Is the Fed Losing Control?

In the past two weeks, we heard from Chairman Hyde and then Chairman Jekyll.  A couple of weeks ago, Ben Bernanke made allusions to gradually winding down the Fed's bond buying program, called quantitative easing.  Up to this point, the market had perceived the current round of QE as infinite, a perception that Fed had encouraged by placing no time limts on the program, and offering only the vaguest of guidance as to when QE might end.

But two weeks ago Chairman Hyde frowned and cleared his throat, and the bond bulls began running.  In their panic, they gored many an investor who had drank the Kool-aid however reluctantly and bought risk assets like long term Treasuries, corporate bonds and junk bonds.

Within days of Chairman Hyde's hint that the punch bowl might be taken away, the ten year Treasury note was yielding over 2.5% (up from 1.6% in May) and 30-year mortgages popped up about 1% to 4.5%.  Stocks quivered, but didn't belly flop like bonds.  Alarmed, various governors of the Fed and presidents of Federal Reserve Banks chimed in and suggested that the punch bowl wouldn't be withdrawn any time soon.  Stocks perked up, but bonds continued to pout and mortgage rates kept rising. This was emphatically not what the Fed wanted, since the Fed is resorting to its old trick of trying to revive the economy by bubbling up the housing market.  Even though this is what got us into trouble in 2007-08 with the mortgage crisis, the Fed evidently has an abiding faith in its old tricks.

With the housing rally now threatened, Chairman Jekyll spoke up this past Wednesday (July 10) and made nice nice.  The little toddler of a recovery would need propping up for a long time, he said, before he'd expect it to walk on its own--a very, very long time.  He also said he was sending the senior Fed staff out for a late night booze run to stoke up the punch bowl.

Stocks did a cheery little conga and stepped up to new heights.  This might produce a bit of a wealth effect to boost the economy.  But it will be hardly a smidgen, if the bond market doldrums continue. Bonds barely budged after Chairman Jekyll's attempted love fest.  The ten-year Treasury dallied briefly with the 2.53% level, but then went back up to 2.59%.  Mortgage rates continue to cloud the skies over the housing market. 

Is the Fed losing control?  This is really two questions.  What message is the Fed trying to send?  The most recent minutes it released indicate sharp divisions within the Open Market Committee, and the truth may be that a highly mixed message would be the most accurate.  Bernanke's initial statements two weeks ago may have been an attempt to be transparent and let the public know what the Committee really thinks.  But the Fed got what it perceived as an over-reaction from the market, and has been trying to cover its tracks ever since.

But did the Fed get an over-reaction, or an accurate reaction?  The sharp sell-off in bonds and rise in mortgage rates may have reflected the erstwhile rationality of betting on a continuing rally in fixed income.  Central banks worldwide have joined together and danced the most accommodative bunny hop in the history of banking.  Anyone who anticipated a reversion to the mean in the money markets has been just about rendered CIA-style. Much of the flash crash in the bond markets may have been hedge funds and other big players unwinding leveraged positions betting on more booze for the punch bowl.  Now that the Open Market Committee may be going wobbly on the idea of giving a drunk yet another pitcher of Martinis, bond pros evidently are becoming wary of the hair of the dog that just bit them.  If so, the Fed may have lost control of the long end of the yield curve.

If the Fed no longer has a clear message to send, and can't maneuver the long end of the yield curve any more, it may lose control of the economic recovery.  But perhaps it never really had that much control.  Maybe things looked good for a while because people wanted to believe, and the Fed provided the only federal economic policy they could believe in.  With Chairman Bernanke now a short timer, courtesy of President Obama, it's unclear what anyone can believe in.  And that won't be good for the market or the economy.

Freddie Mac's Silly Boo Boo

We are told today that Freddie Mac has some $3.4 billions in derivatives called "inverse floaters" that profit if homeowners do not refinance out of high interest rate mortgages. At the same time that Freddie Mac was accumulating its holdings of inverse floaters, it was tightening requirements for refinancings, thus either wittingly or unwittingly increasing its chances of profiting from its inverse floaters.

The contradiction between Freddie's investment in inverse floaters and its mission of fostering affordable housing for Americans is obvious. Freddie's regulator, the Federal Housing Finance Agency, has been pushing Freddie and Fannie Mae to limit the extent to which they receive taxpayer subsidies. Seeking investment gains has been one way of pursuing that goal. That may be why Freddie took a flyer with the inverse floaters.

While details remain scarce, it appears from news reports that these inverse floaters are interest only strips--investments that paying the holder (Freddie, in this case) the interest payments from a large pool of mortgages. Refinancings of these mortgages mean that interest payments from the pooled mortgages would stop (while interest payments on the new, refinanced mortgages would go to whoever holds the right to those payments, not to the strip). So the more the old mortgages in the pool are refinanced, the greater the likelihood of Freddie losing money on the strip. Inverse floaters are likely to be volatile in value if interest rates change, and probably aren't very liquid because they're risky.

Refinancings increase as interest rates drop. By investing in the inverse floaters, Freddie was in effect speculating on the direction of interest rates. If rates dropped, the inverse floaters would lose money. If rates rose, the inverse floaters could rise in value (although higher mortgage rates would detract from the value of the stream of interest payments, which would be detrimental to the value of the inverse floaters). These inverse floaters may have been a bet on largely stable interest rates.

