about subprime mortgage lending are all the rage these days.
were not big news before this year. When the mortgage brokers were
raking in big bucks in loan-origination fees, and the subprime lenders’
stock prices were soaring, the mainstream media were uninterested.
Now that the companies are going bankrupt along with 10% of their
victims, the stories are everywhere. "Default! Default!"
"Whose fault? Whose fault?"
media never sound warnings when warnings might possibly do some
good (but probably not, manias being what they are — maniacal).
However, when the horse is out of the barn, "missing horse"
stories are everywhere.
A sad story
on subprime lending appeared in the San Jose Mercury News
like [J W.] may be affected. [She] is an 80-year-old retired Gilroy
homeowner who said she’s not sure her current loan was subprime,
because she says she has excellent credit. But her loan has many
characteristics of those subprime borrowers typically get, including
a hefty penalty if she refinances within the first two years;
and a negative-amortization "teaser" rate of 1.75 percent
that’s causing her loan balance to grow with each passing month.
of 35 years would have been paid for by now if she had not refinanced
three times to remodel and pay debts.
I ended up owing $590,000 on it," she said with a rueful
had she been willing to match her spending with her income, would
now be $590,000 richer and not be facing eviction from her home.
But she did not understand this simple concept:
your outgo is higher than your income, your upkeep will be your
There are millions
of Americans just like her. It takes a recession to bring them and
their creditors back to reality.
They are going
to get a dose of reality soon enough.
Who is at fault?
As Pearl Bailey sang half a century ago, it takes two to tango.
played the fool, no doubt about it. She spent $590,000 of her capital.
She just had to have a nicer home, so she remodeled with borrowed
money. She just couldn’t find a way to pay her bills, so she borrowed
even more. It was tax-free income! She could even deduct her interest
payments from her gross income. Whoopie!
Here is an
elderly woman in debt up to her ears, who was borrowing to pay her
bills. She still thinks she has good credit, but she borrowed at
subprime rates. She doesn’t know the difference. She is about to
lose her home.
A fool and
her money are soon parted.
But far bigger
fools are the companies, now busted, that loaned maybe half a trillion
dollars to people just like this woman. (The total subprime mortgage
market is over a trillion dollars.) Some well-dressed commission-seeking
salesman extended money to her, even though she was over half a
million dollars in debt. Now her creditor is facing judgment day.
23, I reported on the Implode-O-Meter
website, which lists mortgage lenders that have gone bankrupt
since December, 2006. There were 23 of them. By March 7, there were
36. On March 14, there were 38. On March 17, there were 41. Watch
this number rise!
paid fat commissions to well-dressed salesmen for making large loans
to high-risk borrowers. The salesmen did this brilliantly. That
was the easy part. Getting repaid is the hard part. That is not
the salesmen’s responsibility. That is management’s responsibility.
Management in at least 41 companies did not have a clue about how
to do this.
Then who is
to blame? Answer: Alan Greenspan and his Ph.D-holding accomplices.
The easy money
policy of Greenspan’s Federal Reserve, beginning in the summer of
2000, lured in the suckers: creditors and borrowers. The FED sent
a false signal to the credit markets. "Look at the low interest
rates today. See? Lenders are ready to lend!" But interest
rates were not low because income-seeking private creditors were
ready to lend their own money and forego present consumption. Rates
were low because the central bank was creating fiat money to buy
Treasury bills. There was additional money for buying T-bills, but
no reduced consumption of goods and services by lenders. Result?
Economic growth and misallocated capital.
of monetary expansion ended under Bernanke, beginning in February,
2006. The result a year later is defaulting mortgage lenders and
anyone be surprised at this? Because they do not understand Ludwig
von Mises’s theory of the business cycle, despite the fact that
it first appeared in print in 1912. I
have written a chapter on Mises’s explanation.
In order to
keep the expected recession of 2001 from becoming a major recession,
the FED started printing money in advance in late 2000. Then, to
keep 9-11 from causing a stock market collapse, which was beginning
to happen, the FED accelerated the rate of monetary inflation.
The short run
conquered the long run. This is basic to politics. It is also basic
to central banking monetary policy. The central banks defer the
day of reckoning. They deal with the immediate problem and hope
that they can find a way later to repeal the laws of economics and
avoid both a recession and rising price inflation.
We are now
facing the results of Greenspan’s decision, from June, 2000 to January,
2006, to defer the day of reckoning.
