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By Daniel R. Amerman, CFA
As a result of apparent systemic incompetence coupled with fraud, it appears there is a chance that most real estate foreclosures may come to a screeching halt on a nationwide basis in the United States. What is missing from the headlines is the real impact on you and I, and how we will be the ones bearing the pain. To understand the implications of this extraordinary situation, we must first pierce a triple charade.
The first charade is the joke which the banking industry - and their regulators - in the United States has been making of contracts and the law. The second charade is the idea that the banks will bear the consequences for their gross negligence and lies, when in fact it is the US government and Federal Reserve that will be bearing the full costs (which is to say, you and I). The third charade is the idea that taxes will pay for these extraordinary expenses, when the only credible source of sufficient funds is ultimately the destruction of the value of the US dollar.
The economic bottom line (as is so often the case in the these troubling times) is that a massive redistribution of wealth is underway, and most of the US population has no idea what is going on. Which means that the older savers and investors who will be paying most of the real costs for this fiasco, will never understand what happened – they'll just pay a devastating price as the purchasing power of their life savings plunges. Fully understand what is happening, on the other hand, and you can not only protect yourself, but position yourself so that wealth is redistributed to you rather than away from you.
Most people have little or no idea how the mortgage market actually works in 2010. There is this outdated idea that banks make mortgage lending decisions, and stand to lose if they make bad decisions with the investment of their money. But effectively speaking, the banks don't actually make the decisions about who gets loans, nor do they guarantee the loans, nor do they buy the loans. The government does all of that, as explained in my article "Futile Attempts To Reflate The Housing Bubble & The Deadly Cost", linked below:
Large scale US government intervention in the mortgage markets is nothing new, as I wrote in my book, Mortgage Securities (Probus, 1993). The US government has played a crucial role in mortgage credit since the formation of the Federal National Mortgage Association (Fannie Mae) in 1938, followed by the formation of Ginnie Mae and Freddie Mac. However, in the wake of the subprime mortgage crisis, the US government has gone from being a major player - the dominant player - to being almost the only game in town, on an unprecedented number of levels.
Few private lenders want to take genuine mortgage credit risks in today's housing market. So the norm for mortgage bankers is to originate "conforming" loans in as many cases as possible, with the standards for those loans being set by FHA, Fannie Mae and/or Freddie Mac, all of which are currently 100% owned by the US government. Because compliance with government standards is required for a loan to be "conforming", the federal government effectively makes the credit decisions for the overwhelming majority of mortgage originations in the US. It is government-controlled mortgage underwriting criteria which determine who is allowed mortgages, and how much they can borrow.
What gives the federal government the ability to set the criteria is that it takes all the credit risk for conforming mortgages, and guarantees the payment of principal and interest to investors. As soon as they are closed, conforming mortgages are nearly always quickly turned into Fannie Mae, Freddie Mac or Ginnie Mae mortgage securities, which are guaranteed in full by the US Government.
By 2009 and early 2010, however, that extraordinary degree of government intervention was not enough. The US government wanted something else that was without precedent in US financial history: it wanted mortgage rates to be lower than the rates the free market would bear. So the Federal Reserve effectively (on a net basis) bought almost all mortgage originations for over a year, once the mortgages had been securitized and turned into government guaranteed mortgage securities.
So the US government decides who qualifies for mortgages, the US government guarantees the mortgages, and the US government buys the mortgages (using money created directly out of thin air as covered in my article "Creating A Trillion From Thin Air").
What that means is that when something goes wrong, and money can't be collected from homeowners who are no longer making payments, then it is the citizens of the US who are already essentially taking 100% of the risk. We're the ones guaranteeing the mortgages, and with recent mortgage originations, we're most likely the mortgage security owners as well.
When seen from this light then, we can understand that far from providing the money and taking the credit risk, the role of the banking institutions in the mortgage market in the United States is to follow government instructions on the origination and servicing of mortgages, which the US government buys for itself, and guarantees to itself. Unfortunately, the collective banking industry has shown itself to be incapable of handling even these tasks.
With genuine capitalism, in a genuine free market, those employees responsible for the current fiasco - as well as their supervisors and top bank executives - would all pay through losing their jobs, and the shareholders would pay with the loss of their investments. Which would then provide keen motivation for the next round of banking executives and shareholders to make sure they get it right the next time.
If you want to understand a good part of the reason why this crisis exists, it is because that situation of genuine capitalism and free markets does not exist, and obviously has not existed for some time. It was the incompetence and negligence of the nation's major banks that created the mortgage crisis in the first place, with even the most basic due diligence not being performed or acted upon, in the quest for ever larger bonuses for the executives involved.
