While We Were Predicting the Worst,
It Had Already Come to Pass

by
William Krehm

What concerned COMER almost from the very beginning of the subprime mortgage mess was that it risked debasing the only legal tender in the US - and to an extent even in the world - to the status of just another subprime loan. For since Washington left the gold standard in 1971, the only legal tender was the credit of the federal government. That was because behind it clearly stood the taxing powers, the vast investment in human creativity and know-how, and physical investments and environmental care of the US. And keep in mind that after WWII and Bretton Woods only the US was really on the gold standard. Other countries were in fact largely on the American dollar standard, and their relation to the gold standard even when that existed came through their holdings of US currency. With that in mind, it should be apparent if you have the US government exchanging good American dollars for subprime mortgages or other debt that the government has taken over to bailout corporations that had gambled too irresponsibly, you undermine the clear sovereign backing of the US dollar - the credit and credibility of the US government.

To make the point, we went so far as to suggest that whereas the debt of the US government or of any developed country has the same negative sign before it as any other debt, that in fact should be distinguished from the negative signs before the debt owed by private sector entities. It should in fact carry a positive sign because when the government spends credit from the central bank, it is creating legal tender.

There is a simpler and more powerful way of making the point. And we made it that way as well. To prevent the collapse of the monetary systems of the world, when bailing out the banks from their heavy losses in taking over the US mortgage trusts in the 1980s, the Bank for International Settlements - the war room of the world banks deregulation efforts to bring back their glorious period of speculative freedom that led the world into the Depression of the 1930s and World War II, BIS had declared the debt of central governments of advanced lands risk-free and thus eligible for banks to load up without down payment. As a result of that, Canadian government quadrupled its borrowing from the private banks to $80 billion.

Since the Canadian federal government was the sole shareholder of the Bank of Canada since 1938, when the government bought out 12,000 private shareholders at a good profit, the interest it had paid on its borrowing from the BoC came back to it almost entirely as dividends. Shifting that debt of the government from the Bank of Canada to the private banks meant that the government headed by Brian Mulroney not only bailed out the banks from their gambling losses, but tried going much farther. He pressed for putting two clauses into the Canadian constitution that was drawn up in 1982 that declared the Bank of Canada independent of the government of Canada. Although the government had paid its 12,000 shareholders good money when it bought them out in 1938. Also, Mulroney wanted to put into the Constitution the need to maintain zero inflation. However, his own House of Commons finance and banking committee voted against the proposal. As a result nobody has dared touch the Bank of Canada Act as it was drawn up in 1938 when the central bank was bought out by the government. So there you have Canadas unspoken shame - the basic act structuring our economy is still intact on the law books - you can find it on your internet with the help of Google, but it is completely disregarded by both the central bank and the government. From there everything about morality in our politics is programmed to go downhill.

But the BIS is not attuned to such delicate moral issues. So when the Mexican government was teetering on the brink of bankruptcy, in the early 1990s, because the North American Free Trade Agreement ruled out protective tariffs, and impediments to the movement of currencies across frontiers, the flight of capital out of the country and the influx of foreign goods chopped the legs off their economy. Unemployment and bank insolvencies multiplied. Its banks, privatized just a few years earlier from an earlier nationalization, were nationalized once again. Well-connected financiers sent their gambling profits out of the land without hindrance well in advance, and the collapse of the Mexican economy - living standards dropped fully 40% - threatened to bring down the world monetary system. So to save the situation the Bank for International Settlements, knowing only one remedy for all complains - raised interest rates close to the skies.

