Inequality and the Fannie/Freddie Bailout
It has become popular among at least some folks in Washington to complain about the growth of inequality over the last three decades. Due to the rise in inequality over this period, the bulk of the workforce has seen little gain from the growth in productivity since the 70s.
The response to the rise in inequality has focused on improving the plight of those at the bottom, for example through increases in the Earned Income Tax Credit (EITC) or raising the minimum wage. These are good, if limited, policies that can improve the plight of tens of millions of people.
However, if more money goes to those on top, there is less available for those in the middle and bottom. This is simple arithmetic. In the last three decades, a huge amount of money has gone to Wall Street. The Wall Streeters' share of compensation rose by 2 full percentage points from 1976 to 2006. If profits rose accordingly, the growth in this narrow portion of the financial sector is sucking $200 billion a year from the rest of the economy; enough to hand every worker in the bottom 70 percent of the wage distribution a check of $2,000 a year.
This is why it is so painful to see the consensus in inside Washington to hand Fannie Mae and Freddie Mac hundreds of billions of dollars in below market loans, no questions asked. This is an incredible chance to directly confront the rising inequality of the last three decades.
Salaries are far more out of line on Wall Street than the rest of the economy. With Fannie, Freddie and the investment banks running to the government hat in hand, we have a unique opportunity to impose market discipline on bankers' salaries.
These are companies that would be bankrupt without the government's help. Their managers' incompetence led them to make hundreds of billions of dollars of bad loans. (How did the management at Fannie and Freddie miss the housing bubble? Following the housing market is all they do.)
It would be a very simple matter for Congress to tell Fannie and Freddie that the condition of getting bailed out is that there is an absolute cap on the compensation of any employee of $2 million (that includes salary, bonus, stock options, and anything else of value). Similarly, we can tell the investment banks that they must meet the same condition to get access to the Fed's discount window. Also, Bernanke's guarantee to the investment banks' creditors would only apply to banks that agree to the $2 million cap.
This is how we reduce inequality through the market. We let banks that insist on paying exorbitant salaries go under. (Who would make loans to the investment banks that were explicitly not protected by the Bernanke guarantee?)
The direct and indirect effect of bringing Wall Street salaries down to earth would be enormous. We could expect to see lower pay rates for top executives everywhere, not only in corporations, but also in universities, hospitals, and non-profits.
If anyone in a position of power in Washington was actually concerned about inequality, and the failure of the poor and middle class to share in the gains of economic growth, they would be talking about these bailouts as an extraordinary opportunity. Instead, the Washington insiders are determined to throw buckets of money at failed bankers, no questions asked. I suppose that we can look forward to a few more nickels and dimes through the EITC and minimum wage.
. . . an absolute cap on the compensation of any employee of $2 million . . . .
Where's the outrage, Baker?
Nationalize the GSEs; bring them back onto the general budget and pay the execs at General Schedule (GS) rates (okay; they get bonuses, too). The American mortgage market doesn't require connected politicos (Franklin Raines) or highly paid lobbyists to run government guaranteed banks.
July 20, 2008 6:49 PM | Reply | Permalink
This is a smart blog. I mean it. You have so much knowledge about this issue, and so much passion. You also know how to make people rally behind it, obviously from the responses. Youve got a design here thats not too flashy, but makes a statement as big as what youre saying. Great job,children health indeed.
January 21, 2011 7:47 AM | Reply | Permalink
I can live with that on the GSEs. I have been advocating a period of receivership during which time we can debate their ultimate status. Frankly, I don't see any good reason at this point for having the private component (what exactly did it add?), but we can have a national debate why Fannie and Freddie get their books in order.
July 20, 2008 7:21 PM | Reply | Permalink
Gather the deposits at 3%, loan them at 6%, and be on the golf course by 3 o'clock.
I'm aware that your call for a $2 million cap on executive salaries is not just a matter of envy and jealousy. With such a cap in place "bankers" would have little inducement to "gear" their way to glory -- and thus, the financial system would be less likely to generate bubbles and run itself off the cliff. But ---
It ain't gonna happen!
So, what's the answer? How do we get the bankers back on the golf course? How does government prevent the "shadow banking" system from generating excess credit ("money")?
July 21, 2008 4:48 PM | Reply | Permalink
Mr. Baker - great job on NPR last week-I think it was the DR Show. It is becoming increasingly clear when the FED issues new mortgage rules like 'lender must verify income' and assure 'mortgagee must have enough income to pay taxes/insurance' that as William Greider said on the Moyers Show this Friday, out public servants in DC, both elected and regulatory, seem to exist in a fantasy world with little conception of what goes on 'out there' in the real world.
