The Great Deformation (79 page)

In fact, the huge revenue margins, massive compensation pools, and outsized profits obtained by Ameriquest were not possible on the free market. No rational investor would have paid anything close to par for mortgages that were so recklessly underwritten, serially refinanced, ill documented, and dependent upon such onerous reset mechanisms as the Ameriquest mortgages.

Stated differently, based on Ameriquest's observable modus operandi, diligent investors would have demanded a deep discount on these hair-ridden loans. Yet had Ameriquest been forced to sell its loans at even 95 percent of par to compensate investors for the virtually unknowable risk inherent in its business model, its revenues would have been wiped out entirely, thereby vaporizing its fabulous profits and lunatic compensation pools.

At the end of the day, Ameriquest and its subprime imitators operated an incredibly destructive feedback loop. Based on stupidly high Wall Street prices for their junk mortgages, they paid salesmen wholly uneconomic levels of compensation, which fueled their predatory sales machines; the huge volumes flowing through this machinery, in turn, generated even larger compensation pools which catalyzed even greater volumes of junk mortgages.

So the whole subprime industry depended upon an egregiously over-priced market for junk mortgages, and there is no secret as to why it existed, especially after 2001. Wall Street created it and grew it to stupendous size. As detailed in
chapter 20
, the $100 billion market in high-risk mortgages that had built up by the year 2000 suddenly morphed into a trillion-dollar monster within just six years.

THE FED'S PERFECT STORM: HOW 1 PERCENT INTEREST RATES FUELED THE BONFIRES OF SUBPRIME

The truly insidious aspect of the subprime assault on America's neighborhoods was not that operators like Roland Arnall and a handful of imitators got preposterously rich running a few thousand boiler rooms populated with predatory salesmen. America is riddled with dial-for-dollars operations, some of them just as seedy.

The difference is that Arnall wasn't selling aluminum siding or cosmetics, but $500,000 mortgages that could never have been funded in the absence of the Fed's prosperity management model. As has been seen, the latter was based on the primitive notion that any amount of money printing was permissible, so long as it did not put undue upward pressure on commodity and product prices.

Yet that was no constraint at all. In a world of massive US current account
deficits and the “China price,” the American economy was, in effect, importing gale-force wage and product deflation. And it would continue to do so until China's rice paddies were drained of excess labor and the People's Printing Press stopped pegging its exchange rate.

So the Fed's panicked money-printing campaign after December 2000 was a pact with the devil in economic terms: it permitted the US economy to live high on the hog in the short run, while it offshored the nation's traceable goods industries and buried its balance sheet in external debt in the longer run. One of these obligations, ironically, was mortgage debt in the form of GSE paper.

Foreign central banks led by the People's Printing Press of China owned less than $100 billion of GSE paper before the Fed ignited the mortgage boom in 2001. Through continuous absorption of excess dollars remitted by their exporters, however, they had accumulated upward of $1 trillion of Freddie and Fannie paper by July 2008. Sequestering unwanted dollar claims, the mercantilist central banks of Asia thereby ensured there would be no flare-up of CPI inflation and no sell-off in the bond market.

With the bond vigilantes incarcerated in a red vault in Beijing, as it were, 1 percent money market rates revived Wall Street's speculative juices and ignited the carry trade like never before. Indeed, it is difficult to imagine a better setup to induce Wall Street to feed the marauding bands of subprime mortgage bankers with warehouse credit, and to carry hundreds of billions of junk mortgage inventory until it could be sliced and diced into private-label MBSs.

As the great housing carry trade gathered momentum on Wall Street in 2002–2003, however, the folly of the Fed's bubble finance was palpable. In a credit-saturated economy, the price that matters above all else is the price of credit; that is, the interest rate on short-term borrowings and the yield curve across the spectrum of longer-dated debt securities.

