissions, and bonuses, right up until their particular company collapses and goes out of business. Individual homeowners who get fooled into buying overvalued properties and/or paying above-market interest rates for mortgages they can’t really afford (see “greater fool” again) will eventually end up losing their homes if they can’t be refinanced (which refinancing makes more commissions and fees for the very industry that got them into the mess in the first place). This time, however, the biggest losses are not (yet) being paid by the federal taxpayer as the losses recognized to date have been realized by major banks and other financial institutions from around the world who invested in so-called “mortgage-backed securities” (MBS). The key word in the previous sentence is “yet.”

The MBS market largely depends upon a set of government-chartered institutions including the Federal National Mortgage Association (FNMA or “Fannie Mae“), the Federal Home Loan Mortgage Corporation (FHLMC or “Freddie Mac“), and the Government National Mortgage Association (GNMA or “Ginnie Mae“). Ginnie Mae is actually owned by the federal government and its debt instruments are issued with the full faith and credit of the federal government. Ginnie Mae makes the MBS market for federally guaranteed loans, including FHA and VA loans, and the standards set for such loans generally eliminate or at least greatly reduce the sort of speculation and fraud which is affecting the rest of the MBS market. Since the federal government stands behind Ginnie Mae, there is no more risk of a failure by Ginnie Mae than there is of the US Treasury itself failing. Fannie Mae and Freddie Mac, on the other hand, are owned by private shareholders. If they fail, the US government will almost certainly step in and save them, as they are government-sponsored enterprises (GSEs). But the private shareholders will almost certainly lose most or all of their investments. Together, Fannie Mae and Freddie Mac hold or guarantee roughly half of the roughly $12 trillion worth of marketable mortgages within the United States, putting the US taxpayer potentially at risk for losses on up to $6 trillion worth of mortgages. Accordingly, this is a much bigger deal than the roughly $125 billion of losses suffered on roughly $394 billion worth of failed S&Ls (see above). If the taxpayer is asked to bear the same percentage cost as the previous crisis (about 32%), it will result in a charge of about $1.9 trillion.

Now let this picture sink in really good. In the 1980s and 1990s, Republican-sponsored deregulation of the savings and loan industry allowed scammers and con artists to take control of nearly $400 billion worth of S&Ls and run them into the ground to where the government had to step in and take control at a cost of $125 billion to the taxpayers. Sure, there were a few of the most-blatant scammers and con artists who went to jail. But the vast bulk of people who made money off of the S&L crisis put their money in a good safe bank and never thought twice about the victims of their scams and cons. And having survived through that process, many of the managers from those failed S&Ls ended up going to work at the new private mortgage broker businesses which were springing up to work the scam for another round. And because they had learned well how to play the system for their own maximum benefit, they managed to create a speculative real estate bubble in the United States which generated trillions of dollars in speculative profits before it finally went bust a couple of years or so ago. The subprime mortgage crisis hasn’t yet played itself out, and it will likely be 5 to 15 years before we can adequately assess the costs associated with the current mess we are living through. But rest assured that there are lots of scammers, con artists, managers, and owners who collectively put billions or trillions of dollars into the bank as they worked the system for their own profit. And ultimately, because housing is so important to the US economy, the federal government is forced to come in and pick up the pieces after the scammers and con artists are all long gone from the scene.

The bottom line here is this: deregulation opened the door for scammers and con artists in ways nobody could have imagined before we saw it happen. And so long as voters keep voting for Republicans, whose mantras are “smaller government” and “less regulation,” we will continue to see these situations play out, over and over again. Why? Because greed is a basic element of human nature, and if government doesn’t put checks and balances in place to control greed, excesses will always happen. So, adequate government regulation is necessary to protect the US economy and the US taxpayer from having to bear the costs of a crisis like this yet again.

But if I were a betting man, I’d bet that, in spite of these lessons from history, we’re getting fooled again!