Small Business Against Big Government

Note: The below is an updated take on a post I wrote and published this in early October 2008 under the title, “The Super Easy Guide to Understanding The Financial Crisis.” Stick with it. When you understand how the Federal Reserve hurts small businesses, you will understand why it is so important that we urge our State Representatives and Senators to support HR1207 and S604 .  These are the precursors to legislation that would allow U.S. Citizens, through the Government Accountability Office (GAO), to “Audit the Federal Reserve” (Can you believe that we can’t do that now?)

Yesterday, The Fox News Show “Freedom Watch” dedicated all conversation to the topic of the Federal Reserve.  Shelly Roche from ByteStyle.tv was a guest on the program and mentioned our group, Small Business Against Big Government.  Aside from being very excited and grateful for the mention, it made me want to do more educating about the Federal Reserve.  Thus, the below.  I hope you (1) enjoy it (2) share it with others (3) call your Congressional Reps and Senators to voice your support of these measure.

The below is intended to be something you can share with employees and co-workers, so please identify someone you can share it with today.

In October 2008 you probably watched what was going on in Washington and on Wall Street  – all these bankers and congressmen running around, the hand wringing, the panicking, the gyrating markets, the claims that we’re heading into a depression, screaming for a bailout – and you thought:

What the devil is going on?

What is this crisis exactly, and why could it cause another depression?

Depressions are marked by mass unemployment and a sputtering economy. As Frank Chodorov put it, “A depression is a halting of production. Production stops when people cut down on their consumption.” People want to work, but can’t find it. People want to borrow money, but no one lends. People can’t pay their debts. They lose their homes, their cars, their businesses, their jobs.

Do you know why depressions happen?

Depressions happen because resources get put to bad uses – really bad uses – and the dislocation between supply of and demand for goods and services leads to a painful restructuring or unwinding from the excesses of earlier times.

People have gone to work in industries that provide “goods and services” that other people no longer want. For example, a few years ago everyone and his dog, it seemed, was becoming a real estate agent or mortgage broker. Today? No demand for that. These people have had to find something else to do. In a depression a lot of people are looking for something else to do all at the same time.

There are causes for these resources being misallocated (a bigger, better word to describe “put to bad use”), but that discussion goes beyond the scope of this discussion.

The issue now is that there’s a real fear that resources have been so terribly misallocated that the resulting adjustment is going to plunge us into another Great Depression.

Apparently – the politicians told us – this Depression was inevitable. That is, unless the government were to intervene. Or so says the government.

But what specifically was happening then, during the adjustment process, that caused this fear of economic crash and resulting depression? What might happen to cause mass unemployment, mass poverty, and why would it happen at that moment?

I’ve been asked this question by people who don’t follow markets or the economy much, and so I resolved to write something that would help explain “how we got here” the best I can.

So, here it is. My attempt to explain in “common folks language” what’s happening right now and why it’s freaking everyone out.

I’ll leave out the numbers and instead stick to broad outlines and discussions of economic cause and effect. Buckle your seat-belt.

Here is the core thing you have to understand about our situation at that time.

We were experiencing a credit crunch of monumental proportions in the credit markets. The credit markets are the places where borrowers and lenders meet up to exchange money for promises. A borrower takes money from a lender, and in exchange for that money gives a promise – to pay back the money with interest.

What’s a credit crunch?

Simply, it’s a state-of-affairs where and when people and companies – especially companies – that need to borrow money (and in a normal market would be able to borrow money) can’t borrow money.

Lenders just aren’t lending, and instead are holding onto their money.

How do you know when a crunch is on? Do you have to ask the lenders? The borrowers?

No. Just watch interest rates. You see the signs of a credit crunch anytime interest rates suddenly go way up (and I mean, way up, like a rocket taking off to the moon).

Why do they go up in a crunch?

Because there’s not enough of the money to go around for everyone who wants it, so the people who are “selling money” have a lot of potential customers bidding for it.

Here’s a somewhat lame but illustrative example. Let’s say you have a ticket to see Britney Spears in concert at a show that seats 100,000 people. It cost you very little – 10 bucks – because no one wants to see her and there were a ton of seats available.

There’s a lot of supply of seats/tickets, and very little demand.

But then you hear that the venue has been changed to a 50 seater. Well, all of the sudden the supply of seats is down, in fact, they’ve all sold out, so now each ticket is worth a little more.

You’re thinking about selling your ticket.

But then Britney gets laryngitis, and a couple of hours before the show they announce a replacement – a surprise performance by Miley Cyrus. Well, everyone wants to see Miley, so suddenly those 50 seats are in very high demand.