However, most of those executives remain with their jobs intact, and the banks have not closed their doors. Instead the United States government in a minor role, and the Federal Reserve playing the major role, have made essentially unlimited funds available to bail the bankers out of their mistakes, while still keeping their jobs. In light of this well understood situation, we can get a sense as to how the banks could be behaving so poorly in their basically clerical duties with regard to the mortgage market at this time. No matter how many mistakes they make, no matter how poorly they perform, the banks will be preserved and protected as institutions because it is held to be a national priority to do so. With the rest of the nation's citizens picking up the tab for this.
Perhaps the biggest and most dangerous charade is the idea that because the US government is guaranteeing the mortgages, and is the owner of so many of the mortgages, that the taxpayer will be taking the hit in the form of higher taxes for the likely huge financial losses that will be associated with this mortgage malfeasance, in one form or another.
But the problem with that assumption, as is the case in so many other areas, is that the US government long ago passed the point where it became reasonable to believe that taxpayers could pay for all the promises. We're already running official deficits well in excess of $1 trillion per year, not accounting for the additional direct monetary creation in even larger amounts by the Federal Reserve. We have no means of paying for the baby boomer retirement promises, nor for the extraordinary international debts we are currently bearing, nor for the ongoing stimulus packages that continue to come out in a series of one after another.
These obligations already add up to over $1 million per non-retired and above poverty line household, as covered in my article "Bailout Lies Threaten Your Savings" ( http://danielamerman.com/Video/BBL1B.htm ). The only credible means of paying for all of these vast obligations is the same means that nations have used again and again over the course of history:
The government devalues the currency through inflation.
Inflation effectively repays much of the debts, and in the process wipes out the value of government bonds for unfortunate bond investors. Even more profoundly, inflation destroys the value of the life savings for the nation's citizens. Indeed, for savers, there is not a more expensive means of repaying debts than a high rate of inflation, even if it seems like the magical cure to government officials in power at that time.
When we look at this fast developing crisis with extraordinarily expensive implications for millions of problem mortgages across the United States, we need to clearly understand that it is not the banks that will be bearing the cost, nor will it be the taxpayers who are primarily bearing the cost, but rather it will be the savers and investors within the United States as well as foreign investors that hold US dollars or securities. Ultimately the only source that is large enough to pay for this crisis, when added to all of the other crises already in existence, is an accelerated and more complete destruction of the value of the US dollar.
Let's consider three houses that have gone into foreclosure, due to each of their homeowners no longer having jobs. Each of the mortgages is for $350,000, and the homes are located in California, Nevada and Florida. In each case, the bank servicing the mortgage has committed fraud in their standard foreclosure process, as an effective matter of bank policy. With the bank having said (in essence) "we don't have to follow these legal technicalities or the letter of the law in general, because well, we're a bank, and that's not our industry-standard."
For the sake of illustration, we will also assume that each one of these foreclosure flaws is effectively "fatal", and the mortgage lender never does get the house. So there is a 100% loss on investment.
The mortgage in California was "conforming", and had been purchased by the Federal Reserve, after having been converted into a Fannie Mae mortgage-backed security. Fannie Mae guaranteed the mortgage – so Fannie Mae (which is 100% owned by the US government) takes a straight up $350,000 loss, and pays the Federal Reserve. In other words, the citizens of the US just took a $350,000 loss. Which the US government can't pay for, so the Federal Reserve creates the money out of thin air, to provide funds to buy the treasury bonds, that give the US government the money to pay the Federal Reserve the $350,000.
(Fannie and Freddie are making noises about going after the banks in these cases, but even if that actually happens we just move to one of the two other categories below.)
The mortgage in Nevada was "non-conforming", with no federal guarantees, and had been thrown into a huge pool with thousands of other mortgages, with a dozen different types of securities then carved out and sold to investors around the world. When this extraordinarily complex financial instrument runs into an unsympathetic and literal minded local judge, it turns out that it is legally unclear who the owner of the mortgage is. So there is no foreclosure, the homeowner keeps his or her house, and the $350,000 that actually funded the purchase of "their" house is a 100% loss to investors.
The next step is a bit unclear and depends on the specifics of the securities offering, but let's assume that the banks involved are legally found to have misrepresented the mortgage securities at the time that they were sold, and required to cover investor losses. So the major banks in the United States have a massive liability which they cannot handle, and would bankrupt them if they had to pay it themselves.
The banks need not worry, as the federal government has already determined that will not be allowed to happen. Instead, the massive losses merely trigger another round of bailouts, and the US government steps forward to cover the $350,000 individual mortgage loss (and hundreds of thousands or millions more like it). Except for that troublesome technicality of the US government not having the $350,000. So again, the Federal Reserve directly creates the $350,000 out of the void, uses the new dollars to buy treasury bonds, which gives the federal government the $350,000, and the federal government gives the $350,000 to the banks which give it to the investors to cover the losses from the banks' mistakes.
