[R-G] [BillTottenWeblog] The Next Big Bail Out

[Bill Totten]

State, Local and Private Pensions

by Michael Hudson

www.counterpunch.com (July 31 2008)


The great economic fight of our epoch is being waged by the FIRE sector
- Finance, Insurance and Real Estate - against the industrial economy
and consumers. Its objective is to maximize property prices and the
volume of debt relative to what labor and industry are able to earn.

Rising debts and real estate prices go together, because asset prices
depend on how much banks will lend. For creditors, the dream is to
obtain an ultimate backup at public expense: government insurance that
they will not lose when debtors are unable to pay. The political problem
is how to get the government to insure and protect bankers rather than
debtors, given that debtors are much more numerous when it comes to the
voting booth. In such cases campaign contributions are the balancing
factor. Governments are "privatized" and "financialized", that is,
turned from democracies into oligarchies. The banking system aims to
make sure that the only losers are the customers it is supposed to
serve: debtors, homeowners and employees of companies being
"financialized" as the economy is de-industrialized. Indeed,
financialization and de-industrialization are becoming almost
synonymous. The trick is to get voters to think they are getting rich
while actually they are being painted into a debt corner, along with
their employers, local government and the federal government too.

For a while the bad-debt overhead can be bailed out by creating yet more
debt, backed by public guarantees in what even the Wall Street Journal
acknowledges is "socialism for the rich", that is, privatizing the
profit and socializing the losses. But when has government been anything
else, for thousands of years before anyone coined the term "socialism"?
The so-called July 30 "housing bill" supports the price of mortgages
that are the major asset base of most banks and other financial
institutions today. What ultimately supports the price of these mortgage
packages is the price of the real estate pledged as collateral. And
despite Mr Greenspan's celebration of soaring housing prices as "wealth
creation", it really was debt creation. As housing prices plunge, the
debts remain in place.

The question is, whose balance sheets are to plunge into negative equity
territory - those of indebted homeowners, or those of banks that have
made the bad loans and the financial institutions (largely pension
funds, I'm sorry to say) that have bought "toxic mortgages"?

Financial bubbles in their early phase inflate asset prices more rapidly
than debts rise. This helps the financial sector encourage a belief that
debt pollution is a quick way to make the economy rich - as long as one
looks at financial balance sheets rather than tracing growth in the
actual means of production and living standards. Living in the short
run, most people do not see the financial war going on, and imagine that
finance and industry, labor and capital are fighting for the same kind
of economic growth and wealth. The reality is a conflict between
financial and industrial growth objectives, subject to the adage that
the solution to every problem tends to create yet new, unforeseen
problems - ones often are larger in scale, requiring yet new solutions
that cause yet larger and even more unforeseen. This is how societies
transform themselves for better or for worse, crisis by crisis.

Usually each side fights for its economic interests. But it is best not
to crow too loudly over victory. The financial bailout is depicted as a
housing bill, not as a giveaway to financial interests. And it is best
not to acknowledge that the financial system's victory now threatens to
push the economy further down the road to insolvency, headed by a
squeeze on state and local finances, and pension funding public and
private. Problems threaten to arise when creditors win too one-sided a
victory.

Here's what has happened so far. Early on the morning of July 30,
President Bush signed the law that the Senate had passed at a special
session the previous Saturday. Its aim was to restore US housing prices
to unaffordably high levels, requiring new buyers to run even deeper
into debts to obtain housing. Rather than rolling debts back to more
affordable levels, the government now will use its own credit to
guarantee payment on whatever portion of the unpayable exponential
growth in debt cannot be sustained by the economy at large.

The new "housing law" (a more honest title would have been the
"financial bailout and giveaway act of 2008") authorizes the Treasury
and Federal Reserve Board to provide unlimited credit to Fannie Mae and
Freddie Mac, and infuse new lending power to the Federal Housing
Administration (FHA) and localities to support the "real estate market".
This is a euphemism for saving mortgage lenders from the traditional
response to falling property prices - defaults and walk-aways. The idea
is for government loans to replace the bad loans that existing mortgage
holders are stuck with, and to do so before property prices sink by
another 25 percent.

