Greenspan was living for the moment: “I believe that equity extractions from homes will continue to be a source of positive growth in personal consumption expenditures.”36 Greenspan then extolled some Fed model (Greenspan ignored them, blamed them, cited them, or cited and then dismissed models as opportunities to salvage a hypothesis as his reputation arose) that calculated 20 percent of personal consumption came from consumers cashing out their “wealth.” Rising house prices were essential to America’s continuous shopping spree.
Through the summer and fall meetings, some members of the FOMC worried about low interest rates. This was often expressed as a concern about house prices. Federal Reserve Governor Edward Gramlich described his growing fears. At the August 13 meeting, he was “uncomfortable that the refinancing of housing should be the source of so much of the support for our recovery.”37 Greenspan was having none of that: “You sound like a true conservative.”38
House-flipping stories grew more bizarre. They left the FOMC in gales of laughter. Al Broaddus, president of the Federal Reserve Bank of Richmond, in September: “ ‘I spoke to the CEO of one of the larger North Carolina furniture companies, and his theory is that younger families are stretching so hard to pay the elevated prices for new homes that once they move in they have to sleep on the floor!’ [Laughter]”39 Jack Guynn, president of the Atlanta branch, in November: “ ‘The south Florida housing market would have to be characterized as red hot. One director reported that when a moderately priced development on the west coast of Florida opened, demand was so great that sales had to be limited to three homes per customer. That’s a semi-true story.’ [Laughter]”40
35 FOMC meeting transcript, November 6, 2002, pp. 67–69.
36 FOMC meeting transcript, June 25–26, 2002, p. 120.
37 FOMC meeting transcript, August 13, 2002, p. 82.
The chairman accentuated the positive. In September, he reported record spending: “We know, for example, that the level of existing home turnover is quite brisk and that the average extraction of equity per sale of an existing home is well over $50,000. A substantial part of the equity extraction related to home sales, which is running at an annual rate close to $200 billion, is expended on personal consumption and home modernization, two components, of course, of the GDP.”41
Greenspan had eliminated the negative at an earlier meeting: “There clearly is concern at this stage about a housing value bubble that is going to burst.”42 He dismissed it: “It’s the notion that there is an equivalency between equity bubbles and housing bubbles that I think is an illusion.”43 This is the first time he had addressed the recent stock market bubble (although, strictly speaking, Greenspan is making a general comment and does not admit to his personally autographed Nasdaq bubble here). He told the FOMC that housing bubbles were different. “[W]ith transaction costs as high as they are . . . and the necessity to move if the house is sold, the incentive to sell a house is nowhere near what it is to sell a stock to take advantage of a capital gain.”44 Granted, Americans never did sell two billion houses a day. Transaction and brokerage costs are high, but it was the next meeting he told the FOMC that the average equity extraction was $50,000.45 That (minus fees) was adequate compensation for many, even with the headache of moving.
39 FOMC meeting transcript, September 24, 2002, p. 48.
40 FOMC meeting transcript, November 6, 2002, p. 56.
41 FOMC meeting transcript, September 24, 2002, p. 78.
42 FOMC meeting transcript, August 13, 2002, p. 74.
43 Ibid.
Greenspan was starting to warm up to another theme at the August meeting: that the decline of interest rates plays an important role in trading, extracting, and spending: “That decline [in the 10-year Treasury yield] . . . has had a major impact on thirty-year fixed mortgage rates… . [W]e are seeing very significant churning in the mortgage markets… . What we are observing at this point is a very high rate of house turnover. Existing home sales are very high.”46
Churning was important. Not only was this true psychologically (the momentum and day-trading swagger), but greater volume contributed funds to the economy. A faster rate of house trading, multiplied by profits from house sales, prompted greater cashout consumer spending. Also, construction workers, Realtors, mortgage companies, title insurers, and new strip-mall employees (in the new towns that blotted the landscape) had more money to spend.