Now there’s a lot of demand, and very little supply.

Everyone wants your ticket, and you sell it for $100 bucks.

That happens with money, too. When demand is low and supply is high, interest rates are low. When demand is high and supply is low, interest rates are high.

For a few weeks in September and October short term interest rates – specifically, the rates at which banks lend each other money overnight – shot up by around 200%.

See, lots of people wanted to borrow money from lenders. And the more time that goes by that they want to borrow, but can’t, the more they’ll need to borrow, and the more desperate they become.

The crunch borrowers experienced was primarily in short-term money that companies needed to borrow.

This kind of debt is called “commercial paper” but the name is really not important to our discussion; you will now understand it when you read about it.

What is important to our discussion is that you understand what happens to a company when it can’t borrow short-term money when it needs it.

Notice I said need to borrow, not want to borrow.  When a company needs to borrow, bad things happen if it can’t.

Many companies borrow money for short periods of time to cover expense or pay for things they need immediately, like inventory or payroll, because don’t have the cash right now.

They can get a short-term loan because they’ll have the cash later. Owing to the fact that they will have the cash later, someone will lend them the money they need right now and get paid back, with interest, a little later.

So the big worry was that there was a shortage of this short term money for borrowing, and it was putting companies under so much pressure that they might have to shut doors, stop delivering services, and lay off people.

How is that exactly?

I mentioned that people use this short term money to stock up on inventory for sales they expect to make in the future, or to meet payroll.

If you don’t have product to sell because you can’t finance it, then you can’t make a sale, can’t turn a profit, can’t pay your people, your rent, your long-term debt, your light bill, etc.

What happens if you can’t pay your people?

They can either work for free, or they can try to get another job. Either way, it’s a hardship. Their mortgages have to be paid. Their kids have to eat. It’s incredibly disruptive. Mass layoffs means mass defaults on consumer debt (they have credit cards and cars that they bought on credit), which means consumer lenders tighten credit, too. And it spirals downward.

So there’s this problem with this short term debt being unavailable.

There’s a second reason people need new short term debt. They need it to pay off the old short term debt they have now.

See, in the business world, people often don’t “pay off” debt with cash in their bank account – there isn’t any cash there. They pay off one loan by going and getting another. This is called “rolling over” debt.

In a normal credit market people “roll over” short-term debt all the time.

For example, a company will borrow some money for a month or so and then a month later, instead of paying it off, they roll it over by borrowing more money to pay off for the old money.

But what happens if it comes time to roll the debt over, but you can’t get a new loan to pay off the old one?

Well, you have to pay off the old one with the money you have in the bank account, If you have any at all.

And what if there’s none there?

Well, you’re shafted.

And that’s what was happening.

People couldn’t roll over their debt, and they couldn’t get cash for their short term needs.

So they were being threatened with having to close their doors and lay people off, all because they can’t roll over this debt.

These are often great companies, profitable companies, companies with customers and demand for products, but they aren’t able to get “grease in their gears” to keep their production engines turning.

So we knew what was happening. But why did it  happen? Why couldn’t good companies get short term debt?

Well, like we said before, because lenders weren’t lending.

But why weren’t they lending? Did they have the money? If so, why did they hoard it? And if they didn’t have money to lend, why not? Where did it go all of a sudden? Why do lenders get afraid to lend?

There are two reasons lenders get afraid to lend.

1 – They’re worried they won’t get their loaned money back.

2 – They’ve also borrowed money, and they’re worried they’ll have to pay back their own debts so want to keep their cash in their own account.

When you borrow money, it doesn’t come without strings attached. There are certain ways you agree to run your business and certain standards you agree to keep. There are also collateral values you agree to maintain so that in case you don’t pay the loan back the lender can take over something of value, sell it, and recover all or part of the loan loss.

Well, as to #1, a lot of defaults were happening, so banks were getting burned and were worried about future loan defaults.

But something else was going on. Even on loans that were getting paid back, the assets (the stuff they’ll take from you and sell if you don’t pay for your loan) backing the loan were dropping in value as collateral.

Now as to #2, the people the lenders borrowed money from didn’t want to give the lenders any additional money(and in many cases were asking for money back) because they see these loans going bad, and this collateral losing value.

So both of those things were going on.

Borrowers and lenders both became INSOLVENT.

Insolvent is an opaque word for a pretty sinister state-of-affairs. Being insolvent means you are unable to meet your debt obligations. You owe more than you’re worth and you can’t pay your loans back. Insolvent means “negative net worth”. It’s de facto bankruptcy.