Hopefully, America itself is too big to fail.
NYT link
July 20, 2008 7:50 PM | Reply | Permalink
Another way to handle the question is to require derivative buyback: When a bank sells mortgages or mortgage-backed securities to an up-the-chain buyer, the originator is required to buy back the securities on demand by the buyer. This includes a requirement of holding sufficient reserve to allow these buybacks.
This provides a market-based feedback mechanism that doesn't impose particular regulatory paperwork requirements but does hold the originators responsible for their actions.
July 20, 2008 8:38 PM | Reply | Permalink
"Sufficient reserve"? Hmm. Let's see.
Since during a boom loss experience is minimal and since home prices only go up (hey! that's history) and distressed mortgagors can always sell for a price sufficient to pay off the loan, I think we should set the reserve at 0.0015% of the loan balance.
Sufficient? No? What would be?
July 20, 2008 8:50 PM | Reply | Permalink
Discussion, including criticism of hypothetical ideas is welcome; smartassed remarks don't inform anyone.
IANAIB
With that said, rules already exist defining how much reserve a bank must hold for its existing business, and the Fed has practice in defining those levels. The rules are kept up to date to accommodate changing reality. I assume that the rules for banking reserves are well understood and an analogous process would work more generally, including mortgage-backed securities. Here is a link to an example of the classical reserve requirements for (what I think are) retail banks:
One example
What's been done during the last 25 years is to allow complex debt instruments (such a high-falutin' euphemism for the cascade of lies that is current banking "technology") to disconnect profit from risk. And I believe it's worth discussing ways to restore the connection.
We can impose fixed regulations, which tend to become onerous and frustratingly inflexible in the face of economic change, or we can set market rules that provide feedback that force the various participants to behave.
July 20, 2008 10:17 PM | Reply | Permalink
Sorry. Suggestions of tiny changes in regulation at the margin annoy me. See, below. As for your idea --
1. Virtually all originators already enter agreements to buy back mortgages -- on certain conditions.
2. Each of those "conditions" is more or less likely to happen.
3. Reserves would have to be calculated by determining the risk of the contingency happening.
4. Retail banks which still count for a large part of the mortgage origination industry are regulated and required to maintain reserves, today.
5. Those reserves are supposed to cover contingent liabilities as well as others. So, presumably, these reserves of which you write are already in place. Ho, ho, ho.
6. They aren't because nobody -- least of all the FRB, the FDIC, or the OHFEO -- has the slightest idea how to put a price on these contingent liabilities.
Finally, the packagers have the knowledge to do their own due diligence. The borrowers' files are sitting on their desks; they should open them up and make their own judgments as to whether the borrowers are reasonable credit risks at the interest rates those borrowers are paying. The warranties of originators are no substitute for due diligence.
Note: There will be some fraudsters at the origination level. That's what prisons are for.
July 20, 2008 11:42 PM | Reply | Permalink
NOW I've learned something.
I really did misunderestimate [sic] the industry. They have engaged in ordinary boring fraud, at every transaction, from the individual buyers who caved in to the suggestions to claim income they didn't have, to the originating mortgage companies who lied to individuals as well as the purchasers of their worthless "securities", to the big buyers who willfully failed to do due diligence.
It's the compensation: The value of lying has been grown to a level that the "good people" in the banking industry are unable to resist the temptation.
Maybe a compensation limit would be exactly what is needed to reduce the temptation to screw over as many people as possible, visible or not.
And I apologize for your annoyance. No male would ever want to annoy the owner of that amazing eye! :-) Seeing the failure pattern in the large investment banks, I had assumed that they were unable to get recovery from the mortgage originators, which is the source of the annoying tiny change on the margin.
This whole thing is about the inevitable margin call...
July 21, 2008 8:07 AM | Reply | Permalink
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December 20, 2010 8:48 AM | Reply | Permalink
I am so frustrated, steam is coming out of my ears.
Where's the debate among our "political" economists? Are they all so attached to, so afraid of not being thought serious that they won't challenge the common wisdom, the view in the rear looking mirror, Samuelson economics?
They tell us that saving the too-big-to-fail financial institutions is critical to the survival of the system! Where's the proof? The Great Depression? This isn't a 50% agricultural economy. We're not on the gold standard. We've got a safety net. We've got public works programs. It isn't 1932.