The Fed can usually nudge longer-term interest rates lower by cutting the funds rate. Greenspan might have wanted to wait until spending slowed, and that, in fact, had already happened by the November meeting: “The important issue here is that we’re seeing some erosion in the props that support demand in the consumer area.”47 Greenspan thought that “it’s hard to escape the conclusion that at some point our extraordinary housing boom and its carryover into very large extractions of equity, financed by very large increases in mortgage debt, cannot continue indefinitely into the future”48 [author’s italics].
Prefacing his suggestion to cut the funds rate, Greenspan leaned on consumer spending more than ever: “In sum, it strikes me that we are looking at an economy that potentially has significant upside momentum if it can get through the current soft spot. . . . [M]y suggestion would be to lower the funds rate 50 basis points—it is possible that such a move may be a mistake. But it’s a mistake that does not have very significant consequences.”49
45 Extraction—equity extraction—is the amount of the equity in a house that is borrowed (extracted). It is not the same as a capital gain but it gives an idea of the amount of additional money a house owner could acquire from a sale. Also of note: unlike stock or bond capital gains taxes when a house is sold there is often no capital gains tax.
46 FOMC meeting transcript, August 13, 2002, p. 71.
47 FOMC meeting transcript, November 6, 2002, p. 81.
Once again, Greenspan was wrong.
All Hail the Professor
Greenspan received help from another source, the newest Federal Reserve governor, Ben Bernanke. Joining the board in August, he seemed at peace with the world: “[P]olicy stances, both monetary and fiscal, remain expansionary.”50 At the September meeting, the former chairman of Princeton University’s economics department rolled out his academic thesis: “I think inflation as low as projected is potentially a serious risk for the economy. . . . [T]his seems to me to be a prima facie case for easing policy at this point.”51By November, he could barely control himself: “The FOMC has been quite patient. We’ve kept the funds rate unchanged for almost a year. So I think it is time to consider taking some action.”52
Bernanke believed that if inflation were too low, deflation would be a risk. Deflation (to Bernanke) is always ruinous. This view is rooted in his papers, most of which analyze the Great Depression of the 1930s. That particular depression was both deflationary and ruinous. There have been many deflations that were not ruinous, but the professor preferred the simplicity of his model.
Although we have not incorporated FOMC transcripts beyond 2002, Bernanke’s thesis would overwhelm any dissenters. The chairman might be light on theory, but his future speeches invoked Bernanke’s jargon. Greenspan needed to keep inflating the housing market, and the ivy-covered professor would awe most audiences with his blinkered knowledge.
49 Ibid., pp. 82–83.
50 FOMC meeting transcript, August 13, 2002, p. 55.
51 FOMC meeting transcript, September 24, 2002, pp. 73–74.
52 FOMC meeting transcript, November 6, 2002, p. 74.
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22
The Mortgage Machine
1989–2007
Groups of women were crushing each other …, a real mob, more brutal for covetousness… . [T]he furnace-like heat with which the shop was ablaze came above all from the selling, from the bustle at the counters… . There was the continuous roar of the machine at work, of customers crowding into the departments, dazzled by the merchandise and then propelled towards the c
ash-desk. And it was all regulated and organized with the remorselessness of a machine: the vast horde of women were as if caught in the wheels of an inevitable force.
—Émile Zola: The Ladies’ Paradise (1883)
To give the same kick to the economy as the stock market bubble, the volume of growth in the mortgage market needed to grow year-in and year-out. Household net worth had risen $2.8 billion from stock gains in 1995, $2.5 billion in 1996, $3.8 billion in 1997, $3.3 billion in 1998, and $4.75 billion in 1999.1 This does not count stock-option cash outs or the contribution of house sales and home equity.