Who wants to loan money when the person receiving it (the counter-party) might not be able to pay it back and whose collateral is so cruddy, losing value, that you might not be able to recover any of it?

You’re scared witless that you’re going to lose your money if you lend it out. So you’re hoarding it.

The threat and fear of insolvency (fear of permanent and/or significant loss) among counter-parties caused hoarding by lenders.

But, you ask, why were companies suddenly becoming insolvent?

The problem was two fold – DEFLATION and ASSET VALUE WRITEDOWNS (which is really just a form of DEFLATION).

Don’t get overwhelmed by those words. They’re easy to understand.

Deflation:
Deflation is an ugly word that means what it sounds like. Deflated tires are tires that have lost air. An economy experiencing deflation is an economy that is experiences a price drop on the stuff in the economy.

Rapid and sudden deflation is also known as a “bust”.

The housing market busted. Housing prices plummeted. Banks that lent against homes, using those homes as collateral, saw the value of that collateral plummet. Who wants to make a loan in an environment like that?

Writedowns:
Let’s talk a little bit more about collateral and its importance, and what happens when it turns out to be worth much less than you think.

See, when a bank lends money, it usually lends against collateral. Let’s say you are from the Maxine Waters school of mortgage lending (see minute 5:06-5:38) and you borrowed 100% of the cost of a home, and didn’t even put any of your own money into it.

The bank lends you $200K to buy a house, and you buy a $200K house. So you owe 100% of what the house is “worth”. Lets say you have an interest-only mortgage (that means you only are paying back the “cost” of the money you borrowed – and not actually paying down the money itself) and pay $1000 a month in interest.

But then a recession hits, homes are overbuilt, etc., and the price of your house in the market drops to $160K. Then let’s say you lose your job and can’t pay your interest payment. You want to sell the house, but you’re $40K “underwater” (your house is worth $40K less than you paid for it). And you can’t even make the monthly payments.

See, the value of that home has to be “written down” by $40K on the lenders financial reports. But it wasn’t your money that was put in the home. It was someone else’s money that they lent you.  Someone else was out $200K and thought they’d get it back from you some day.

Since you can’t pay the debt, you’re insolvent. The bank takes the house back, but now that $200 “asset” on their books has to be written down to $160K. That’s a $40K loss for them. That’s real money the lender lost because the loan wasn’t paid back and the home couldn’t be sold for the value of the loan.

See, that’s what happened.

Prices dropped on homes, people couldn’t afford them, and banks had to take them back for fractions of what they’re worth (this process continues today). As they write down the value of the home, they are finding that they themselves – the banks – are becoming insolvent. See, they borrow money, too, then lend it to you . . . and when you don’t pay them back, they can’t pay back the people they borrowed from, and they go bankrupt, too. It’s like dominoes.

When banks are writing down the value of the loans they’ve made, they hoard cash because they need it to make sure they’re still solvent. When they’re hoarding, they can’t lend. And if homebuyers can’t borrow in order to buy homes, what happens to home prices? Yep, they go down even more.

A really smart guy named John Hussman explains how write-downs and deflation lead to insolvency better than anyone else I’ve ever read. He specifically talks about banks, and he shows  how deflation leads to write-downs, which leads to customers making withdrawals from banks, which leads to more stress on a bank. There are some words in there you might not understand, but read it anyway, just in case.

1) As the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;

2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;

3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;

4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.

(From his article “You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet ” http://hussmanfunds.com/wmc/wmc080929.htm You should read it after you finish reading this.)

So deflation and write-downs can be very bad, because they often wipe out the equity value of assets and leave just the debt, and they can go so far so as to actually give the company a negative worth (i.e. they have more in debt than the company is even worth).

So what causes deflation?

Busts.

But what causes the bust that causes deflation?

Well, are you ready for this? (don’t get confused)

INFLATION.

What is inflation?

Sounds like when tires get full. The opposite of deflation. So it’s good right?

Look. Having your tires stay stable, full of air, at the right pressure, is good. Over- or under-inflating your tires is bad.

Fill a tire too full of air (inflation) and . . . pop (deflation). Same with an economy.

To be precise, inflation is an increase in the money supply, which then raises the prices of goods and services people are selling.

One of the evil things about inflation is that can make you feel richer – for a while – without actually making you richer. And when you figure that out, you feel poorer.

If I get a raise at work and my salary is doubled, I now make twice as much money as before. But if, at the same time, the price of everything in the economy doubled, well, I’m just where I was before. If I make a buck today and a coke costs me a buck today, but tomorrow I make two bucks and a coke costs two bucks, am I really richer?