The silly thing about all this is that Freddie was speculating on the direction of interest rates in volatile investments that would be an embarrassment if the financial press found out about them. After being nationalized in 2008, Freddie should have become greatly sensitized to the need to look good while doing good. These inverse floaters could produce outsized losses if refinancings pick up. Taxpayers might then be called on to provide more subsidies to Freddie, not fewer. And not because Freddie took losses trying to make homes more affordable for America but because it was betting homes wouldn't become more affordable.

It's entirely possible that Freddie's traders have an explanation for the inverse portfolios that sounded pretty good when they talked among themselves. But from a public relations standpoint, the inverse floaters are silly, at best. The true problem is that Freddie and Fannie have too many conflicting goals, attempt to fulfill too many differing expectations, and are simply too big. There are some pretty good arguments that the biggest banks should be broken up into smaller, not too big to fail pieces. All of those arguments apply a fortiori to Freddie and Fannie.

Retire By Making Your Dollars Last

Managing your money in retirement is often depicted as a problem of how to allocate your portfolio, how quickly to draw down your net worth, when to begin taking Social Security and whether or not to buy long term care insurance. But managing one's financial assets is only part of the picture. Consider how you spend--the less your cash outflow, the easier it is to afford retirement. And you don't necessarily need to become a connoisseur of cat food or learn the dozens of ways to prepare rice and beans.

Pay off the mortgage. One of the most surefire ways to reduce month expenses is to pay off the mortgage. Since your retirement income will probably be less than your income while working, offloading the mortgage will improve the quality of your sleep.

Take the auto mechanic off your speed dial. Buy cars that are reliable and known for longevity. With the increased computerization of cars, the cost of repairs is skyrocketing. You don't have to buy a tinny econobox. If you can afford a luxury car, choose an Acura or Lexus, not some other brands that enrich repair shops.

When it comes to appliances, spare your back. High quality in home appliances isn't, to borrow a stock market phrase, closely correlated with price. The most reliable and long lasting washing machines and dryers tend to be the traditional, modestly priced top loaders. Currently fashionable side loaders have their attributes, but at the cost of higher purchase prices and less longevity. Plus you have to bend over or kneel down to get access to them. Your back and knees may have an opinion as to whether or not that's a good idea. Cheaper, more reliable, longer lasting, and easier on the back and knees is a pretty good bargain.

Use generics whenever possible. Generic drugs can be much cheaper than name brands. Why pay for a fancy name when the medication is the same at a lower price?

Avoid credit card debt. The most expensive loans most Americans take are credit card balances carried over from month to month. If you use credit cards, only charge what you can pay off at the end of the month. That way, you earn rewards, cashback bonuses, etc., without paying any interest. Why enrich banks in your golden years?

It's the Economy, Stupid, and Republicans and Democrats Are Stupid

Politicians make their livings bashing other people, so it's only right and fair to bash them. There's a lot of grist for this mill.

Republican Congressional leaders were quick to criticize the Obama administration on Friday, June 3, 2011, after bad unemployment numbers were announced. Total job creation in May was 54,000, and the unemployment rate rose from 9.0% in April to 9.1% in May. The weak job creation number wasn't surprising, given other recent data signaling stagnation. The unemployment rate increase naturally flowed from the economy's need for a net increase of over 100,000 jobs every month simply to keep up with population growth (which increases the labor force). In addition, some previously discouraged workers may have jumped back into the labor force to actively look for work. That expands the labor force and raises the unemployment rate when there aren't enough jobs for them.

How did the Republicans shoot themselves in the foot? The private sector increased employment in May by a net of 83,000 jobs. That's not a great number, but it shows hiring exceeded firing. The reason for the lower total of 54,000 new jobs was that governments laid off a net 29,000 workers. This is due to state and municipal governments cutting back to meet austerity demands from primarily Republican governors and legislators. Do we think these government workers who lost their jobs because of Republican policies will blame the Obama administration? (Hint: take a look at recent events in Wisconsin politics.) Government employment levels have fallen for seven months in a row, and that's not because the Obama administration is laying off federal employees. If unemployment trends continue like this, expect the growing numbers of unemployed government workers, and many among their family and friends, to vote Democrat. Republicans hoping to see their party do well in 2012 should be careful what they wish for because the jobless have plenty of time to vote.

As for the Democrats, the Obama Administration announced on Saturday, June 4, that it would make a renewed push for principal reductions on defaulting mortgages, in an effort to keep more homeowners in their homes. This is meant to help not only struggling homeowners, but also to keep more houses off the foreclosure and resale markets, where distress sales continue to nudge home prices lower. But principal reduction has been a fools errand. It hasn't worked well in the past and isn't likely to work well now. The people who need principal reduction the most--the jobless--won't qualify because of their lack of income. Banks aren't required to reduce principal, and have little incentive to do so. There may be arguments why banks and mortgage investors lose less from principal reductions than from foreclosure. But the legal latitude banks have to make principal reductions on mortgages they have sold to investors is less clear than proceeding with foreclosure, and banks may be stuck with some or all of the loss to lenders when principal is reduced. In other words, banks may be in a riskier position with principal reduction than they would be with foreclosure (where they can generally pass the loss onto investors because banks mostly sell mortgages they originate). So why would they put themselves at increased risk in order to give a defaulting borrower a break? Never forget that on Wall Street, money talks and bullswaggle walks.

