Why Fannie Mae and Freddie Mac were (and are still) a Disaster Waiting to Happen
Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon is a new book out by a veteran New York Times reporter and a consultant.
The Economist magazine this weekend reviewed the book, saying that the book is the “best account yet of how this system went off the rails”. More from this review:
The authors join up the dots between Congress, interest groups, government-sponsored enterprises (GSEs) and Wall Street, including many that other books had failed to link. And they shine a light on powerful figures whose roles in causing the mess have gone unchronicled.
Chief among them is James Johnson, who, for most of the 1990s, ran Fannie Mae, the largest of the GSEs. Tall, charming and politically shrewd, Mr Johnson spotted a golden opportunity to use a popular cause—increasing home ownership—as a means of building Fannie’s power in Washington, and also feather his and his fellow executives’ nests along the way.
We suggest that you read it to understand how government had a big role in the U.S. mortgage crisis. In addition, Wall Street had a role, as did the accounting profession, real estate professionals, and the ratings agencies, but the federal government machinations were a prime cause of the crisis.
Banking System Contraction and Lack of Investment Are Leading the Economic Downturn
For several years we have been pointing out that the U.S. is experiencing a banking system contraction much like Japan has experienced for two decades. Now, we are seeing the same phenomenon happening in Europe. A credit contraction is another name for a banking system contraction.
The credit contraction is a declining credit cycle that leads to a declining business activity. To put it another way, as our friend Larry Jeddeloh of the Institutional Strategist likes to say, we are in a credit cycle not a business cycle, and that is why the traditional stimulus measures are not having much of an effect.
It is a truism and one that too few have yet to recognise, mature economies need credit expansion in order to grow. As long as the banking system is contracting and banks are dealing with bad loans made in the past, you are not going to get credit expansion.
Banks must be recapitalized and bad loans must be admitted to, marked down, and written off. Then, when less bad debt clouds consumers’ balance sheets, demand for goods and services can rise and new loans can be made. This will provide the capital needed to increase the supply of goods and services and lead the economy forward.
As a result, the economies of Europe, Japan, and the U.S. will continue to experience shorter economic expansions and longer contractions until they can incentivise capital formation and revive the banking system.
Many approaches can be taken. The one that we believe has the best chance of working was mentioned in our market commentary dated September 27, 2011. As we explained at the time, the U.S. needs to create an environment where investors with capital will be allowed to make profits and where they will be confident that their capital’s future in the U.S. is stable. Investors should know that they will be fairly treated and that they will be allowed to keep a fair share of the profits that they help create.
For the economy to grow, people have to be willing to take risks and invest for the future. This is what President Reagan helped spur in the 1980′s when the tax changes gave rise to an expanding venture capital industry which invested in computer, wireless, internet, and biotechnology companies. These investments led over time to the creation of many new industries, many new jobs, many new tax receipts, and many new profits for investors.
The U.S. policies need to promote capital formation so that people are incentivized to invest in new businesses and hire new employees.
A Boiling Electorate
A source of discontent in America is undoubtedly the fact that household incomes in America have been in a state of decline while the prices of basic needs has been rising. This standard-of-living impairing cocktail is what the American electorate has consumed for more than a decade.
The Guild Basic Needs IndexTM data becomes even more relevant when you consider the following chart published by Reuters financial journalist, Felix Salmon. Mr. Salmon took data from the Bureau of labour Statistics’ monthly survey of 50,000 interviewed households over the past 138 months and published the following chart. It illustrates how real U.S. Median Household Income has declined since the 1990’s. Click here to read more of Mr. Salmon’s arguments.
Thank you To Our Readers.
It has been 40 years that we have been managing investment portfolios for clients. We hope the newsletter serves to sharpen your investment perspectives and strategies. To request information about Guild Investment Management services and offerings please call (310) 826-8600 or email us at [email protected]
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