By the way, the cost of a home in my city did double from 2003-2006, but my income didn’t, so I actually felt poorer. But now that home prices are back down, the people who bought at the peak feel poorer.

So everyone feels poorer. Way to go inflation.

There are different kinds of inflation, but the one we’ve just seen in our economy is one that has been very, very, very bad. It’s called “asset inflation” and it manifests itself particularly in the inflation of home prices.

When there’s too much money in the market chasing goods (supply of money increasing), it drives up the price of things.

Think about houses. When lots of people wanted to buy homes in 2005 and 2006, there were more and more buyers bidding up the prices of homes.

So, to reiterate, inflation and deflation are caused by a change in the amount of money in the economy, relative to the goods that are in the economy.

You get inflation by printing money or lending people money on credit – both of which increase the amount of money in the economy.

When you realize that borrowing on credit increases the money supply, and that reducing the amount of money lent in the economy decreases the money supply, you understand that the prices of goods follows – simple supply and demand.

More money chasing a fixed amount of goods? Inflation (rising prices).

Less money chasing a fixed amount of goods? Deflation (falling prices).

So what caused inflation and why did it [inflation] have to stop?

A boom in lending caused inflation.

Yes, you say, but people have been lending money forever without asset inflation this nasty.

What was different this time?

Here’s your answer:

This kind of lending was “Cheap Money” lending.

Cheap Money Lending.

What do I mean by cheap money? Isn’t a dollar worth a dollar?

Well, yes, in a sense.

But money costs something if you borrow it.

No one will lend you money unless you give it back with a little extra for their having rented it out to you.

That little extra is called interest.

Interest is the cost of money.

Interest rates fluctuate. When interest rates are low, it’s very “cheap” to borrow money. When interest rates are high, it’s more expensive.

When it’s cheap to borrow, lots more people want to do it than when it’s expensive.

Do you remember the attacks on 9/11?

Of course you do.

Financial markets tanked in the aftermath. The economy was already in recession, having just suffered a massive misallocation of capital in the Internet and technology boom and resulting bust. The 9/11 attacks on American soil caused the economy to slow further.

So to stimulate the economy the Federal Reserve (NOW we’re getting to it, you say . . .) dropped interest rates.

Why would that help the economy?

Well, because people would borrow money, then spend it on stuff, or invest it in stuff, and the economy would be fine.

(But wouldn’t everyone just have more debt and have to pay it back someday, making it harder on them? you ask. Hey, don’t ask smart questions like that. Live in the now, baby.)

So they dropped rates, big deal. So money is cheaper to borrow.

But how do they do that? Do they just say “money now officially costs less” and suddenly interest rates everywhere drop.

No.

Then how do they control the interest rate?

They don’t just tell everyone to lend money at a cheaper rate, they actually do something.

Let’s just review a couple of concepts we hit on before:

When money is cheaper, more people want to borrow it, right? Right.

So there’s a need for more of it to be available, right? Right.

So what comes first, the interest rate or the money supply? The money supply!

The Federal Reserve puts money into the economy until the supply and demand for money meet at the interest rate they’ve targeted.

It’s sort of a “cart and horse” thing. If there’s a lot of money in the system, rates will be cheaper. If people think rates will be cheaper, there HAS to be an increase of money in the system to have them actually be cheaper (you can’t “think” them cheaper).

So the Federal Reserve “prints” money until the interest rate they’ve chosen gets hit.

Wow, money out of thin air?!

Yep.  Basically.

So money got cheap to borrow after 9/11. Dirt cheap. The government lowered the interest rate to 1% (they call it the “Fed Funds” rate). And banks got that cheap money from the government and lent it out cheap.

Do you know what people like to buy when they can get a low interest rate?

They like to buy homes.

A mortgage is just a loan you get and pay interest on. Mortgage loans are normally for 30 years, so a low interest rate makes a huge difference over a high interest rate over the life of the loan (often hundreds of thousands of dollars difference in payments over the life of the loan).

So when people realized that they could buy a house for cheaper at these post-9/11 rates, they started to do it. And as they bought more homes, there were more jobs in construction, realty, mortgage brokering, etc. And as there was more money in that, the economy appeared to be picking up. People started “refinancing” their homes at cheaper rates (replacing their old mortgages with new, cheaper ones), saving more dollars each month, buying stuff with it.

This went on and on.

Until pretty soon everyone wants a home. They’re getting into “bidding wars” and the prices of homes are going higher and higher.