Japan's lost decade? Bulls**t! That wasn't a financial problem. Ever hear about demographics -- an aging non-consumerist society? Ever hear about 19th century feudal lords running a corrupt system for their own benefit?
There's too much "money" in the world! We don't need more "money" (otherwise known as credit). We need less.
We don't need these so-called "banks." Bear Stearns wasn't an investment bank. It was a hedge fund. It didn't perform any useful function.
Less than 5% of investment bank funds can, in anyone's wildest imaginings, be thought to be "investment capital" -- capital invested in the firms that operate in the real economy. The vast majority of firms finance their expansion from internally generated cash (last Fall the S&P 500 firms had $500 billion in cash sitting around -- and what were they doing with it? Investing in their businesses? No, they were buying back their shares to support share prices and their executives' stock option prices).
Tell me, smart guys. What's this disaster everbody's so sure'll happen if we let these too-big-to-fail POSs fail.
July 20, 2008 8:34 PM | Reply | Permalink
Give 'em hell Ellen.
Damn good questions that'll probably go unanswered. We'll probably only be told about all the jobs that'll be lost...aka 'economic blackmail'.
July 20, 2008 11:45 PM | Reply | Permalink
Why, it's just terrible. Look at this woman's horrifying loan-rejection story and all because of the credit crisis.
She's a 26-year old owner of a Philadelphia asbestos removal company (probably got the mitigation contracts nepotistically) who doesn't own a home, drives a used car, and has never taken a salary from the company (maybe it doesn't make enough to pay her, hunh?).
Good for her, but when she applied for a $250,000 line of credit, the bank turned her down.
According to Reporter Elizabeth Olson and her editor it was all the fault of the credit crunch. That's the kind of ridiculous reporting we're getting.
No wonder there's no outrage if that's all the credit crunch is about.
July 21, 2008 12:28 AM | Reply | Permalink
She took in $2,000,000 last year and wasn't able to draw a salary? Ummmmmm...a red flag maybe? I don't know if I would lend any money to her either. Nor would I be inclined to 'bail out' someone who did.
But, not surprisingly, that is the kind of reporting I have come to expect.
July 21, 2008 12:54 AM | Reply | Permalink
My own reply to "too big to fail" is: so make them smaller.
Of course, it's too late to do at the moment, but regulating future institutions (to keep them small enough that it is OK for them to fail) is still possible ... and, I claim, desirable.
July 21, 2008 5:09 AM | Reply | Permalink
Well, yes. The hedge funds, and Bear Sterns, serve(d) little useful purpose. Is that not true of the Stock Market in general? Is the Stock Market really a mechanism to provide investment capital to business? That was the original idea. It is no longer an investment pool. It is a casino. The Stock Market does more harm than good. We need lots of reforms. I agree. Let the hedge funds go broke. And, reform the stock market. Go back to the basics. One share, one vote. A share must be held for at least 6 months. No golden parachutes. (Wouldn't a parachute made of gold fall straight and hard to the ground?)
July 20, 2008 11:01 PM | Reply | Permalink
Agreed; but there is a difference between the hysteria conventional economists exhibit when they contemplate the collapse of the financial world as we know it and their measured response to market declines.
Of course, if the Plunge Protection Team ever came out of its cave, I'm confident these same economists would be explaining why a stock market crash would be a disaster of a magnitude heretofore unknown to mankind and must be avoided at any and all costs.
July 21, 2008 12:57 AM | Reply | Permalink
"If anyone in a position of power in Washington was actually concerned about inequality, and the failure of the poor and middle class to share in the gains of economic growth, they would be talking about these bailouts as an extraordinary opportunity."
There is someone in a position of considerable power right now who could help this national conversation take place and his name is Barack Obama. As far as I know, Obama has had absolutely nothing to say on this subject. Obama also happens to have been the candidate who was backed more heavily by Wall Street interests than any others. Nonetheless, now would be the time for the public and netroots in paricular as well as well-placed Democrats who have made much of their concern for the poor such as John Edwards an Hillary Clinton to name two. These people could exert tremendous pressure on Obama to help make sure the public actually benefits to some degree here by putting some limits on the wages these scoundrels can earn as well as keeping these agencies fully owned by the people and not owned by privte interests.
Prof. Baker, do you see even a possibility that Obama might do something along the line you suggest or at least take a position similar to your suggestion?