A second, and more important point for political purposes, is that the neighbors are watching. Yes, they want to see if the person next door has a better big screen TV than they, or if the person across the street is having an affair, or if the teenagers two houses away are getting out of control. But keeping up with the Jones would become most urgent if neighbors got a reduced mortgage because they didn't keep up with their monthly payments. Talk about envy. The defaulting Jones would get, perhaps, the equivalent of tens of thousands of dollars over time because they were deadbeats. Principal reductions could have a bandwagon effect--give one to the Jones, and others on their block will start defaulting so they, too, can get a principal reduction. After all, how can you tell your kid to borrow tens of thousands of dollars for college because you wouldn't stiff the bank like the folks next door? If entire neighborhoods start having mortgage default parties, bank earnings will fall and bankers contributions to the Republican Party will soar. Neighbors too proud or too protective of their credit ratings won't default. But they will likely vote Republican to assuage their anger.

So politicians are stupid. That's not news. The scary thing is they don't move up the learning curve. Governance failures are now in vogue. The Japanese government's dysfunction exacerbated its slow reaction to the nuclear crisis that followed the recent earthquake. The Euro bloc's weak governance structure makes bailouts without a true restoration of fiscal discipline the only way to cope with its sovereign debt crisis. This is not a solution, but a deferral of the train wreck to come. California's governance failure has pushed its budget crisis virtually beyond the realm of resolution. And, last but certainly not least, the mud-slinging, gotcha-politics in gridlocked Washington have imperiled the creditworthiness of the U.S. government and the strength of the U.S. dollar. The dumb thing about all this is that Japan, Europe, California and America are all very wealthy. They have the resources to solve their problems. But they can't make their political processes work in a constructive way. Forget all the predictions for the economy and the stock market you're now hearing. Politics has thrown a wild card into the game, and no one knows how things will turn out.

Taxpayer Liability for Banks: the Missing Link in Balancing the Federal Budget

As if the federal budget balancing debate weren't complicated enough, a key issue is absent from the discussion. Virtually no attention is being paid to the potential budget-busting problem of taxpayer liability for the banking system. Although this is a contingent liability, it can wreak astounding havoc when the banking system hits the fan. Ireland illustrates the problem.

Like so many other nations, Ireland rode to seeming prosperity on a rising real estate market. Its banks were instrumental in financing this bubble. When Lehman Brothers collapsed in September 2008, Irish banks rapidly slipped off the precipice. Their stock prices fell and a liquidity crisis loomed. The Irish government moved posthaste to stem the panic, guaranteeing some $570 billion of bank liabilities (which should be compared to Ireland's GDP of approximately $170 billion). Eventually, the Irish government nationalized one major bank, Anglo Irish. While the Irish government's direct debt is about 65% of GDP (not much different from the U.S. government's direct debt), its guarantee of bank liabilities vastly increased its potential obligations. The resulting morass was so bad that Ireland needed an EU bailout earlier this year.

The U.S. government (and American taxpayers) are on the hook for the liabilities of the largest American banks. Not officially, but we all know they'll get a bailout if they need one. In addition, taxpayers are liable for the housing banks--Fannie Mae, Freddie Mac, the FHA and Ginnie Mae. The amounts of all these contingent liabilities are unclear but likely very large. Illiquid real estate assets held by banks (so-called Level 3 assets) may be overvalued by hundreds of billions. Vast numbers of defaulted mortgages remain in limbo as the foreclosure mess crawls toward a resolution that will probably entail more losses for banks. The continued decline of the real estate market means more mortgages going underwater, and probably more defaults.

In addition, the largest banks have trillions of dollars of derivatives exposure. Much of the derivatives exposure is hard to see right now. Current accounting standards allow banks sometimes to net derivatives assets against derivatives liabilities. Netting means we don't see them on balance sheets. Once international accounting standards replace U.S. generally accepted accounting principles (probably within a couple of years), a lot of current netting of derivatives holdings would likely have to be unwound. Balance sheets of the largest banks could balloon by more than $7 trillion, in the aggregate. America's GDP is around $14 trillion, while annual federal spending is around $3.5 trillion. Readers may painfully recall that during the 2007-08 financial crisis, derivatives assets had a scary way of losing value while derivatives liabilities remained unwavering. Taxpayers would be on the hook for the losses. Reining in the amounts of bank derivatives exposure may be necessary to reducing the potential bite on taxpayers.

So, we can see that balancing the budget doesn't just mean getting expenditures down and government revenues up. It also means limiting contingent liabilities. Ireland's government didn't flagrantly overspend. Profligate lending by too big to fail Irish banks made it fail. Fortunately, Ireland's not too big to be bailed out by the EU. But there's no brother big enough to bail out America. Truly balancing the U.S. government's budget requires limiting taxpayer exposure to the banking system.

Progress on that front is painfully slow. The Volcker Rule is constraining some of the riskier activity. But reform of the derivatives market is hard to spot, even on sunny days at high noon. Banks remain Brobdingnagian in size, and executive compensation may soon run wild again. Implementation of the Dodd-Frank provisions for improved financial regulation is hindered by lack of funding. Fannie, Freddie and the FHA guarantee almost all new mortgages. Proposals for limiting the burdens they place on taxpayers will be obstinately contested by the real estate industry. Although neither Republicans or Democrats want to face the tough issues in balancing the budget--entitlement programs like Medicare, Medicaid and Social Security--we will eventually have to reform those programs. But all the pain and controversy we will endure squabbling over entitlements will be for naught if there is another financial crisis. And another crisis hardly seems any less likely than the one we still haven't recovered from.