People are getting rich! The difference between the cost of their home and its current “market value” is pretty big, so they take out a “home equity line of credit” which is a just a big phrase for “putting the ownership in my home at risk so that I can have a chunk of cash right now to spend on a boat.”

People took out new mortgages on their now-more-valuable homes, paid off the old mortgages, and used the difference between what they were able to borrow and what they paid off to buy boats, and do remodeling, and travel to far-away places.

Or, buy a second or third home. Yikes.

And other people start seeing home prices go up, equity in homes being captured buy homeowners, second and third homes being bought, boats being bought, and they think – hey I’d better get in now, too. If I don’t, I might miss the run up and then I won’t be rich!

So more people pile in the market looking to buy a home and, hey, there are all kinds of loans out there that give them a low monthly payment (even if they are just paying for the interest and not paying for any actual ownership in the home – but don’t worry, the value of the home is going to go up forever and to infinity!)

But pretty soon home prices are really skyrocketing and something really, really weird is happening.

People with really low incomes are buying really expensive homes.

People who have no business buying homes (people who months earlier were struggling to make rent on their apartments) are now getting the money to buy a McMansion.

It’s clear there’s a problem, or there’s going to be a problem at some point, because there’s no way many of these buyers should be able to afford these homes. At some point, when they have to actually pay something other than interest on their homes, there’s going to be big trouble.

But then banks keep letting people buy these homes with these crazy mortgages.

Soon, the economy is totally “overheating”. Home prices have gone far, far too high to justify any sense of value.

And the Federal Reserve is worried about this “asset bubble” (that’s what they called it).

They decide that they’ve got to raise the interest rate to slow things down.

Well, how do they do that?

You know the answer. The only way to raise the interest rate is to reduce the amount of money available.

How does that work?

Just imagine that there are two dollars in the world and they are owned by one person, and two other people in the world each want to borrow a dollar. The guy who has the dollars gives them each a buck and they agree to give it back to him in a month along with 10 cents (to pay for the “rent” of the money). So it’s a 10% monthly interest rate.

They pay the guy back, with interest at the end of the month.

Now, a year later, the two borrowers go back to the guy, but this time he’s only got one buck, and it’s the only dollar in the world. He says, “Sorry, I’ve only got one, so I’ll rent it to the highest bidder.” The two borrowers start bidding, one after the other. Money is in tighter supply, harder to get, so this one, scarce dollar is now more valuable to each of the borrowers. Finally, one of them bids 20 cents to rent it for the month (20% monthly rate) and the other guy says, “Fine, you have it. I’m not paying that.”

Did you see what happened? The fact that money was more scarce drove up the interest rate. Once it got high enough, one of the borrowers dropped out.

The rate got high precisely because there was less money.

(Same as in a credit crunch, when there’s less money to borrow.)

Demand for (or desire for) money was there until the rate got high enough that one guy said “Not worth it to me, I’d rather lay in the sand”.

So all of that to underscore that money supply – along with money demand – determines the interest rate.

In our example, when there was only one dollar to borrow the economy was then only half as “hot” (only one dollar borrowed and put to work, instead of two).

Well, that’s what happens in real life, except with millions and millions of people, and billions and billions of dollars.

So back to the Federal Reserve.

The economy is hot, so they’ve got to get this interest rate up, cool things down, and stop the home price increases before they get any crazier.

So they start pulling money out of the system, and the interest rate climbs until it hits their “target”.

But then the economy stays hot, so they pull more out, and more, and more, and more, until . . .

. . . it’s overdone. It’s too high.

Now these homebuilders who had seen all these people with all these money are building tons of homes . . . that nobody wants anymore.

Whoops. Misallocation of resources. (Hey, isn’t that what causes depressions? Uh oh.)

Lots of houses. Not a lot of buyers. Builders start to slash home prices – even further, accelerating deflation – to get out of this inventory of homes they’ve overbuilt.

The bubble bursts … deflation takes hold. All that equity created when the home prices ran up gets wiped out.

But, oops, a lot of people borrowed against that equity and replaced it with debt, and now their houses are worth far less than what they owe on them.

You know the rest of the story – we talked about it above. This bust, this asset deflation, leads to insolvency, and that leads to a credit crunch, which could lead to a depression.

And the KEY PLAYER in this Drama of Dunces is the Federal Reserve Bank.  You, as a small business employee or owner, are greatly impacted by these boom/bust cycles.  Through interest rate manipulation, the Federal Reserve not only causes instability in the financial system, they also send you false signals.