But in their haste to bail out the world banks from the billow of insolvencies moving upon them, the BIS and all the central bankers it gathered around its knees overlooked an important detail. When you raise interest rates the hoards of bonds issued earlier with lower interest coupons, plummets. And when interest rates touched and went beyond the 20% range the banks - loaded with debt bought wholly on the cuff, found itself in trouble. Hastily, without even consulting Congress, the Clinton government put together the largest standby fund up to that time - $51 billion, $25 billion each from the US and the IMF and one billion from Canada - one of the first fruits of NAFTA. That standby fund wasnt used, but helped bring the panic under control. To Clintons Secretary of the Treasury, decided that the days of sky-high interest rates were over, because they were incompatible with those government bond hoards acquired with no deposit which the banks had such desperate need of. As a result, and here we rejoin the main line of our story, the government for the first time introduced double-entry bookkeeping into its account - something that the Templars are supposed to have brought back from the Holy Land almost a thousand years ago. What until then despite the recommendations of four royal commissions and countless auditors our government had resisted doing. When the government built a building, a road, a bridge, or whatever, it carefully amortized the debt that was incurred over a period roughly equivalent to the useful life of the asset created, but the value of the asset itself was written off in a single year, leaving the debt but not any estimate of the value of the capital asset it had paid for. Obviously this utter lack of serious accountancy was immensely useful in providing highly profitable privatization deals. You could multiply the book value of the asset - by ten thousand - for a building or a length of highway, and lease back to the public what as taxpayers they have already paid for fully. Throughout the world in fact, highways, railways and buildings have been sold to special international corporations that specialize in toll income. The CNR, the more northern of Canadas transcontinental railways was in fact privatized and sold to a very leading civil servant - something that one would expect to happen in a corrupt Latin American land. However if you start with crooked bookkeeping, the door is thrown open for any sort of corruption.

But getting back to the distinction between central government debt that should have a large positive sign before it to prevent confusing it with non-sovereign debt, we might note that the acknowledgment of the value of government investments in its accountancy (in the US as of 1996, and in Canada six years thereafter) is now confined to material investments. To this day in both Canada and the United States and most other countries throughout the world, money invested in human capital - education and training, and hence inevitably the vessels in which these are conserved - health, and social services, are still not treated as assets.

Elsewhere we have fought to keep alive the memory of Theodore Schultz of the University of Chicago. As a young man he with hundreds of other young economists were sent by Washington to Japan and Germany to study the war damage and predict how long it would take for those two countries to rebuild sufficiently to become the formidable competitors that they had been before the war. Twenty years later, Schultz wrote that it is remarkable how wide of the mark their forecasts were. This he ascribed to their having concentrated on the physical destruction, but ignored the fact that the highly educated and disciplined work force of these two defeated countries had come through the war essentially intact.

For that historic conclusion Schultz for a year or two was feted around the world and even awarded the Bank of Sweden Nobel price for Economics. He was even invited to Canada by the second Governor of the Bank of Canada, Louis Rasminsky. But his conclusion was buried and forgotten because it ran counter to an important finding of yet another great economist, the Frenchman FranÁois Perroux, the “dominant revenue.” This recognizes that the revenue of a particular class or social group by its volume and rate of return is taken to indicate the degree of well-being of society as a whole is judged. Schultzs great discovery was denied incorporation into the official body of economic doctrine because it ran counter to the interests of the dominant revenue of our period, which is speculative finance that claims to forecast the future and take a profit on it in advance. Its contrivances to maximize this revenue revolve around interest rates, and the higher powered derivatives of these, which are believed to foretell the future even if by swaps and other derivative of growth rates. These come to approximate the exponential rate of increase which is the mathematical expression around which the atomic bomb is structured.

For our purposes Schultz provided just what we needed to put a positive sign before the recognized investments in government investments into more than a large positive sign to distinguish them from all other debt. In this way we could fix in the public mind that what we call “government debt is a misnomer because it is the result of the absence of serious double entry accountancy when it comes to the investments of our government in physical and human capital. For not only would the latter have unusually long periods of depreciation that span generations. The children of educated parents tend to be more readily educated, better adjusted and confident of their role in society. Government debt would undoubtedly turn out to have violated serious accountancy.

When the US Government Peddled Subprime Mortgages

And with an apology for this lengthy but necessary introduction let us cite The Wall Street Journal (21/07, “FDIC Faces Mortgage Mess After Running Failed Bank” by Max Maremont): “It turns out that the US government itself was one of the lenders giving out high-interest, subprime mortgages, some of them predatory, according to government documents filed in federal court.

“The unusual situation, which is still bedevilling bank regulators, stems from the 2001 seizure by federal officials of Superior Bank FSB, then a national subprime lender based in Hinsdale, Ill. Rather than immediately shuttering or selling Superior, as it normally does with failed banks, the Federal Deposit Insurance Corp. continued to run the banks subprime mortgage business for months as it looked for a buyer. With FDIC people supervising day-to-day operations, Superior funded more than 6,700 new subprime loans worth more than $550 million, according to federal mortgage data.