Hope For the Financially Lost

Financial plans can be blown up because of job loss, illness, elderly parents who need support, or bad investments. Some people simply can't save. Whatever the situation, there remains hope for the financially lost to have at least a decent retirement.

Boost your benefits. Work as long as possible to build up Social Security and, if available, pension benefits. This is especially important for those that can't save. Even if you aren't working, delay taking Social Security benefits as long as you can (unless you're 70 or older). Delaying Social Security increases benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html.

Stay together. Couples generally are better off than singles, because they can pool their resources. Even if their only resources are Social Security benefits, a couple are usually better off together than individually. Of course, togetherness isn't always possible. When it is, there are financial, as well as other, benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_03.html.

Get a job with a pension. Government, law enforcement, military and educational jobs usually offer a pension or other retirement plan. Although pension benefits in many state and municipal jobs are being adjusted to meet fiscal realities, they will still be better than nothing. Not everyone is cut out for these lines of work. If you find a private sector job with a pension, then try to stay there long enough to accrue meaningful benefits. For those who can't save, a pension is golden. You just have to work long enough to vest; saving isn't necessary. If you need assistance figuring out if the amount of pension benefits your employer promises is correct, contact the American Academy of Actuaries at http://www.actuary.org/palprogram.asp. They'll give you up to four hours of free help. If you think your benefits are too low, contact a regional pension counseling project for free assistance. http://www.pensionrights.org/counseling-projects.

Buy a house and pay off the mortgage. Buy a house, pay off the mortgage, and don't borrow against the house until you retire. This strategy will build equity in a piece of real estate that you can add to your Social Security benefits (and pension benefits, if any). Even though strategic defaults have become fashionable, the unfashionable may have an advantage in the long run.

None of these strategies will finance a yacht. Remember that it's never too late to save, even if you're living on just Social Security. Cash is sublime when times are tough.

It's Not Just a Foreclosure Problem, It's an Accounting Problem

A recent decision by the Supreme Judicial Court of Massachusetts (U.S. Bank, NA v. Ibanez, Jan. 7, 2011) to block certain foreclosures has deeper implications than has generally been reported. The court ruled that two banks, trustees holding pools of securitized mortgages that tried to foreclose on two of the mortgages, hadn't submitted the documentation required to establish valid ownership of the mortgages. Thus, the banks couldn't prove they legally held the mortgages in question, and consequently couldn't foreclose. Nor could they obtain title to the mortgaged homes when they purported to buy them at the auction, so they couldn't resell them. Although the court didn't expressly say so, the homes would appear to be still owned by the original mortgage borrowers.

The court's decision implies that, for perhaps numerous securitized mortgages in Massachusetts, foreclosure may be difficult or near impossible. Such a legal conclusion, if applied nationwide, would gum up the recovery of the real estate markets. Even though halting foreclosures will hold homes off the market (because foreclosing banks can't resell what they don't legally own), prospective buyers will be cautious with the prices they pay for the remaining houses on the market. The foreclosure problems will eventually be resolved and foreclosed homes would then be dumped onto the market. This would push prices downward. Anyone who paid an optimistic price today could end up underwater in a year or two. The real estate markets will not stabilize until the foreclosure problems are dealt with. Delaying them, which will be the result of the Massachusetts decision and similar decisions by the lower courts of other states, will only postpone the day of reckoning. And the delay will add to the costs to the banks for having been so careless about documentation requirements.

What makes things worse is that there's more than a foreclosure problem here. If mortgages haven't been legally transferred to trustee banks, the principal process for financing home purchases--securitization--would have broken down. Mortgages being securitized are supposed to be pooled together and held by trustees for the benefit of investors. The big banks that underwrote the mortgage-backed securities would have breached their contracts to the investors by failing to deliver mortgages to the securitization pool. Investors could demand their money back. And refuse to accept losses the banks claim were sustained on defaulting mortgages, on the ground that those mortgages were never validly transferred to the securitization pool and the investors have no liability for losses from mortgages not held by the pool.

Moreover, depending on how the courts interpret the law, the banks might be liable for fraud, especially if bank officers were aware of the documentation deficiencies but sold mortgage-backed investments anyway. That could result in more liabilities, to investors and in SEC enforcement actions. In the worst case scenario, criminal charges could be filed. Since trillions of dollars of mortgages have supposedly been securitized, but now perhaps weren't, the potential liabilities could be very large.

Another problem would come up with mortgages that banks bought, either directly or as part of a securitization offering. If those mortgages have the same documentation problems the Supreme Judicial Court found deficient, the banks wouldn't really own the mortgages (or securitized interests in them), but would have reported phantom assets on their balance sheets. Again, depending on how widespread the documentation problems are, the quantity of improperly reported assets could be tens of billions, or even hundreds of billions.