The cover story highlighted in the first line of the press release was
that the new act was "intended to provide mortgage relief for 400,000
struggling US homeowners and to stabilize financial markets". The real
aim is to help struggling banks and institutional investors, with little
likely aid for homeowners. Mortgage defaults and foreclosures were
threatening to wipe out the collateral valuations for the loans packaged
and sold to US pension funds, other institutional investors and foreign
banks - including the $1 trillion in Fannie Mae and Freddie Mac
securities to foreign central banks and sovereign wealth funds.

Piercing the cloud of public relations rhetoric, the actual impact on
strapped mortgage debtors is that the increased funding for Fannie Mae,
Freddie Mac and FHA are part of a $1.4 trillion emergency supply of
government credit intended to keep housing prices from falling back to
more affordable levels. An alternative use of this funding would have
been to save individual debtors from foreclosure and re-set their
mortgages at more realistic levels. But the constituency of the Treasury
and Federal Reserve is Wall Street, not homeowners. This is not a
constituency whose interests reflect those of the economy as a whole
over the long run.

Finance and real estate extract interest and rents from the rest of the
economy, shrinking rather than expanding it. This causes property prices
to fall. Speculators (who have made up about fifteen percent of the
housing market in recent years - one out of every six buyers) stop
buying, while an over-supply of foreclosed or abandoned properties come
onto the market. Falling prices push debt-leveraged homeowners into
negative equity, followed by banks and the hapless buyers of the
mortgages they have sold off.

During the real estate bubble homeowners, commercial speculators and
corporate raiders were able to borrow the interest charges by
refinancing their properties at higher and higher appraisals. But banks
now are pulling back from mortgage lending, largely because buyers of
packaged mortgages find themselves stuck with paper that is a far cry
from the security its AAA bond ratings implied. Companies that have
insured these mortgages are far undercapitalized to sustain the risks,
and themselves are threatened with bankruptcy. So the mortgage packagers
and insurers Fannie Mae and Freddie Mac are being kept in business to
"save the real estate market", by which is meant the exponential growth
of debt.

The parties being bailed out are the large institutions that hold the
bad mortgages extended and packaged in recent years, and companies on
the hook for having insured the face value of these mortgages. The
growth of real estate debt has been achieved by the semi-public Fannie
Mae and Freddie Mac providing "liquidity" not just by buying up and
packaging mortgages in bulk, but by insuring their income streams. As
William Poole, head of the Saint Louis Federal Reserve Bank from 1998 to
2008, points out: "Fannie and Freddie exist to provide guarantees for
mortgage-backed securities trading in the market. The business is simply
insurance." This insurance against mortgagees defaulting (and ultimately
against banks and mortgage brokers making bad loans beyond the home
buyer's ability to pay) is what has made their sale so irresponsibly
liquid. And matters have reached the point where between two and three
million US homeowners are still expected to default this year, leading
to foreclosures.

Mr Poole adds that the government's assumption of the mortgages
underwritten and guaranteed by these two public agencies technically
doubles the federal debt, from five to ten trillion dollars. The asset
side of the government balance sheet also rises, but there may be a
substantial shortfall. Private bondholders and stockholders of Fannie
and Freddie also have claims on these assets, so any attempt at
real-world accounting becomes thoroughly tangled.

A deeper problem is that Fannie and Freddie underwrote and insured a
debt increase whose continued exponential growth is unsustainable,
because it causes domestic debt deflation. What Mr Greenspan called
"wealth creation" - pumping up housing and stock market prices on credit
- was actually debt creation. Asset prices are a function of how much
banks will lend. If they lend more money on easier and easier terms,
property prices will continue to soar. This is why the economy is facing
debt deflation. More and more money will be diverted from being spent on
consumption and paying taxes, in order to pay creditors. This will
shrink the domestic market, squeezing profits, and also will squeeze
state and local finances.

