Brown Web of Debt The Shocking Truth about our Money System (3rd ed)

Chapter 30 - The Lure In The Consumer Debt Trap

The touted increase in “home ownership” actually means an increase in debt. Households today owe more debt relative to their disposable income than ever before. In late 2004, mortgage debt amounted to 85 percent of disposable income, a record high. The fact that interest rates approached historic lows appeared to keep payments manageable, but the total amount of debt rose faster for the typical family than interest rates declined. As a result, households still ended up paying a greater share of their incomes for

their mortgages. Total U.S. mortgage debt increased by over 80 percent between 1991 and 2001, and residential debt grew another 50 percent between 2001 and 2005. From 2001 through 2005, outstanding mortgage debt rose from $5.3 trillion to $8.9 trillion, the biggest debt expansion in history. In 2004, U.S. household debt increased more than twice as fast as disposable income; and most of this new debt-money came from the housing market. Homeowners took equity out of their homes through home sales, refinancings and home equity loans totaling about $700 billion in 2004, more than twice the $266 billion taken five years earlier. Debts due to residential mortgages exceeded $8.1 trillion, a sum larger even than the out-of-control federal debt, which hit $7.6 trillion the same year.3

Baiting the Trap: Seductively Low Interest Rates

and “Teaser Rates”

The housing bubble was another ploy of the Federal Reserve and the banking industry for pumping accounting-entry money into the economy. In the 1980s, the Fed reacted to a stock market crisis by lowering interest rates, making investment money readily available, inflating the stock market to unprecedented heights in the 1990s. When the stock market topped out in 2000 and started downward, the Fed could have allowed it to correct naturally; but that alternative was politically unpopular, and it would have meant serious losses to the

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banks that owned the Fed. The decision was made instead to prop up the market with even lower interest rates. The federal funds rate was dropped to 1.0 percent, launching a credit expansion that was even greater than in the 1990s, encouraging further speculation in both stocks and real estate.4

After the Fed set the stage, banks and other commercial lenders fanned the housing boom into a blaze with a series of high-risk changes in mortgage instruments, including variable rate loans that allowed nearly anyone to qualify to buy a home who was willing to take the bait. By 2006, about half of all U.S. mortgages were at “adjustable” interest rates. Purchasers were lulled by “teaser” rates into believing they could afford mortgages that in fact were liable to propel them into inextricable debt if not into bankruptcy. Property values had gotten so high that the only way many young couples could even hope to become homeowners was to agree to an adjustable rate mortgage or ARM, a very risky type of mortgage loan in which the interest rate and payments fluctuate with market conditions. The risks of ARMs were explained in a December 2005 press release by the Office of the Comptroller of the Currency:

[T]he initial lower monthly payment means that less principal is being paid. As a result, the loan balance grows, or amortizes negatively until the sixth year when payments are adjusted to ensure the principal is paid off over the remaining 25 years of the loan. In the case of a typical $360,000 payment option mortgage that starts at 6 percent interest, monthly payments could increase by 50 percent in the sixth year if interest rates do not change. If rates jump two percentage points, to 8 percent, monthly payments could double.5

Homeowners agreeing to this arrangement were gambling that either their incomes would increase to meet the payment burden or that the housing market would continue to go up, allowing them to sell the home before the sixth year at a profit. But by 2006, the housing bubble was topping out; and as in every Ponzi scheme, the vulnerable buyers who got in last would be left holding the bag when the bubble collapsed.

Even borrowers with fixed rate mortgages can wind up paying quite a bit more than they anticipated for their homes. Loans are structured so that the borrower who agrees to a 30-year mortgage at a fixed rate of 7 percent will actually pay about 2-1/2 times the list price of the house over the course of the loan. A house priced at $330,000

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at 7 percent interest would accrue $460,379.36 in interest, for a total tab of $790,379.36.6 The bank thus actually gets a bigger chunk of the pie than the seller, although it never owned either the property or the loan money, which was created as it was lent; and home loans are completely secured, so the risk to the bank is very low. The buyer will pay about 2-1/2 times the list price to borrow money the bank never had until the mortgage was signed; and if he fails to pay the full 250 percent, the bank may wind up with the house.