See, in a truly free market low interest rates are a sign of savings (since interest is the “cost” of money, when supply of loanable funds is high, lenders have to compete and lower the “cost” of the money they lend.)  This is a signal to small businesses to borrow money, because with all those pent up savings there are customers-a-waiting, and low-cost funds to employ to make them stuff they’ll later buy.

But when the Federal Reserve artificially lowers the rate (precisely BECAUSE there’s a lack of savings and they need to “stimulate” the economy), they send exactly the wrong signal to small businesses, who then make incorrect decisions.  Yuck.

And right at that moment, the bottom drops out.

As the eloquent Frank Chodorov says it, “A depression is a halting of production. Production stops when people cut down on their consumption. They are compelled to curtail because they burdened themselves with obligations during the boom and now they are unable to meet the interest payments. Values did not rise as fast as they had expected; mortgages and other debts hang heavy on their necks, and in an effort to save their original investment they cut down on their consumption. Cutting down on consumption means putting people out of jobs, and so the whole house of cards collapses. Only when the false values are liquidated, the mortgages wiped out, can there be a resumption of production. The depression is a period of deflation following a period of inflation.” (http://mises.org/etexts/rootofevilb.asp)

Hmmmm, you say, something doesn’t add up.

No bank HAD to make these loans. Smart people work there. They have rules and regulations they have to follow. Even with cheap money, and even though it made it seem more likely people would pay the loans back (after all, they had low interest rates), the banks would still make money, right?

Banks don’t have or want to make loans to people who they’re worried won’t pay them back, right?

Oh, but they did.

Really?!!! But why would they?

Well, for one, they knew that they ultimately wouldn’t have to pay the full cost if the loans went bad.

Huh? Someone else would pay the cost if the loan went bad?

Yep.

AND, for two, they were forced to make the loans.

Well, forced is a strong word. They actually had a choice: make the bad loans, or go out of business.

But, you ask, if the banks weren’t bearing the full cost of the loans, who was?

First of all, lot of disappointed investors that the banks sold loans to bore the cost. But you know what? That’s not too terribly bad because investors take on risk, that’s part of the deal.  Sadly, many of them were misled by “Rating Agencies” they trusted but should not have.

Rating agencies rate the riskiness of assets, and these agencies were wrong about that risk.  I’m not going to spend too much time on this issue (though it is extremely important) because it was government – through their regulations – that told banks and institutions that they had to trust and utilize the values produced by these ratings agencies.  So people trusted these ratings, took on more risk than they thought they were (but they should’ve known better …), and bad things happened.

But enough about the investors who lost their shirts.

There were people other than investors taking on this risk – taking on this risk without their knowledge, totally involuntarily – and that’s the part that is scandalous.

The victim in all this is the American Taxpayer.

If it were just investors that got wiped out, that would be one thing. We’d still have the problems of inflation and deflation, and as individual homeowners people would have problems, but the American Taxpayer would largely be protected.

But unfortunately, it wasn’t just investors that took these loans and lost money. There were other companies, sponsored by the government, that bought these loans and also sold “insurance on the loans”.

We’re getting to what is perhaps the saddest part of this whole thing.

We’re about to uncover the fuel that allowed the forest fire to burn.  This is the tinder that Federal Reserve Policy lit on fire.

There are some names you need to know. Learn these names and what they mean and you’ll be on your way to untangling the debacle. They are the names of one government bill and two organizations.

The bill is the Community Reinvestment Act (hereafter CRA).

The names of the organizations are Fannie Mae and Freddie Mac (aka Freddie and Fannie).

We’ll get to the details, but here’s what you need to know.

1 – The CRA allowed for the extortion and blackmail of banks so that they’d be put out of business if they didn’t make risky loans to unqualified borrowers.

2 – The banks went ahead and made the risky loans because the government, through the organizations of Fannie Mae and Freddie Mac, agreed to back the risky loans, implicitly guaranteeing that if they went bad, the government (i.e. the US Taxpayer) would pick up the tab, not the original lender.

These organizations are authorized and implicitly backed by the government to make mortgage loans, buy mortgage loans from people who hold them, and also to insure them.

If Fannie or Freddie lose money and need a bailout, the government will bail them out. (They insist that they’re only “implicitly” not “explicitly” backed by the US government, but look what’s happening now. Their takeover by the government happened in September 2008 and there are lots of ways US taxpayers are footing the bill for the intervention.)

So what is being insured by Fannie and Freddie?

They are insuring mortgage loans against default. Default, as we noted above, is a word for non-payment.

If a loan defaults – the borrower stops paying it – and Freddie or Fannie has sold insurance on that loan, then when the loan doesn’t get paid back to the person who made the loan Fannie or Freddie has to pay the outstanding loan amount to the guy that got stiffed.