In the 1990s, total mortgage debt (commercial, residential, and farm) rose an average of $268 billion a year.2 In 1995, total mortgage debt increased $233 billion, and home mortgage debt increased $153 billion.3
1 Gloom, Boom & Doom Report, September 2000.
2 Doug Noland, “Credit Bubble Bulletin,” Prudent Bear Web site, March 9, 2007, p. 12.
3 Federal Reserve Flow-of-Funds Accounts, Z-1.
265
That was when Larry Lindsey told the FOMC, “[T]here has been a lot of easing of credit terms. At some point that is going to stop.” As it turned out, easy credit was not enough. The stock market bubble was needed as a supplement. In 2000, home mortgage debt rose $380 billion.4 Stock market collateral could, in part, explain how households were able to buy more and higher-priced houses. By 2001, though, the mirage of Internet wealth was collapsing. Median household incomes were falling (after having risen between 1994 and 2000),5 and layoffs were rising. Yet, Americans acquired $506 billion of new mortgage debt. By most standards, 2002 was an even worse year for Americans (stock prices and incomes continued to fall), but they added an additional $708 billion of mortgage debt.
Greenspan’s Attempt to Block Fannie and Freddie
The backbones of the government effort to stoke credit were Fannie Mae and Freddie Mac. These government-sponsored entities (GSEs) played the central role in the mortgage balloon. If Fannie and Freddie had not grown to such mammoth proportions, it is doubtful that the rest of the machinery could have achieved such destructive capacity.
Alan Greenspan spoke out against Fannie Mae’s and Freddie Mac’s promiscuity, to no avail. The interests supporting the federal agencies were too great to be swayed by even the most influential public figure in the United States.
The Federal Reserve chairman gave a speech in May 2005 titled “Government-Sponsored Enterprises.” This speech was a primer on the original purpose of the GSEs. He explained how they had restructured their mode of operation to serve themselves rather than the country. Greenspan cited statements by Freddie Mac in 1989 and 1990. When Freddie implied it was important to remain small. The Fed chairman quoted from Freddie’s 1990 annual report: Its function was to buy “mortgages from lenders, pooling and packaging them into securities, and selling these securities to investors.”6
4 Federal Reserve, Flow-of-Funds Accounts, Z-1
5 U.S. Census Bureau, “Historical Tables—Household,” Table H-6; www.census.gov.
6Alan Greenspan, “Government-Sponsored Enterprises,” speech at the Conference of the Federal Reserve Bank of Atlanta, May 19, 2005.
Greenspan explained that a portfolio of mortgages would compromise its function. That would encumber its ability to maintain “a presence in the secondary mortgage market each and every day—regardless of economic conditions.”7 To meet its stated objective, in Greenspan’s opinion, its portfolio should hold Treasury bills or cash and not mortgagebacked securities: “To sell mortgaged-backed securities to purchase other mortgagebacked securities clearly adds no net support to the mortgage markets.”8 At the end of 1990, Fannie and Freddie’s portfolios held 5.6 percent of the single-family home-mortgage market. Their combined portfolios were worth $132 billion.9 (A clarification of the distinction: In 1990, Fannie and Freddie bought mortgages that banks and S&Ls had made to homeowners; it packaged them together and sold the package as a security. Its balance sheet was not a warehouse for mortgages. It held only very liquid securities such as Treasury bills. By 2005, Fannie’s Mae’s “mortgage purchases” were bought, and many remained on its balance sheet, which grew by leaps and bounds.)
Freddie caught the growth bug. Greenspan explained why: “When Freddie Mac became owned by private shareholders and began to realize the potential for exploiting the risk-adjusted profit-making of a larger portfolio, the message changed.”10 Greenspan explained how, quoting from its 1993 annual report: “[T]o achieve our earnings objective, we are striving to [grow] faster than residential mortgage debt growth … [and] generate earnings growth in excess of revenue growth.”11 By 2003, Greenspan noted, the two agencies’ portfolio’s held 23 percent of the U.S. home mortgage market.12
Yet Greenspan had reason to thank the supersizing agencies. When, in 1994, the bond market went into a tailspin (described in Chapter 10), the GSEs held a commanding presence in the secondary market. They increased liquidity when injections were badly needed. In the five years before 1994, they added between $132 billion and $173 billion of agencyand GSE-backed securities; in 1994, $292 billion of these securities were sold to the market.13 Fannie and Freddie performed the same service when LongTerm Capital Management sent banks scurrying for their bunkers in 1998 (described in Chapter 15). Volume had dropped to a range of $205 billion to $229 billion between 1995 and 1997; in 1998, volume rose to $473 billion.14
7 Ibid.
8 Ibid.
9 Ibid.
10 Ibid,
11 Ibid.
12 Ibid.
These efforts may not have involved Greenspan. More important, the Federal Reserve chairman did not turn the government agencies into shareholder-friendly companies. Fannie and Freddie were way stations of political patronage. The bigger they were, the more favors and money could be distributed.