Banks are now closing their books for 2010, and will be filing their financial statements at the end of March. The impact of the mortgage documentation problems will grow as a result of the Massachusetts ruling. The banks will have to account for these problems, and make a variety of disclosures. The banks' auditors will likely advocate caution; the New York Attorney General's recent case against Ernst & Young over Lehman Brothers' accounting for quarter end repo transactions will surely loom large in their minds. If the banks understate their problems, they (and their auditors) could buy more fraud suits from other classes of investors or government agencies. Stay tuned. This crisis could make our times even more interesting.

The Foreclosure Crisis: Time to Put the Mortgage Industry in Federal Court

Another major bank, Wells Fargo, announced today that it's placing its foreclosures under review. Morgan Stanley estimated that as many as 9 million foreclosures might be open to legal challenge. (See http://www.bloomberg.com/news/2010-10-12/disputes-may-affect-9-million-foreclosures-morgan-stanley-says.html.) Mortgages whose ownership is unclear create an additional, potentially massive problem. They may have to be written off bank balance sheets. Or, if they were supposedly sold but really not, the "purchasing" investors may be entitled to reimbursement for failure of the underwriting bank to deliver the mortgages. The number of mortgages where title is unclear hasn't been reported. But it could be very large.

Legal processes are erupting nationwide. Lawsuits by the truckload are being filed. Attorneys general in 40 or more states are investigating. Federal agencies and departments are huddling and inquiring. Subpoenas are flying. The legal profession is smiling. Its recession has just ended and prosperity is around the corner.

The foreclosure crisis has become a raging bull. There are, or will be, many, many thousands of lawsuits brought over one aspect or another of the morass. The courts will be clogged for years. Title to millions of homes could be clouded for a long time. Real estate sales could slump as buyers back off and title insurance becomes far more expensive than before.

There's no easy or quick way out of the mess. Indeed, we got into this mess because banks owning or servicing mortgages wanted a quick and easy way through the complexities of recording liens against real estate and foreclosing on those liens. Those banks apparently didn't want to bother with the due process of law. They will now get a shipload of due process, from the courts of just about every state in the nation, and many federal courts as well.

Not even Charles Dickens could write so byzantine a novel, nor Mary Shelley so horrifying a story. The prospect of 50 or more judicial systems reaching every variety of result in this ocean of litigation (and taking years to do so), with no established mechanism for consistency or predictability, is stupefying. Homeowners could experience widely varying outcomes, depending on where they live. Investors in mortgage-backed investments may have little or no idea what their now increasingly illiquid investments are worth. Banks would face unenviable choices for accounting for the situation. Mortgage investors and bank shareholders may well indulge in class action litigation.

A gargantuan problem such as this needs an organized and unified nationwide process for resolution. The current multi-jurisdictional mosh pit promises only legal pandemonium. The financial markets will stomach such bedlam for only so long, and that won't be very long.

But how to institute a national claims resolution process? Federal regulators can correctly say, as they did with the Lehman situation, that they have no statutory authority to take on the problem. State officials have no authority beyond the borders of their respective states.

A claims process in federal court may offer a solution. The process would involve reviewing records relating to mortgage ownership, resolving disputes and deciding who owns what. Attorneys with appropriate backgrounds could be recruited to serve as special masters to handle the enormous amount of work this would entail. The federal claims process could also look into foreclosures, past, present and prospective, and resolve uncertainties and competing claims. (The latter process could be handled through related proceedings in federal district courts in each state, where local lawyers having knowledge of their particular state's laws could serve as special masters to resolve mortgage recordation and foreclosure issues, but as part of a national process to keep the overall resolution of the problem coordinated.) By using attorneys as special masters, the resources of the courts would be magnified exponentially. As things now stand, the foreclosure process has clogged up numerous state courts, with no obvious way to clear up the traffic jams.

Other claims, such as class actions by investors or shareholders, could also be incorporated into the master claims process and resolved as part and parcel of the nationwide cleanup of the mortgage market and foreclosure process. Judges and federal magistrates might be the best adjudicators for these other claims, as they are the most likely to resemble the kind of litigation judges and magistrates routinely handle.

A unified national process could offer at least some degree of consistency in procedures and principles. It might also provide for coordination of various claims, and some notion of a timetable. And the appeals process would be greatly simplified. Information about the mortgage problems would be centralized and presented in a more organized way, offering greater transparency to the financial markets. The big banks, which may face the greatest liabilities here, would have a single process in which to resolve the myriad claims they now likely face, simplifying their management, accounting and regulatory problems.

The federal courts have experience administering cases with vast numbers of claims. Products liability litigation over asbestos related illness and injury provides an example, in which the claims of thousands of individuals have been resolved, in some cases with substantial payments. A nationwide mortgage and foreclosure cleanup process might well be the most complex proceeding ever undertaken by the federal courts. But if there were ever a time to take on such a challenge, this is it.

There isn't an obvious way to institute such a proceeding. Perhaps a number of interested parties, including major banks, the key mortgage guarantors such as Fannie Mae and Freddie Mac, their regulator (OFHEO, or Office of Federal Housing Enterprise Oversight), the FHA, as many state attorneys general as can be mustered, federal financial regulators (citing their need to promote the safety and soundness of banks, and monitor and control systemic risk), and whoever else has legal standing to join the party could band together and petition a federal district court in Washington or New York (where the federal district courts have substantial experience handling massive litigation, and where there are hordes of lawyers who could be lined up to serve as special masters). As a legal foundation for such a process, the petitioners might invoke the equity jurisdiction of the federal courts (a body of law that, more or less, says the courts can, within certain limits, create solutions to problems that the existing legal system can't handle or doesn't handle well). Even though it's unlikely any of these parties alone could convince a court to institute such a proceeding, the combined interests of a consortium of interested parties might present a strong enough foundation that a judge would find jurisdiction.