Sounds risky, huh?  You get a little bit of insurance money (a premium) but if a loan goes bad you have to pay for the whole thing!

Well, it’s not expensive when everyone is making their house payments. When there aren’t any defaults you just collect that premium payment and pay managers millions of dollars a year to pretend they’re running the company safely.

From Wikipedia.

“[Freddie and Fannie make money] by charging a guarantee fee on loans that it has purchased and securitized into mortgage-backed security bonds. Investors, or purchasers of Freddie Mac [loans], are willing to let Freddie Mac keep this fee in exchange for assuming the credit risk, that is, Freddie Mac’s guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays.” (http://en.wikipedia.org/wiki/Freddie_Mac#Business )

OK, you say, I get it, so there are these organizations that guarantee that if loans aren’t paid, they’ll pick up the tab, and in exchange for the guarantee they get some dough.

Freddie and Fannie didn’t just sell insurance, they also bought and owned a lot of cruddy loans in order to help the US government meet its housing goals.

But why would they ever write insurance or take ownership of crappy loans? Wouldn’t they just refuse to insure or own those?

Of course, because politicians would never allow taxpayers to be put in a position where they’d have to pony up to pay for all the mistakes that Freddie and Fannie made.

Right?

Well, not exactly. See,

“Fan and Fred’s patrons on Capitol Hill didn’t care about the risks inherent in their combined trillion-dollar-plus mortgage portfolios, so long as they helped meet political goals on housing.”
(http://online.wsj.com/article/SB122204078161261183.html?mod=special_page_campaign2008_mostpop)

Political goals on housing? What’s that all about?  The federal government decided long ago to intervene in the housing market.  On June 28, 1934, Franklin Delano Roosevelt signed into law the National Housing Act (NHA) of 1934, which initiated a series of unfortunate government interventions you can read about here.

Now fast forward to 1977 and enter the Community Reinvestment Act (CRA). The name of that bill you learned about above. One of the big, bad culprits.

“The Community Reinvestment Act is a United States federal law that requires banks and savings and loan associations to offer credit throughout their entire market area. The act prohibits financial institutions from targeting only wealthier neighborhoods with their services, a practice known as ‘redlining.’ The purpose of the CRA is to ensure that under-served populations can obtain credit, including home ownership opportunities and commercial loans to small businesses.” (http://en.wikipedia.org/wiki/Community_Reinvestment_Act )

Well that sounds innocent enough, you say. You don’t see any problems.

But if you look more closely it says that lenders shouldn’t be able to lend to whomever they deem to be creditworthy. They have to take considerations other than credit-worthiness (ability to pay back the loan) into account when they make loans. So, the stage was set for some abuse.  And in 1995, we got it.

“In early 1993 President Clinton ordered new regulations for the CRA which would increase access to mortgage credit for inner city and distressed rural communities. The new rules went into effect on January 31, 1995 and featured: requiring numerical assessments to get a satisfactory CRA rating; using federal home-loan data broken down by neighborhood, income group, and race; encouraging community groups to complain when banks were not loaning enough to specified neighborhood, income group, and race; allowing community groups that marketed loans to targeted groups to collect a fee from the banks. (http://en.wikipedia.org/wiki/Community_Reinvestment_Act#Clinton_Administration_Changes_of_1995 )

Robert Litan, an economist at the Brookings Institution, told the Washington Post that banks:

“had to show they were making a conscious effort to make loans to subprime borrowers” (http://online.wsj.com/article/SB122204078161261183.html?mod=special_page_campaign2008_mostpop )

So banks had to lend to people who were not credit worthy because if they didn’t companies could complain against them.

But who cares? It’s not like these complaints could actually be used to blackmail the banks, right?

Wrong.

These groups, if they filed a complaint – whether real or imaginary – could completely freeze a lender out of a neighborhood, county, city, or region, have their licenses stripped, etc.

They’d threaten complaints against a lender and then tell the lenders that they’d only remove the complaint if the lenders paid them money and agreed to make loans to people who had no business doing it (yeah, that part about “marketing loans to targeted groups  to collect a fee from the banks”).

Since the lender couldn’t do business until the complaint was removed, the banks caved. If they didn’t agree to make the bad loans, they’d be out of business altogether.

So these groups extorted money and blackmailed banks into making bad loans.

“[Clinton’s CRA changes] compels banks to make loans to poor borrowers who often cannot repay them. Banks that failed to make enough of these loans were often held hostage by activists when they next sought some regulatory approval.