“The FDIC then sold a big chunk of the loans to another bank. The loan pool was afflicted by the same problems for which regulators have faulted the industry, inflated appraisals and poor verification of borrowers incomes, according to a written report from a government-hired expert. The report said that many of the loans should never have been made in the first place.

“Hundreds of borrowers who took out Superior subprime loans on the FDICs watch with initial interest rates higher than 12% - have lost their homes to foreclosure.

“Banking regulators are grappling with a new round of woes related to subprime mortgages, which were generally made to people with poor credit histories. This month, the FDIC took control of the IndyMac Bank, a major lender that specialized in higher risk loans, after it failed. The FDIC intends to keep IndyMac open, as it did with Superior, but it doesnt plan to originate any new mortgages.

“FDIC Chairman Sheila Bair has been unusually forthright in putting part of the blame of the mortgage mess on regulators, who she says should have acted earlier. But Ms. Bair - who took office in 2006, long after FDIC ran Superior - also has faulted lenders, criticizing them for lax lending standards, making poorly underwritten loans, and placing borrowers in products that create financial hardship rather than building wealth.

“Some subprime loans have been blamed on lenders giving out mortgages for more than a house is worth, immediately putting the borrower in a financial hole.”

“When FDIC learns a bank is about to fail, it tries to locate a buyer ahead of time to assume its deposits and loans. With Superior, the agency had little warning. A private-sector rescue plan had fallen apart at the last minute. The agency decided that the best way to maximize the value of the failed bank was to continue operating it under a new name while it searched for buyers.

“It continued to employ many of the banks workers who originated subprime mortgage loans. The FDIC sold Superiors branches and its deposit-taking business for $52.4 million in late 2001, but no prospective buyers materialized for its subprime lending unit. The FDIC stopped funding the new loans early in 2002, and shuttered the operation by that May 31.

“Both before and after the FDIC takeover, Superior relied heavily on a national network of independent mortgage brokers to locate potential borrowers. Some such brokers have been criticized for focusing more on the fees they collect from generating loans than on the ability of borrowers to pay. In a deposition in May for the Beal Bank litigation, a senior FDIC official suggested that fixing the bank wasnt the agencys top priority. Our job was to go in and sell the assets of the institution, and not try to clean up the operations, per se to make this a better bank, said the official, Gail Pateinas.”

The Innocence of Government Staff

Clearly the staff around FDIC had not been enlightened about how special a place the Federal Reserve was, now that the debt of the federal government was the only legal tender of the land. “It is at crucial moments like that that the bill for burying our history is presented.”

“Real Bank, based in Piano, Texas, sued the FDIC in 2002, not long after it finished paying the agency about $339 million for 5,315 Superior mortgages. Roughly half were New Superior loans originated when the FDIC was in control, and half were underwritten by Old Superior.

“Although the FDIC usually sells such loans on an as-is basis, the agency backed the Superior loans with extensive warranties about their quality, indicating that there was no fraud or misrepresentation in their origination.

“In its court filings, the Beal Bank claims that many of the loans werent as represented by the FDIC. It says some were based on negligent or fraudulent appraisals, and others were based on false or inaccurate information about borrower income. It also says that minority borrowers were given loans with higher fees and interest rates that similarly situated white borrowers, in violation of federal law.

“The FDIC has established high standards of ethical and legal conduct for mortgages that it regulates, but has demonstrably failed to meet these standards in its lending activities at Superior and loan sales to Beal Bank, says Andrew Sandler, an attorney at Skadden Arps Slate Meagher & plom LLP, who represent Beal Bank. This lawsuit is about requiring the FDIC to meet its own standards of accountability.

“An internal FDIC legal memo on the case that was turned over to Beal Banks lawyers refers to gross discrepancies in some loan files, including forged signatures or wildly different signatures claiming when she to be that of the same person. A single mother claimed two children in applying for a loan, but later cited the needs of five children when she failed to make a single payment, according to the memo which was undated.”

Clearly this is hardly an environment that will raise the central bank to the dignity that will keep the credit and credibility of the state high enough above the water line to enable the central bank to dispense with a gold standard for buttressing its credibility.