In the meantime,
millions of home owners have used their home’s monetary inflation-generated
equity to spend, just as the U.S. government did with the FED’s
fiat money. They also used the money to pay off debt, just as the
U.S. government did when it sold T-bills to the FED to pay the interest
on the existing U.S. debt.
imitated the FED: "Lend!" The debtors imitated the U.S.
government: "Borrow!" The money supply rose. The national
debt rose. The stock market rose. Home prices rose. It was all so
A handful of
nay-sayers warned: "The bills will eventually come due."
But Ph.D-holding economists replied: "Deficits
don’t matter." So did the politicians.
shot back: "Deficits will matter." The economists and
the politicians replied calmly: "That will be then. This is
In the subprime
mortgage market, the bills are coming due. Deficits do matter. The
future is now.
POSITION AND TIME PREFERENCE
ago, Edward Banfield, a Harvard political science professor, wrote
a book, The
Unheavenly City. In that book, he offered a profound insight:
A person’s class position is established by his view of the future.
Present-oriented people are lower class. Future-oriented people
are upper class.
As soon as
I read that, I made a connection. Ludwig von Mises described the
interest rate in terms of time-preference. People with high time-preference
want to consume in the present. They discount the future sharply.
They pay very high interest rates for consumer loans. They must
be offered even higher interest rates to persuade them to save.
people with low time-preference are willing to save when offered
a much lower rate of interest. To get them to borrow, you must make
money available at very low rates.
Banfield’s insight with Mises’s insight, we can explain why there
are pawn shops in ghettos, commercial banks in middle-class neighborhoods,
and merchant banks in international money-center banking districts.
We can also explain why their respective dress codes are different.
present-oriented Americans have used their homes as ATMs. Instead
of sticking a credit card into a slot and retrieving Federal Reserve
Notes, they called a mortgage re-finance company and signed a contract
promising to repay the loan, subject to losing their homes should
they stop paying.
card withdrawal is a signature loan, meaning a signature-only loan.
Your signature is on your credit card application. Your collateral
is your fear of bankruptcy.
loan is both a signature loan and a recourse loan. Your collateral
is your fear of bankruptcy coupled with your fear of losing your
home. You borrow against your home’s equity: sales price after sales
loans were made to people who do not fear bankruptcy very much and
who had no equity. They regard the loss of their home as they would
regard eviction from a rental unit. Some of them are used to evictions.
When you think
about it, a Treasury bill is a signature loan. No one can foreclose
on the Federal government, so it surely is not a collateralized
loan. With the U.S. government with an unfunded debt liability —
on-budget and off-budget — to the tune of $71 trillion, it surely
is not an equity loan. It has to be a signature loan.
Who would allow
himself to go in the hole by $71 trillion? Not a future-oriented
debtor, surely. If Banfield is correct, the U.S. government is a
But it can
borrow at low, low rates. Why? Because the creditors do not perceive
that there is going to be a default. This default will be on a scale
never seen in financial history.
You may think,
"But that can’t be true. Why, the best economists on earth
have not issued a warning." The best economists on earth —
as certified by themselves and their peers — believe that deficits
don’t matter, that the day of reckoning is always decades away.
Call them Dr. Micawber. "Something will turn up."
have allowed the U.S. government to run up gigantic debts to them,
they are like the subprime mortgage lender who extended credit to
that 80-year-old woman with no equity. They think it’s a great idea
to get a promise of repayment. "We can’t go wrong. Our future
Here is the
on-budget debt Implode-O-Meter
for the U.S. government.
I don’t know
of an off-budget debt Implode-O-Meter. A good summary is here: Prof.
Kent Smetters’s testimony before the House Budget Committee
(Feb. 17, 2005). He estimated that, as of 2007, the unfunded liability
of the U.S. government would be over $71 trillion. (See Table 2).
that "we, the people" are expecting a miracle in our old
with the largest debtor in history, it is not wise personal financial
planning to rely on miracles.
voter thinks he will be repaid for all his loans — called "contributions"
— to Social Security. He thinks that money extracted for Medicare
will be repaid if he gets sick in his old age. So, he is a lender.
The money is extracted by force, but he and his peers vote for politicians
who oversee the extraction system.
today in the hope of repayment in the future. They are very much
like all those subprime mortgage companies that loaned money to
subprime borrowers. Those companies are now falling like pins in
a bowling alley. "Strike!" Down they go, all in a heap.
find that default is more convenient than repayment for subprime
Like the 80-year-old
woman who borrowed her way into home disownership, so are millions
of American homeowners. They, too, think they have a perpetual ATM
machine: their homes. They also think they have a backup ATM machine:
the U.S. government.
some point, they will insert their credit cards, and the cards will
be rejected: "insufficient funds."
There is only
one alternative: the cards will not be rejected, but the funds will
not buy much. Inflation is the default method of choice for governments.