For the first five years of a thirty-year home mortgage, most of the buyer’s monthly payments consist of interest. For ARMs, the loans may be structured so that the first five years’ payments consist only of interest, with a variable-rate loan thereafter. Since most homes change hands within five years, the average buyer who thinks he owns his own home finds on resale that most if not all of the equity still belongs to the lender. If interest rates have gone up in the meantime, home values will drop, and the buyer will be locked into higher payments for a less valuable house. If he has taken out a home loan for “equity” that has subsequently disappeared, he may have to pay the difference on sale of the home. And if he can’t afford that balloon payment, he will be reduced to home serfdom, strapped in a home he can’t afford, working to make his payments to the bank. William Hope Harvey’s dire prediction that workers would become wage-slaves who owned nothing of their own would have materialized.

The Homestead Laws that gave settlers their own plot of land have been largely eroded by 150 years of the “business cycle,” in which bankers have periodically raised interest rates and called in loans, creating successive waves of defaults and foreclosures. For most families, the days of inheriting the family home free and clear are a thing of the past. Some individual homeowners have made out well from the housing boom, but the overall effect has been to put the average family on the hook for a substantially more expensive mortgage than it would have had a decade ago. Again the real winners have been the banks. As market commentator Craig Harris explained in a March 2004 article:

Essentially what has happened is that there was a sort of stealth transfer of net worth from the public to the banks to help save the system. The public took on the risk, went further into debt, spent a lot of money . . . and the banks’ new properties have appreciated substantially. . . . They created the money and lent it to you, you spent the money to prop up the economy, and

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now they own the real property and you’re on the hook to pay them back an inflated price [for] that property . . . They gave you a better rate but you paid more for the property which they now own until you pay them back.7

The Impending Tsunami of Sub-prime Mortgage Defaults

The larger a pyramid scheme grows, the greater the number of investors who need to be brought in to support the pyramid. When the “prime” market was exhausted, lenders had to resort to the riskier “sub-prime” market for new borrowers. Risk was off-loaded by slicing up these mortgages and selling them to investors as “mortgage-backed securities.” “Securitizing” mortgages and selling them to investors was touted as “spreading the risk,” but the device backfired. It wound up spreading risk like a contagion, infecting investment pools ranging from hedge funds to pension funds to money market funds.

In a November 2005 article called “Surreal Estate on the San Andreas Fault,” Gary North estimated that loans related to the housing market had grown to 80 percent of bank lending, and that much of this growth was in the sub-prime market, which had been hooked with ARMs that were quite risky not only for the borrowers but for the lenders. North said prophetically:

. . . Even without a recession, the [housing] boom will falter because of ARMs . . . . These time bombs are about to blow, contract by contract.

If nothing changes -- if short-term rates do not rise -- monthly mortgage payments are going to rise by 60% when the readjustment kicks in. Yet buyers are marginal, people who could not qualify for a 30-year mortgage. This will force “For Sale” signs to flower like dandelions in spring. . . .

If you remember the S&L [savings and loan association] crisis of the mid-1980s, you have some indication of what is coming. The S&L crisis in Texas put a squeeze on the economy in Texas. Banks got nasty. They stopped making new loans. Yet the S&Ls were legally not banks. They were a second capital market.

Today, the banks have become S&Ls. They have tied their loan portfolios to the housing market.

I think a squeeze is coming that will affect the entire banking system. The madness of bankers has become unprecedented. . .

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Banks will wind up sitting on top of bad loans of all kinds because the American economy is now housing-sale driven.8

The savings and loan industry collapsed after interest rates were raised to unprecedented levels in the 1980s. The commercial banks’ prime rate (the rate at which they had to borrow) reached 20.5 percent at a time when the S&Ls were earning only about 5 percent on mortgage loans made previously, and the negative spread caused them huge losses. Although banks in recent years have off-loaded mortgages by selling them to investors, the banks may still be liable in the event of default; and even if they’re not, they could find themselves defending some very large lawsuits, as we’ll see shortly. The banks themselves are also heavily invested in securities infected with subprime debt.