Equity jurisprudence may be insufficient. If so, an act of Congress would be required. That's a scary thought. The temptation for the politicians to politicize such a process is obvious. But the alternative is a legal quagmire stretching from sea to shining sea. A unified national claims process, even if polluted by the underhanded, craven and disgraceful manipulations of pompous, self-interested politicians, may offer a less imperfect solution. (The biggest problem could turn out to be that Congress won't act quickly enough, a distinct possibility given today's shifting political winds; and that would aggravate a seriously aggravated situation.)

The bonfire of the mortgages is burning hot and fiercely, spreading its flames like a prairie fire on a windy day. A unified nationwide claims resolution process may be the only feasible alternative to the inferno.

How Big Is the Foreclosure Mess?

The size of the foreclosure morass is a crucial question. The moratoriums are hitting the real estate markets like a tractor trailer. Bank losses are inevitable. If the crisis is large enough, it could present systemic risk. Federal regulators and the rest of us need to know pronto if the banking system is going have a fainting spell just because some pennywise and pound foolish bankers thought it would be a good idea to disregard formal legal procedures for making mortgage loans, securitizing them and then foreclosing on them. Probably hundreds of thousands of foreclosures have now ground to a halt, and possibly hundreds of thousands more will be brought into question (including many foreclosures already done). Questions over ownership of mortgages and flaws in foreclosure procedures present the potential for another body blow to the banking system. Even though some of the foreclosure problems have been known for many months or even longer than a year, federal banking regulators have missed the boat again in not seeing this hot tamale right in their laps. Oh well, America will always have taxpayers, so there's a ready herd of sheep to be sacrificed if the bankers don't want to bear the losses themselves.

One potentially useful way to get a sense for the magnitude of the monster would be to read the 3rd quarter financial reports that the major banks will be filing soon. The foreclosure crisis couldn't have blown up at a worse time for them. The third quarter ended for most banks on September 30, 2010. The publicly traded ones have to file a public quarterly report by November 14, 2010. Those filings would include disclosure about the foreclosure mess, and the financial information reported would have to reflect costs and losses from the crisis (such as reserves to cover potential liabilities and writeoffs). Banks that understate the extent of the problems may find themselves sued by regulators and shareholders, so they have strong reasons to be forthright. At the same time, if the foreclosure problems are really big, being forthright might make their creditors a little weak at the knees. Memories of firms with names like Bear, Stearns and Lehman would stir. Bank creditors might be overheard muttering something about the devil taking the hindmost.

Five weeks remain until the banks must file their 3rd quarter reports. That's not much time to get a handle on the situation. They have to figure out the actual and potential losses from their own mortgage holdings, and also the extent of the blowback from mortgages they thought they sold, and securitizations they underwrote or are servicing. Because many banks issue quarterly financial results in press releases within two or three weeks after the end of the quarter, they actually have much less time than the formal filing deadline gives them. The numbers and information in those press releases must also accurately reflect the impact and ramifications of the mess. The heat is on. We may know more very soon.

The Monster Within the Foreclosure Crisis

The foreclosure crisis is going from bad to worse. More foreclosures are stopping. Buyers are stepping back from bank owned properties. The U.S. Department of Justice has started looking into the mess.

The crisis is a tabloid's dream: Robo-signers gone wild, lawyers and courts operating foreclosure mills, homeowners booted through fraud, politicians pontificating, and subpoenas flying. But there's a Frankenstein that lurks within this house of horrors: the question of who owns mortgages. This is the worst aspect of the crisis, and if the problem is widespread, it could have extremely damaging consequences.

News coverage has reported that, sometimes, banks attempting to foreclose couldn't prove they owned the mortgage in question (or that they represented the true owner, if the bank was servicing the mortgage). When proof of ownership was lacking, the bank evidently provided courts with documentation that may not entirely be on the up and up. This practice, which could amount to a fraud on the court and be subject to criminal punishment, is now under review as banks, judges, plaintiffs lawyers, prosecutors, and all kinds of other folks try to sort things out.

If the ownership problem is widespread--and it might be, since it seems to have arisen from the hyper-pace of creation and securitization of trillions of dollars of mortgages in past years--the implications could be enormously bad. Banks would have to write off mortgages they can't prove they own, and reverse any past recognition of revenue and earnings from those mortgages. After all, banks can't claim as an asset a mortgage they don't own, nor can they recognize revenue from a non-owned mortgage. The sheer scale of mortgage lending and securitization is such that even if only 1% of mortgages are affected by ownership problems, the amounts involved could reach $100 billion or more of mystery mortgages. (There are about $14 trillion of mortgages outstanding, $7.5 trillion of which are securitized.) The U.S. banking industry would have a tough time swallowing another $100 billion of losses, especially now that banks already need to bulk up their capital to meet heightened capital requirements. Taxpayers, put your hands on your wallets.