Yet the Fed's prosperity management model completely ignored the need for honest and accurate pricing of liquid credits and debt capital. In fact, by completely disabling free market interest rates, it fueled both the final binge of household mortgage borrowing and also fostered Wall Street's capacity to fund and securitize the junk mortgage loans being generated by the brokers' boiler rooms.

At the end of the day, the great housing fiasco did not represent a failure of the free market. It happened because the free market had been supplanted by two great financial deformations of the state: the GSEs which gave birth to the predatory mortgage boiler rooms and the central bank which favored them with a rogue funding machine parked at each and every notable Wall Street address.

CHAPTER 20

 

T
HE EFFECT OF THE FED'S 2001 MONEY-PRINTING PANIC WAS THAT
“cap rates” on long-lived assets like real estate were driven sharply lower, thereby causing prices to soar. Soon the increased collateral value of properties, both homes and shopping malls, begat even more lending and even higher prices.

Furthermore, Main Street was now populated by a small army of former dot-com speculators who were bitterly disappointed, but also eagerly looking for the next asset class that could generate instant riches. Accordingly, they quickly caught on to the homeowners' leveraged buyout (LBO) gambit: repeatedly refinancing and flipping properties as valuations rocketed.

The figures for mortgages crystallize the massive debt loop which emerged in the domestic real estate markets. In the case of the residential sector, home mortgages outstanding rose by $750 billion, or 13.2 percent, in 2002. This was a robust figure under any circumstances, but extraordinary in light of the fact that the US economy was just emerging from its post-dot-com slump.

During the course of 2002, there had been zero net job creation and wage and salary incomes had grown by less than 1 percent. From day one of the home mortgage boom, therefore, the driving force was rising housing asset prices, not burgeoning household incomes and capacity to borrow.

As the housing bubble inflated, the level of outstanding home mortgages just kept growing at faster and faster rates. During 2003 mortgage debt outstanding increased by 15 percent and then grew by another 15 percent in 2004. The latter gain represented an annual increase of $1 trillion and was no aberration: annual home mortgage debt growth remained in
the trillion-dollar-per-annum league until the housing bubble finally started cooling off in the second half of 2007.

By any historic standard, these were outlandish gains. Annual home mortgage growth, for example, had averaged only $170 billion per year during the five years after the 1990 recession and had peaked at just $425 billion in 1999.

Yet the parabolic climb of home mortgage debt outstanding, which rose from just over $5 trillion to $11 trillion between 2000 and 2007, is actually the subdued part of the home mortgage story; it does not begin to capture the explosive churning which was going on underneath in the form of a refinancing boom.

THE EPIC CHURN OF HOME FINANCE: HOW $20 TRILLION OF MORTGAGES FUELED THE HOUSING PRICE BUBBLE

The refinancing boom meant that massive amounts of existing mortgages were being replaced by new ones. As a result, the figure for “gross originations” was many times larger than the net gain in mortgage debt outstanding cited above. In fact, it was literally off the charts by the standard of any prior experience.

During 2002, gross home mortgage originations totaled $3.1 trillion, or 4.1X actual new home purchases. The Fed's interest rate repression policy and the rapid spread of floating rate and teaser mortgages which were priced off short-term money rates thus conferred on homeowners a massive windfall of mortgage savings.

As the Fed manically pursued what amounted to an interest rate destruction campaign and brought short-term interest rates down to 1 percent in June 2003, the mortgage financing system literally came off the rails. Gross home mortgage originations for the full year totaled $4.4 trillion. This meant that in a single year, the red-hot machinery of home finance generated gross proceeds amounting to nearly 40 percent of GDP. By contrast, prior to 2001 gross home mortgage financing had never exceeded 17 percent of GDP and normally averaged about 12 percent.

During the second quarter of 2003, mortgage financings literally shot the moon: gross origins clocked in at a stupendous $5.4 trillion annualized rate. Yet during the same period, the Fed poured kerosene on the fire, cutting interest rates yet again. The minutes of the June meeting at which it ratcheted the federal funds rate to the near free money level of 1 percent made no mention whatsoever of the raging mortgage boom. Instead, the Fed's statement justified the rate cut as necessary to “provide additional insurance that a stronger economy would in fact materialize.”