Fannie projected (in mid-2003) mortgage originations of $3.7 trillion for the year—in an economy with a GDP of $10 trillion.15 The volume of total mortgage borrowings (not just by the GSEs, but also by banks, credit unions, and so on) in the first six years of the 1990s was $1 trillion.16 In this context, Fannie’s April 2003 mortgage purchases of $139 billion would have gobbled up nearly a single year’s mortgage volume during the earlier period.17
By 2003, the GSEs had attracted scrutiny. Congress would not hear of it: “These two entities—Fannie Mae and Freddie Mac—are not facing any kind of financial crisis,” claimed Congressman Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee.18 Whatever Frank’s qualifications for his post, reading a balance sheet was not one of them. In fact, reading Fannie’s balance sheet was impossible. When a government report criticizing Fannie Mae was later delivered, it “[offered] little in the way of quantifiable analyses.”19 This was because Fannie Mae had ignored requests by its regulating agency to release financial information for the past five years.20 [Despite their pretense of being publicly traded companies, Fannie and Freddie did not file financial statements with the SEC, but only with an underfunded government agency: the Office of Federal Housing Enterprise Oversight (OFHEO).]
13 Federal Reserve Flow of Funds Accounts, Z-1
14 Federal Reserve Flow of Funds Accounts, Z-1
15 David W. Berson, Fannie Mae chief economist, statement on June 2, 2003, quoted in Doug Noland, “Credit Bubble Bulletin,” June 6, 2003, p. 6. The $3.7 trillion included $1.1 trillion of mortgage originations and $2.6 trillion of refinancings.
16 Noland, “Credit Bubble Bulletin,” June 6, 2003, p. 7.
17 Noland, “Credit Bubble Bulletin,” May 16, 2003, p. 4.
18 Stephen Labaton, “New Agency Proposed to Oversee Freddie Mac and Fannie Mae,” New York Times, September 11, 2003; http://tinyurl.com/ovv3zt.
19Timothy O’Brien, “Mortgage Giant Agrees to Alter Business Ways,” New York Times, September 28, 2004.
Chairman Greenspan’s first warning to Congress was on February 24, 2004. This was late in the day, but that he threw his body in front of th
e GSEs is commendable. Very few did. The date of Greenspan’s first broadside is interesting—one day after his ode to adjustable-rate mortgages. (This will be discussed in the next chapter.) An obvious interpretation is a Greenspan attempt to take business from the GSEs and move it to the banks. This might have been true earlier, but by 2004, the largest banks and brokerage houses needed the higher mortgage volume that flowed through the agencies to create more complicated and profitable securities, such as collateralized debt obligations (see “The Washington-New York Symbiosis” which follows).21
Testifying before the Senate Banking Committee, Alan Greenspan took up the cudgels and warned that “GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and non-mortgages, that they hold.”22 Later the same year, the Office of Federal Housing Enterprise Oversight cited “numerous examples of accounting irregularities and managerial conflicts that OFHEO examiners contended were used to doctor Fannie’s earnings and inflate executive compensation.”23
Fannie Mae’s chairman, Franklin Raines, who had been Bill Clinton’s budget director, declared his innocence even as he was escorted out the door. Raines was paid over $90 million between 1998 and 2003; of that, more than $52 million was directly tied to achieving earnings per share targets.24
20 Timothy O’Brien and Jennifer S. Lee, “A Seismic Shift under the House of Fannie Mae,” New York Times, October 3, 2004.
21 It has also been suggested that the timing was Greenspan’s effort to move variable-rate mortgage risk from the GSEs to the banking system, where the interest-rate risk would presumably be better managed.
22Alan Greenspan, “Government-Sponsored Enterprises,” before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, February 24, 2004.
Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession Page 29