Another implication of the mortgage ownership problem is that the downturn in the real estate market could be dragged out for years longer than otherwise. Foreclosures aren't legit unless the true creditor is seeking to collect the loan. It will now take months and even years to plow through legal records to establish true ownership of the many, many thousands of mortgages that might be in question. Buyers will step back from bidding for foreclosed properties. No matter, since some title companies aren't insuring title to such properties, so the banks probably couldn't sell them anyway. The foreclosures now in suspension won't be held off forever. Eventually, some resolution of the current mess will be achieved, those foreclosures will proceed, and the recovered properties resold. So these properties overhang the market, and buyers will be cautious about bidding even for non-foreclosure listings.

Then, there are the foreclosures in states where court approval isn't required. About 23 or so states that require court approvals for foreclosures. The rest allow foreclosures to proceed without court orders. But that doesn't mean that inability to prove ownership of the mortgage is okay in those states. To the contrary, booting a homeowner without being the true creditor on the mortgage probably violates the law in more than one way. Doing so may well be a fraud on the owner. If a sheriff's deputies were used to evict the owner, the lender might be deemed to have lied to sheriff. Lying to a peace officer is never a good idea. A subsequent buyer would not obtain clear title, so the lender might well be deemed to have perpetrated a second fraud. If such clouds over title are widespread, real estate markets in nonjudicial foreclosure states could be crippled for years, as title insurance companies try to sort out their risks and buyers stay away.

Another aspect of the mortgage ownership problem emerges in the securitization market. Large quantities of foreclosure mortgages are or were securitized. The mortgage ownership question implies that investors in the securitizations of those mortgages might or might not have invested in actual mortgages. To the extent, they did not, the banks that underwrote the securitizations can look forward to receiving investors' fraud claims. To make things worse, in the case of past foreclosures, investors who received the proceeds of foreclosures on mortgages they didn't actually have an interest in might be liable to repay the money. Needless to say, they would look to the banks servicing the mortgages for recompense. Given the apparently lousy state of the recordkeeping, the morass on the securitization end of the things could take years to clear up. The revival of the securitization market might be pushed back for a similarly long period. If things turn out to be really bad, securitization as a large-scale method of financing may be gone forever.

The foreclosure mess bears watching. It seems to be about where the financial crisis was in 2007: a year before we see the worst of things. If the foreclosure mess turns out to be a real monster, expect Wall Street and the real estate industry to try to dump it where the financial crisis ended up--in the laps of taxpayers. Whether that will be politically feasible is open to question. We are now witnessing the largest taxpayers' revolt since the Whiskey Rebellion in the 1790s. Maybe this time the banks will have to bear the losses they created.

Foreclosure Mess: the Mortgage Monster Rears Its Head Again

Like a ghoul in a low budget horror flick, the mortgage morass never dies. Just when you think it's dead, its eyes snap open. Then it smiles a fang-filled grimace and gets up to lurch again in search of victims. The latest resurrection of the beast is the foreclosure mess.

Recent news reports indicate that financial firms servicing mortgages have many times foreclosed on defaulting homeowners without really knowing if they had the legal right to foreclose. Mortgage records in some cases seem to have been evanescent. But, no matter, as key employees whose job it was to review mortgage files and determine that foreclosure was warranted apparently paid scant attention to the contents of the files anyway. One such employee reportedly signed off on thousands of foreclosures a month, perhaps spending only a minute or two per file. Let's guess that his nickname is Robopen.

Other news stories in recent months have reported courts balking at foreclosures when banks couldn't prove they owned the mortgages that were supposedly in default or that they truly had authority to proceed with the foreclosure. There have been allegations of document forgeries and other irregularities. Foreclosures by two major financial institutions--Ally Financial (formerly GMAC) and J.P. Morgan Chase--are grinding to a halt. Today's Washington Post reported that other banks may follow in applying the brakes to their foreclosures. Some state attorneys general are starting to investigate and members of Congress are making noise about compensation for homeowners improperly ejected from their homes.

This is seriously bad shhhhh . . . stuff. The news reports probably reveal only the tip of the iceberg. It's impossible right now to identify all the potential ramifications of this sewage spill. But what we can see already is really stinky.

Systemic risk. With the recently enacted Dodd-Frank legislation, systemic risk is all the rage. So why don't we start with it. There are trillions of dollars of mortgages still held by America's major financial institutions. If the recordkeeping of mortgage servicers is really bad, and numerous mortgages cannot be connected to a legal owner (i.e., a lender or investor who truly has title to the mortgage), a lot of bank writedowns may be necessary. If a bank can't prove it holds the mortgage it thought it held, it will likely have to write off the entire debt. And it will have to stop taking payments from the homeowner, since it can't legally take money it's not entitled to get. We aren't just talking about defaulting and defaulted mortgages. We're talking about all mortgages. A bank that can't document its legal right to a mortgage will have to write it down because you can't count as an asset something you don't own. And the bank can't take payments from a homeowner who doesn't legally owe it any money. The recordkeeping problem here could mean many billions of losses. Federal regulators concerned about bank capital levels just got another massive migraine.

A heroic effort to straighten out the recordkeeping problems might eventually link up a lot of orphaned mortgages with their true owners. But that will probably take months and years. By all indications, each mortgage's file will have to be manually reviewed and straightened out--and not by Robopen or his clones. Such labor intensive work, which likely will require lots of lawyer time, will blow up bank legal budgets nationwide. And, given the inadequacy of the records, lawsuits will sprout like mold in damp drywall. All the while, massive amounts of bank capital will be tied down in mortgages, because the banks won't be able to sell what they can't prove they own. And they may have to reimburse mortgage investors to whom they sold mortgages they didn't own in the first place. Future lending--for new home purchases or to support economic recovery--may recede from today's sputter to a trickle.