By January 2007, the housing boom had substantially cooled, after a series of interest rate hikes were imposed by the Fed. An article in The New York Times that month warned,“1 in 5 sub-prime loans will end in foreclosure . . . . About 2.2 million borrowers who took out subprime loans from 1998 to 2006 are likely to lose their homes.” In an editorial the same month, Mike Whitney noted that when family members and other occupants are included, that could mean 10 million people turned out into the streets; and some analysts thought even that estimate was low. Whitney quoted Peter Schiff, president of an investment strategies company, who warned, “The secondary effects of the ‘1 out of 5’ sub-prime default rate will be a chain reaction of rising interest rates and falling home prices engendering still more defaults, with the added foreclosures causing the cycle to repeat. In my opinion, when the cycle is fully played out we are more likely to see an 80% default rate rather than 20%.” Whitney commented:

40 million Americans headed towards foreclosure? Better pick out a comfy spot in the local park to set up the lean-to. Schiff’s calculations may be overly pessimistic, but his reasoning is sound. Once mortgage-holders realize that their homes are worth tens of thousands less than the amount of their loan they are likely to “mail in their house keys rather than make the additional mortgage payments.” As Schiff says, “Why would anyone stretch to spend 40% of his monthly income to service a $700,000 mortgage on a condo valued at $500,000, especially when there are plenty of comparable rentals that are far more affordable?”9

As with the Crash of 1929, the finger of responsibility is being pointed at the Federal Reserve, which blew up the housing bubble with “easy” credit, then put a pin in it by making credit much harder

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to get. Whitney writes:

[The Fed] kept the printing presses whirring along at full-tilt while the banks and mortgage lenders devised every scam imaginable to put greenbacks into the hands of unqualified borrowers. ARMs, “interest-only” or “no down payment” loans etc. were all part of the creative financing boondoggle which kept the economy sputtering along after the “dot.com” crackup in 2000.

. . . Now, many of those same buyers are stuck with enormous loans that are about to reset at drastically higher rates while their homes have already depreciated 10% to 20% in value. This phenomenon of being shackled to a “negative equity mortgage” is what economist Michael Hudson calls the “New Road to Serfdom”; paying off a mortgage that is significantly larger than the current value of the house. The sheer magnitude of the problem is staggering.

The ability to adjust interest rates is considered a necessary and proper tool of the Fed in managing the money supply, but it is also a form of arbitrary manipulation that can be used to benefit one group over another. The very notion that we have a “free market” is belied by the fact that investors, advisers and market analysts wait with bated breath to hear what the Fed is going to do to interest rates from month to month. The market is responding not to supply and demand but to top-down dictatorial control. Not that that would be so bad if it actually worked, but a sinking economy can’t be kept afloat merely by adjusting interest rates. The problem has been compared to “pushing on a string”: when credit (or debt) is the only way to keep money in an economy, once borrowers are “all borrowed up” and lenders have reached their lending limits, no amount of lowering interest rates will get more debt-money into the system. Lenders managed to get around the lending limits by moving loans off their books and selling them to investors, but when the investors learned that the loans were “toxic”

--infected with risky subprime debt -- they quit buying, putting the “credit market” (or debt market) at risk of seizing up altogether. The only solution to this conundrum is to get “real” money into the system

--real, interest-free, debt-free, government-issued legal tender of the sort first devised by the American colonists.

By 2005, financial weather forecasters could see two economic storm fronts forming on the horizon, and both were being blamed on the market manipulations of the Fed . . . .

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Chapter 31

THE PERFECT FINANCIAL STORM

Uncle Henry sat upon the doorstep and looked anxiously at the sky, which was even grayer than usual. . . . “There’s a cyclone coming, Em,” he called to his wife. . . . Aunt Em dropped her work and came to the door. . . . “Quick, Dorothy!” she screamed. “Run for the cellar!”

– The Wonderful Wizard of Oz,

“The Cyclone”

The rare weather phenomenon known as “the perfect storm” occurs when two storm fronts collide. What analysts are calling “the perfect financial storm” is the impending collision of the two

economic storm fronts of inflation and deflation. The American money supply is being continually pumped up with new money created as loans, but borrowers are increasingly unable to repay their loans, which are going into default. When loans are extinguished by default, the money supply contracts and deflation and depression result. The collision of these two forces can result in “stagflation” – price inflation without economic growth. That is a “category 1” financial storm. A “category 5” storm might result from a derivatives crisis in which major traders defaulted on their bets, or from a serious decline in the housing market. In a June 2005 newsletter, Al Martin stated that the General Accounting Office, the Office of the Comptroller of the Currency, and the Federal Housing Administration had privately warned that a decline of as much as 40 percent could occur in the housing market between 2005 and 2010. A housing decline of that magnitude could collapse the economy of the United States.1