Nor did the frenzy abate after 2003. Gross originations remained above
$3 trillion annually and totaled nearly $20 trillion over the housing boom period of 2002–2007.

The cascade of negative repercussions on the Main Street economy from this deluge of cheap mortgage money started with the unprecedented and manic surge of housing prices, as detailed in
chapter 19
. These kinds of gigantic price increases in short time intervals can occur for nonmonetary reasons in commodity markets owing to big supply disruptions; for example, a drought in the corn belt or a major copper mine strike. But in a decentralized asset market with low turnover and high transaction costs like residential housing, such huge, sudden price gains were possible only due to the aberrationally cheap mortgage financing enabled by the Fed. The housing price spiral most certainly did not reflect the opposite; namely, organic demand owing to meaningful gains in the earned income of the American households. In fact, while housing prices were soaring by 50 percent during 2000–2003, wage and salary incomes rose by only 6 percent in nominal terms during that three-year period, and actually declined after adjusting for inflation.

Needless to say, this initial price spiral accelerated when house flipping became a national pastime, accounting for up to 35 percent of activity in many overheated markets. Flippers were willing to pay higher and higher prices, believing that they could quickly capture the gains and then reload for another go-round. Whether intended or not, the Fed's money-printing spree effectively transplanted the gambling mania from dot-coms to residential housing.

THE MEW MADNESS: LINCHPIN OF THE FED'S PHONY PROSPERITY

Not everyone wanted to sell the family castle, of course, so refinancing became the alternative of choice. In an environment of rapidly escalating prices, this gave rise to the infamous MEW trade; that is, mortgage equity withdrawal from owner-occupied properties. MEW represented the excess proceeds from a new mortgage at current housing prices after paying off an older mortgage which had been financed at lower property values and, frequently, at a much lower loan-to-value ratio.

The amount of cash that could be extracted from ordinary homes in this manner amounted to a stupendous windfall. Nothing like it had ever before been seen on Main Street.

For instance, when a $100,000 home which carried a partially paid-down mortgage of $60,000 was refinanced at a doubled appraisal of $200,000 and a 92 percent loan-to-value ratio, the cash takeout after closing costs would have been $120,000. Accordingly, during the peak of the
MEW boom in 2003–2007, thousands of Main Street households walked away from mortgage settlement conferences every day with $50,000, $100,000, and even $200,000 of found money.

MEW thus generated a powerful sense of instant riches along the length and breadth of Main Street because it brought unexpected and undreamed of dollops of hard cash, not just the paper gains of the dot-com stocks. Needless to say, it also resulted in massive increases in contractually fixed household debts, propped up for the moment by wildly inflated asset prices which were bound eventually to come back to earth.

MEW was one of the worst economic poisons ever fostered by a central bank, but the Greenspan Fed actually embraced it as an important tool of prosperity management. The minutes of the same June 2003 meeting in which the FOMC voted to goose the economy with a 1 percent federal funds rate also claimed a double-barreled wealth effect.

In the first instance, improved economic growth would result from “the effects of rising stock market wealth on consumer balance sheets.” Not done with the wealth effect elixir, the Fed minutes also anticipated an economic lift from “continued opportunities for many consumers to extract equity from the appreciated value of their homes.”

Widespread home equity extraction through borrowing would have horrified sound money men only a few decades earlier. But the Fed's debt-pusher-in-chief urged that there was no cause for alarm about the massive raid on home ATMs being triggered by rising housing prices and easy mortgage credit. Indeed, by issuing a “do not be troubled” advisory, the future Fed chairman proved he didn't know the difference between honest GDP growth earned by labor and productivity and a “higher print” reflecting speculative borrowing.