(http://online.wsj.com/article/SB122204078161261183.html?mod=special_page_campaign2008_mostpop)

Who were these groups and activists?

Every heard of ACORN? ACORN stands for Association of Community Organizations for Reform Now. ACORN made a lot of money abusing this law and shaking down banks .

You heard a lot about ACORN during the election of 2008 because of Barack Obama’s affiliation with them and also because of alleged fraud that ACORN committed in registering voters for the presidential election.

Do you know what “sub-prime” means (it was used in one of the quotes above)?

It means, “loans to people with really bad credit scores due to the fact that at some point in the past they borrowed money from people and then didn’t pay it back the way they’d promised to.”

So groups like ACORN – with the support of the Clinton administration – created a hostage-like environment for the banks and ensured that loans were being made to subprime borrowers.  But those loans were often quickly packaged and passed on to Fannie and Freddie, where the American Taxpayer would pick up the tab if there were any problem with the loan.

And these practices continued on into the Bush Administration.

The reason this connection with ACORN was such a big deal is because Barack Obama at one time trained ACORN activists and funded their operations . And he sat on a board with Bill Ayers for an organization that dispensed money to groups like ACORN.

But we’re digressing.  So – back to our story – you see there were a lot of bad loans out there that “needed” to be made.

And, you see, Freddie and Fannie helped them get made by both making loans and insuring the loans that the banks were extorted to make.

So why would politicians let them get away with it?

Because the organizations helped politicians buy votes, by putting people into bigger and better houses than their incomes justified.

Who was the person at Fannie Mae running the organization, overseeing and encouraging the buying all this crap up and then criminally cooking the books to make it look like everything was fine?

Franklin Raines, who was in the news not only because of the accounting fraud but also because he has advised Barack Obama on housing policy, according to the Washington Post.

Another was Jim Johnson, who was in the news because he oversaw the committee to select Barack Obama’s vice presidential running mate.

Lots of politicians have received money from Freddie Mac and Fannie Mae employees. John McCain has even accepted some, though he historically fought against Freddie and Fannie and fought to oversee them. Barack Obama received more money from Freddie Mac and Fannie Mae employees in the last two years than any other politician has (except for one) in the entire history of campaign donations.

Those are just the two highest profile politicians but there are a lot of them who should have overseen Freddie and Fannie but had conflicts of interest.

So there you have it. The corruption was allowed because the organizations not only bought off politicians but the politicians also used these organizations to buy votes.

When you get bad policy with cheap money, it’s like flame and gunpowder.  Because of the Federal Reserve, Freddie and Fannie, and bad Government Housing Policy we experienced a bust of monumental proportions.  And small businesses are suffering.

And so long as the Federal Reserve retains the ability to alter the money supply at whim and will, and manipulates interest rates, the boom-bust cycle will continue, alternately sending false signals to entrepreneurs that lead them to undertake unprofitable projects, and later crashing the economy through the resulting misallocation and adjustment.

So, to recap the above.

Depression is caused by economic failure which is caused by markets seizing up which is caused by deflation which is caused by a bubble bursting which is caused by the misallocation of resources and inflated prices which is caused by inflation which is caused no government discipline plus government cheap money plus government intervention plus horrible government laws that were abused that is caused by pandering to voters and extorting taxpayers while simultaneously trying to stimulate an economy artificially to provide the illusion of wealth and progress.

Got it?

And another thing. Government permitted an environment where corruption could flourish.

Our government is deep in debt. That debt has to be paid back.

Who’s paying it back? We’re paying it back. One way or another, we’re going to pay. We’ll pay now, we’ll pay later, we’ll pay for a long time, and we’ll get very little in return because the money has already been spent.

The government can make money in two ways.

It can create monopolies for itself and charge high rates while operating inefficiently, like they do with the post office.

Or it can take your money, with or without your consent, as it does through taxes.

So, pick your poison.

Maybe the government will take over the health care system. That’s one monopoly they’d love – but if you think the lines at the post office and DMV are bad, try waiting in one while you’re dripping blood from a head wound.

When considering who to elect to ANY office, the question that matters isn’t “are you a Republican or are you a Democrat…or will you give me X or Y and make me A or B promise.”

The only question that matters is:

“Do you believe there is such a thing as a free lunch?”

(hint: there’s not!)

To learn more about the Federal Reserve and how it hurts small business, read mises.org and the book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods.

So now, what can you do about it?   Urge your State Representatives and Senators to support HR1207 and S604 .  The first step in reforming (or abolishing) the Federal Reserve is to audit it, to make it accountable, and to allow people to see its operations.

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