The mortgage in Florida is very similar to the mortgage in Nevada, except that the bank is not one of the anointed ones. Perhaps the bank had only been committing small-scale fraud on a local basis, rather than massive national fraud, or perhaps the bank executives have been failing to make their expected congressional campaign contributions. The bank is required to make up investor losses that resulted from the bank's negligence, but can't do so, and it is taken over by the government. With the FDIC covering the losses and paying off the depositors. Governmental accounting aside, the FDIC is just as broke as the rest of the federal government, and doesn't have the $350,000. So the Federal Reserve brings forth $350,000 out of the nothingness, buys $350,000 worth of treasury bonds, the US government takes the new cash and gives it to the FDIC, which uses the money to pay off bank depositor claims. (There is also the interesting question of whether the government would stiff the mortgage security investors and not make good the losses, thereby sending major shockwaves into other corners of the financial world, including already stressed pension funds.)
Do you see a pattern here?
A bank that projects financial expertise to the world turns out to be unable to handle clerical and administrative functions, or maintain clear ownership of assets.
These bank errors result in numerous homeowners across the United States "winning the lottery" and being given the homes they live in, without having to repay the mortgages that paid for their homes.
This leads to massive investor losses. Those losses are covered by the federal government in one form or another, whether it be mortgage security guarantees, further rounds of bailouts, or federal deposit insurance payouts.
The federal government does not have the money to pay for those losses, so they are paid for by direct new monetary creation by the Federal Reserve. This may look like "free money", and is being treated as such by the federal government and Federal Reserve these days, but there is no such thing as free money. Every time the Federal Reserve creates another $350,000, or another billion, or another trillion, it brings forward in time - and increases the severity - of the inflationary explosion that is coming.
Which risks the annihilation of the life savings of all savers in the United States, as well as overseas investors holding US dollars and dollar-denominated securities.
Week after week, the financial media have been filled with stories of the trouble the banks have gotten themselves into. These headlines tend to create the impression that those banks are in a lot of trouble. Indeed, they are.
But the banks can't pay for their way out of the trouble that they are in. So the US government will do so, with the only question being the specifics of the form of the payout. Except the US government can't pay for these losses either, as it's already effectively bankrupt, and running huge deficits that can be expected to only grow larger in the future.
So the colossal losses are "paid" by the Federal Reserve creating new money on a fantastic scale. The Federal Reserve, however, possesses neither real economic resources nor taxing authority. Ultimately, all it can do is dilute the money supply.
Which dilutes the value of money. Which brings us back to your savings.
When piercing through the multiple levels of deception, every time you read about another huge problem with Foreclosuregate, understand that it is not the bank that is in deep trouble so much as it is the value of your savings, and your standard of living in future years.
Perhaps the most natural reaction to this article is one of outrage, followed by flight. This is a very understandable reaction. The banks, the US government, and the Federal Reserve have all been behaving in an outrageous fashion that works to the benefit of insiders, while cheating almost the entire rest of the population. The simple solution when the outrage reaches a sufficient point, is to pull all you can out of paper investments and symbolic currencies, put them into gold, and hunker down to survive the still developing crisis.
Unfortunately, we live in a complex and deeply unfair world, that makes mincemeat of emotional reactions and simple solutions. As shown in step-by-step, simple – but irrefutable – detail in the article "Hidden Gold Taxes: The Secret Weapon of Bankrupt Governments" linked below, a simple solution of just buying gold leaves you handing a good chunk of your starting net worth - or perhaps even most of your starting net worth - over to the government by the time all is said and done. The way the government under existing laws effectively confiscates the wealth of gold investors in a highly inflationary environment is little understood by most gold investors, but should form the central point for their planning.
Let me suggest an alternative approach,which is to study, learn and reposition. Almost all financial and economic articles that you see today are really about the upcoming re-distribution of wealth, whether those words are used in the article or not. Learn not just how wealth will redistribute, but how unfair government tax policies (that can be relied upon to grow still more unfair) will cripple most simple methods of attempting to survive inflation.
|Click Here To Learn About A Free Mini Course That Will Teach You How To Turn Inflation Into Wealth.|
Then, yes – buying gold (and perhaps alot of it) can be one key component of a portfolio approach, as discussed in my Gold Out-Of-The-Box DVD set. Use multiple components in a dynamic process over the stages of the crisis, with each component doing what it does best, and position yourself so that wealth will be redistributed to you in a manner that reverses the effects of government tax policy. So that instead of paying real taxes on illusionary income, you're paying illusory taxes on real income. And the more outrageous the government actions – the more your after-inflation and after-tax net worth grows.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation – the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free “Turning Inflation Into Wealth” Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com .
Daniel R. Amerman, CFA
This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.
Copyright 2010 by Daniel Amerman