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Chapter 31 - The Perfect Financial Storm

The Debt Crisis and the Housing Bubble

After a series of changes beginning in 2001 dropping the federal funds rate to unprecedented lows, housing prices began their inexorable climb, aided by a loosening of lending standards. Adjustable-rate loans, interest only loans, and no down payment loans drew many new home buyers into the market, putting steady upward pressure on prices. Soaring housing prices, in turn, deepened the debt crisis. To keep all this new debt-money afloat required a steady stream of new borrowers, prompting lenders to offer loans to shaky borrowers on more and more lax conditions. In 2005, a Mortgage Bankers Association survey found that high-risk adjustable and interest-only loans had grown to account for nearly half of new loan applications. Federal Reserve Governor Susan Schmidt Bies, speaking in October 2005, said that average U.S. housing prices had appreciated by more than 80 percent since 1997.

Rock-bottom interest rates salvaged stock market speculators and big investment banks from the 2000 recession, and they allowed some politically-popular tax cuts that favored big investors; but they were disastrous for the bond market, where retired people have traditionally invested for a safe and predictable return on their savings. By 2004, real returns after inflation on short-term interest rates were negative.2 (That is, if you lent $100 to the government by buying its bonds this year, your investment might grow to be worth $102 next year; but after inflation it would be worth only $98.) The result was to force retired people living on investment income out of the reliable bond market into the much riskier stock market. Today stocks are owned by over half of Americans, the highest number in history.

The Fed’s low-interest policies also discouraged foreign investors from buying U.S. bonds, and that is what precipitated the second financial storm front. Foreign investment money is relied on by the government to roll over its ballooning debt. New bonds must continually be sold to investors to replace the old bonds as they come due. The Fed has therefore been under pressure to raise interest rates, both to attract foreign investors and to keep a lid on inflation. Higher interest rates, however, mean that increasing numbers of homes will go into foreclosure; and when mortgages are voided out, the supply of credit-money they created shrinks with them. Although the sellers have been paid and the old loan money is still in the system, the banks have to balance their books, which means they can create less money in the form of new loans; and borrowers are harder to find, because

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higher interest rates are less attractive to them. In the last “normal” correction of the housing market, between 1989 and 1991, median home prices dropped by 17 percent, and 3.6 million mortgages went into default. Analysts estimated, however, that the same decline in 2005 would have produced 20 million defaults, because the average equity-to-debt ratio (the percentage of a home that is actually “owned” by the homeowner) had dropped dramatically. The ratio went from 37 percent in 1990 to a mere 14 percent in 2005, a record low, because $3 trillion had been taken out of property equities in the previous four years to sustain consumer spending.3

What would 20 million defaults do to the money supply? Al Martin cites a Federal Reserve study reported by Alan Greenspan before the Joint Economic Committee in June 2005, estimating that two trillion dollars would simply evaporate along with these uncollectible loans. That means two trillion dollars less to spend on government programs, wages and salaries. In 2005, two trillion dollars was about one-fifth the total M3 money supply. Accompanying that radical contraction, analysts predicted that stocks and home values would plummet, income taxes would triple, Social Security and Medicare benefits would be slashed in half, and pensions and comfortable retirements would become things of the past. And that was assuming housing prices dropped by only 17 percent. A substantially higher drop was feared, with even more dire consequences.4

Fannie and Freddie: Compounding the Housing Crisis with Derivatives and Mortgage-Backed Securities

In a June 2002 article titled “Fannie and Freddie Were Lenders,” Richard Freeman warned that the housing bubble was the largest bubble in history, dwarfing anything that had gone before; and that it has been pumped up to its gargantuan size by Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Mortgage Corporation), twin volcanoes that were about to blow. Fannie and Freddie have dramatically expanded the ways money can be created by mortgage lending, allowing the banks to issue many more loans than would otherwise have been possible; but it all adds up to another Ponzi scheme, and it has reached its mathematical limits.

Focusing on the larger of these two institutional cousins, Fannie Mae, Freeman noted that if it were a bank, it would be the third largest bank in the world; and that it makes enormous amounts of money

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