Malinvestments, Predatory Lending, and Demagogues

Caroline Baum has another great article out today entitled As Housing Goes Bust, Lenders Become Predators? What follows is the condensed version. I suggest reading the entire article.

Congress is gearing up for hearings on predatory lending, the latest chapter in its long history of barn-door-closings on already-departed horses. Delinquency rates on these risky home loans are rising, subprime lenders are going belly up at an alarming rate, criminal probes of some lenders are under way (the trial lawyers must be salivating at the prospect of a whole new class of class-action suits), and front-page stories are proliferating almost as fast as you can get a no-money-down, no-questions- asked mortgage.

Last week, federal financial regulators, including the Federal Reserve, Office of the Controller of the Currency and the Federal Deposit Insurance Corp., proposed a series of guidelines "to address certain risks and emerging issues related to subprime mortgage lending practices, specifically, particular adjustable-rate mortgage (ARM) lending products."

Congressional committee chairmen have already invoked the idea of "predatory lending" to create interest in planned hearings. In an opening statement at a Feb. 7 hearing, Dodd said "that predatory and irresponsible lending practices are creating a crisis for millions of American homeowners."

"We've created an unproductive asset," says Joe Carson, director of global economic research at AllianceBernstein. "A house doesn't produce income." Mortgage debt rose by $4.7 trillion from the end of 2000 through the third quarter of 2006, according to the Fed's Flow of Funds report. "We created as much debt in housing in the last six years as we did in the prior 50," Carson says.

After the late 1990s stock market bubble, the economy recovered with a combination of interest-rate relief and income growth, he says. That rate relief was the cause of the current housing bubble, former Fed Chairman Alan Greenspan's claim about the Berlin Wall coming down notwithstanding. How can the cause also be the cure?

By the Time Congress or the Fed gets around to doing something, the time to do it is already long over. Subprime lenders are dropping like flies, bankruptcies are soaring, flippers have stopped flipping, and credit lending standards have tightened dramatically in the aftermath of one housing disaster after another.

Now that the market has imposed its solution (dramatically tightened credit lending standards in the wake of bankruptcies, foreclosures, defaults, and REOs) Dudley Do-Right (as played by Congress) is leading the charge to save Nell Fenwick from Snidely Whiplash. (Click on the above link for an audio of the charge. Image thanks to IMDb.)

Sorry Dudley (aka Congress/Fed), Nell Fenwick has already lost the deed to her ranch.

Congress and the Fed are acting trillions of dollars too late in credit lending and four years too late in time to save dear Nell and tens of thousands of folks just like her. This was entirely predictable right down to the Avalanche of Lawsuits, the congressional hearings, and the final finger pointing. Those hearings are nothing but demagoguery and a complete waste of time. Not only has the market already imposed its solution but all the finger pointing will be in the wrong direction.

The roots of this problem are numerous attempts by Congress and this administration to promote the "ownership society", the creation of GSEs, hundreds of pieces of congressional legislation supposedly to make housing more affordable all of which had the exact opposite effect, and to top it all off the Greenspan Fed came along slashing interest rates to 1% in a misguided attempt to prevent deflation in the US.

In short it is not "that predatory and irresponsible lending practices are creating a crisis for millions of American homeowners" it is Congress and the Fed fostering an environment that not only allowed but actually encouraged this to happen.

Unfortunately the demagogue's fingers will be pointing every which way except at Congress and the Fed. Ultimately legislation will be enacted to prevent this from happening again. That legislation is sure to do nothing to solve the existing problem , but rather it will be written in a manner that will cause some other different problem down the road.

The key point in Baum's article, however, is not predatory lending, nor is it about congressional demagoguery, nor is it about the avalanche of lawsuits that are coming down the pike. Here is the key paragraph.

"We've created an unproductive asset," says Joe Carson, director of global economic research at AllianceBernstein. "A house doesn't produce income." Mortgage debt rose by $4.7 trillion from the end of 2000 through the third quarter of 2006, according to the Fed's Flow of Funds report. "We created as much debt in housing in the last six years as we did in the prior 50," Carson says.

Bingo! Austrian economists would call this malinvestment. For all this artificial boom, we did not create any productive capacity, we did not even improve infrastructure. All we did was pile on debt. That debt will not be inflated away, wages will simply not rise fast enough, and jobs will become harder to find in the upcoming recession. That debt will be deflated away via bankruptcies. The process has started and it has a long, long way to go before it's over.

Instead of spending money on productive assets we are actually selling assets to foreigners to finance our reckless spending habits. We have also wasted what will eventually amount to trillions of dollars to blowing up Iraq, and since no one else is willing to say this, I will: Every life lost in Iraq was wasted as well, every single one of them.

Compare and contrast how we have been wasting dollars to what China and India are doing with their dollars. Yes, China has built tons of overcapacity, but unlike us they at least have capacity, and unlike us China and India have massively improved infrastructure while we have allowed ours to go to waste. Proof of that statement is easy. Schwarzenegger needs $500 billion to rebuild California and that is just California! Other states are in similar messes with both infrastructure and pension plans.

The market is in the process of repricing those malinvestments right now. That is why subprime lenders are blowing up, home prices are falling, defaults and foreclosures are rising, and credit lending is imploding. In attempting to prevent deflation the Fed has essentially guaranteed it. Congress played right along giving the banks and credit card companies exactly what they wanted: A bankruptcy reform act written to make people debt slaves forever. This fostered risky credit card lending in the belief that those loans will be paid back. They won't.

Instead of taking a hit in 2002, Greenspan and Bernanke made matters worse by creating the mother of all housing bubbles. Instead of allowing people to go bankrupt, we passed laws making it harder, and those laws have already started to backfire. Instead of stopping subprime lending earlier, institutions repeatedly dropped lending standards to meet growth requirements. Instead of taking writeoffs now, lenders are refusing to admit mistakes hoping on a wing and a prayer that these bad home loans will cure themselves. Those loans will not be paid off either. We are following in the footsteps of Japan except that our consumer debt loads will make it worse. The Fed has learned nothing every step of the way.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/