I would also love to hear your thoughts on why DC doesn't simply provide direct relief to homeowners in the form of guranteed below market rate interest on 30 year mortgages? Seems to me that would be the quickest and best solution to the banking crisis caused by mortgages that were sold knowingly by banks who understood many of those receiving the loans could not actually pay in the long run. The payoff of the previous mortgage would satisfy the banks that are hurting and the homeowners would be given interest rates they can not only live with right now, but continue to live with for years and years.
July 21, 2008 2:18 AM | Reply | Permalink
What happened here was foreseen and predicted but resulted from a lack of oversight and regulation. And those errors have been accumulating since deregulation started in the 80s.
You can't have a big enough reserve if what you buy is rated AAA and includes very marginal paper. Who knew? Well, obviously the originators, at least.
There never seems to be any blowback to the people that dream up the snake oil. They walk away with their accumulated millions (or billions) and everyone else sucks up the shit left behind. The capital belongs to the shareholders. They are the ones at risk. Workers, broomers to executives, should be rewarded with this in mind.
It seems obvious that those forming the reward packages are the very same who recieve them. There's no time delay, no proportionality, they're exorbitant, and they are only (very much mostly) for the executives! If the encentive stimulates them, how about all the other company workers? That would immediately open a corporate debate, big time.
I very much like the idea of a cap on rewards for officers of any company wanting, seeking, or needing any public support -- federal, state, county or city.
Just one quibble, Ellen. Japan's lost decade wasn't because of their societal make up but because they hid and never dealt ruthlessly with all the debt and loss, particularly property with the repurcussions to the financial sector, and clear it all out. Their very closed economy, both externally and internally, couldn't handle the disruption in any straightforward manner.
The reason I object is that an aging demographic doesn't have to mean lack of growth and the US really needs to rethink this widespread dogmatic blindspot. For the economy and ecology.
July 21, 2008 2:31 AM | Reply | Permalink
Japan's Lost Decade
I threw that economic history analogy into the pot because it's one of conventional economists' favorite examples of the perils of monetary deflation. See, Paul Krugman's "Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis" and the so-called (after Black of Black & Scholes?) "zero boundary" problem.
I am aware that one of conventional economists' favored explanations for the "lost decade" is Japan's having failed to put a bunch of their "zombie banks" out of their misery. Result -- according to these same conventional economists -- the banking sector with its inadequate balance sheets was unable to create the amount of "money" (credit) the Japanese economy would require if it were to grow.
Standard conventional economic theory building!
Lost your keys up the block? Look for them under the lamp post because that's where the light is.
July 21, 2008 3:38 PM | Reply | Permalink
Re: When a bank sells mortgages or mortgage-backed securities to an up-the-chain buyer, the originator is required to buy back the securities on demand by the buyer.
This is already in place in regards to mortgages, with limitations. If a mortgage goes bad in the first six months the originator generally has to repurchase it from the buyer. This is exactly why so many mortgage companies have gone out of business; the cost of these repos overwhelmed them. I would also say having a time limit makes sense. If a mortgage goes bad very early in its life it's probably a mortgage that should never have been written. However one that goes bad after, say, five years was probably sound and the default is due to factors (illness, job loss etc,) that neither home owner nor originatior could have anticipated.
In regards to securities there is no buy back requirement, however the major investment banks do purchase back individual defaulted or charged off mortgages from their securities: that's the source of much of the write-downs you read about.
July 21, 2008 7:28 AM | Reply | Permalink
Ellen, thanks for the Krugman story. Personally I think he's closer on "nervousness" than the demographics, as you are on the non-consumerism than aging. After all, Japan's population is growing slower than ever yet the economy is gradually picking up steam. The conversations I've had with young Japanese graduates leads me to believe that Japan is no longer their father's Japan although these are the people in charge for now.
Japan's long lasting 90s depression was structural in the sense of it's high savings rate, export fired boom and strong yen, combined with such an extreme asset bubble and collapse of credit, and the psychology. Every government stimulus stuttered. Zero real interest rates meant nothing. That it took 13+ years for the stockmarket to bottom argues for allowing shit to happen, as long as it happens in the right way to the right people, and not maintaining the status quo. Which I think is the same as you are arguing.
Zero boundary is beyond my math.
July 21, 2008 6:03 PM | Reply | Permalink
U.S. Lawmakers Reach Deal on Fannie, Freddie Bill
Guess it's time to close this thread down.
July 23, 2008 12:26 AM | Reply | Permalink
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