The government will not solve this problem by providing yet more loans
for stronger parties to buy the existing supply of homes otherwise in
foreclosure. The dream is to keep housing high-priced to support the
mortgage lenders, not for prices to fall so that new buyers do not need
to run so heavily into debt to afford housing.

Supporting real estate prices thus entails keeping the existing volume
of debt on the books, and indeed running up even more debt. This levies
an enormous charge on the economy to pay interest and amortization.
These payments leave less available to be spent on goods and services or
paid in taxes. The economy shrinks, leaving it even less able to carry
its debt burden. Many individuals no doubt will default on their credit
card debt, auto debt and other debts, but the largest remaining debt
consists of pension and health care obligations to the private and
public sector work force.

This problem has been growing beneath the view of most public media.
Private-sector pensions are insured by the federal Pension Benefit
Guarantee Corporation (PBGC), which is substantially undercapitalized. A
much larger problem is state and local pension programs. not only are
underfunded; they have no insurance at all. The expectation was that
public-sector pensions would be paid out of rising property tax revenues
and capital gains. But taxing property now threatens to cause defaults
on mortgage payments. This is the corner into which the economy has
painted itself by trying to preserve the exponential growth of mortgage
debt.

To cap matters, this threatens to push state and local budgets into
deficit at a time when their pension and medical insurance payments are
soaring. On the expense side of their balance sheet, localities must
spend more money to cope with the consequences of empty houses being
stripped of building materials, occupied by squatters, burned down and
generally becoming a source of blight. On the fiscal income side, states
and localities are facing populist political pressure crafted by large
real estate interests and promoted with the usual flow of crocodile
tears on behalf of retirees and other homeowners whose debt squeeze
prompts them to support politicians promising to reduce property taxes.

At first glance the connection between bailing out Fannie Mae and,
behind it, the real estate market to keep prices high for American
homeowners might not seem closely linked to corporate, state and local
pension plans. So let us trace the linkage. Bailing out mortgage lenders
ultimately must be achieved at the expense of state and local property
tax revenues. Revenue that is used to pay interest is not available to
pay taxes. If debts are to continue to grow exponentially and extract
more carrying charges, this forces a tax shift onto labor and industry.

For the past century the financial sector has made steady incursions to
take over what used to be the role of government. Today's libertarian
anti-tax "free market" rhetoric is simply a cover for the financial
sector's replacement of elected democratic government. Forward planning
is being distorted to serve the financial sector, not aiming to promote
long-term growth and raise living standards, and certainly not to
protect the public sector's fiscal position.

One of the lesser-known features of this week's real estate bailout is
the endorsement of "negative mortgages". These debt agreements add the
accrual of interest onto the principal. The cover story is that this
enables low-income homeowners to keep their houses with a lower carrying
charge, borrowing the interest rather than paying it. But this means
that what used to accrue to homeowners or their heirs as a "capital"
(land-price) gain henceforth will accrue to the mortgage lender. For
over a century, the main way that most American families have become
rich has been by the free lunch of exponentially rising land prices.
What is to rise exponentially in years to come is now their debt
overhead. It is the financial sector that will get the free lunch of
land-price gains.

Adding the interest charge onto the principal is how Ponzi schemes work.
They cannot work for long, because no real economy can keep up with "the
magic of compound interest". The Bush-Paulson bailout plan calls for
mortgages to become larger and larger, regardless of whether property
prices keep pace. The interest is to accrue to the federal government as
mortgagee at first, but this innovation is really a test run. It is the
path of least resistance for private banks to start making mortgage
loans that give them a return in the form of "capital" gains as well as
interest.

These gains consist of the inflation of land prices in cases where
state, local and federal government fails to capture this gain for the
economy at large. So the scheme obliged the public sector to turn
elsewhere than property for its revenues - namely, to consumers and
industry.

Who is not going to get paid: bankers and bondholders, or pensioners?