Investors, lawyer up and stop buying mortgages. Investors who hold mortgage-backed securities just found themselves living in a world of septic content. They may, or may not, own any mortgage interests. If banks can't be sure who owns which mortgages, they can't be sure what they sold to mortgage investors. The 2007-08 mortgage crisis was bad enough. But today's clouds over title to mortgages means the pricing of numerous mortgage-backed investments may have become hazy indeed.

Fannie Mae and Freddie Mac have been backing new mortgages, so investors in newly issued debt may be at less risk. But if the recordkeeping problems include recent mortgages, the U.S taxpayer (that would be you, dear reader) just got screwed. Oh well, chalk it up to life in a world of too-big-to-fail financial institutions.

Homeowners, to the ramparts. If you're struggling to pay the mortgage, and the mortgage servicing bank or firm is getting ugly, fight back. Fight back hard, because you don't want to be shoved out of your home by someone to whom you don't legally owe any money. Demand to see documentation proving their ownership of your mortgage. Hire a lawyer if you don't understand legal documents. If you're getting the runaround, call your Representative and Senators in Congress, and your state's attorney general. If you truly have defaulted, there may well have to be a settling of accounts eventually. But don't get bullied out of your home by someone who has no legal right to foreclose.

Buyers beware. If you're looking to buy a house, don't buy at a foreclosure auction, and don't touch any property that is a bank sale after a foreclosure. Also, if the property is now owned by ordinary individuals, think about avoiding it if it was foreclosed on in the past. There's no way to tell when the recordkeeping mess might have begun; if you want to be truly careful, don't buy anything that has ever been foreclosed on. You can usually tell if there's been a foreclosure by looking at the history of ownership of the home (often available online in county or city records). If a bank, other corporation, or corporate trustee, is listed as an owner, there's a good chance the property was foreclosed on. If you buy a property with a foreclosure in its history, the mortgage mess may mean that the previous owner who was forced out may actually still own the house and might be able to reclaim it from you. You would probably be able to recover money under your title insurance policy (be sure you have one of these, even if your lender also has one). But you'd be out of the house.

There are legal rules that would probably bar prior homeowners from trying to reclaim the house after a number of years, but you'd have to hire a lawyer in the state where the house is situated to find out how many years that would be. This isn't the short time period homeowners have after foreclosure to recover the home, but a longer period that homeowners would have to recover after being forced out due to the foreclosing lender's fraud. The law may not be entirely clear on this issue, which is why you might want to avoid homes that have ever been foreclosed on.

Sellers beware. Sellers may think that with foreclosures grinding to a halt, the flood of bank sales onto the market will abate and prices will rise. They shouldn't smile too quickly. The foreclosure mess will eventually be resolved and the defaulted properties put on the market. That overhang will keep buyers on the cautious side. Mortgage loans may become harder than ever to get, as mortgage investors from Fannie and Freddie to institutional investors everywhere step back from buying more problems until the current problems are fixed. Title insurance premiums could rise sharply. Higher costs mean fewer buyers. Closings could become more difficult, as title insurers verify two or three times over that the correct mortgagor and home equity lender, if there is one, are being paid off. The home(s) down the street whose foreclosures were just suspended may not be well-maintained, as neither a defaulting homeowner nor a bank that may or may not hold the mortgage have much incentive to keep the place up. Your neighborhood could go to weeds if no one is responsible for ownership. A vibrant real estate market can't exist without good recordkeeping.

Taxpayers. Need we say it? After the bailouts of 2008 and 2009, we all know who gets nailed in the end. Senior government officials will solemnly intone well-rehearsed proclamations about protecting the viability of the financial system, etc., etc., so on, and so forth. Then they'll foist the dog doo on you. Bank bonuses might again temporarily fluctuate, but rest assured that the wealthy and powerful won't truly bear the burdens.

The Good Elizabeth Warren Will Do For the Banking System

To listen to bank lobbyists, one would conclude that Elizabeth Warren, recently appointed an adviser on consumer protection to President Obama and Secretary of the Treasury Geithner, must be a really bad person incarnate. They were planning to pull out all the stops to prevent her confirmation by the Senate as the head of the new consumer protection bureau at the Federal Reserve. President Obama's appointment of her as an adviser does not require Senate confirmation.

What Warren and the new consumer protection bureau can, and hopefully will, do is stop the lunacy in the banking system. The baseline reason for today's economic problems isn't the federal deficit, or the tax system, or the exchange rate between the yuan and the dollar, or the Fed's printing of trillions of dollars, or the new health insurance legislation. The baseline problem is that the banking system made a shipload of really stupid, indefensibly idiotic mortgage loans. Bankers loaned money without verifying borrowers' income, assets, or employment, and paid scant heed to credit histories. All many borrowers really needed was a pulse and a signature. Bankers utterly disregarded lending standards and risk management, blithely assuming that the risks associated with the lending insanity would be passed to the investors that bought this toxic financial waste. Because of the way the mortgage market worked, higher compensation was paid to mortgage bankers and brokers for underwriting riskier loans than for 30-year fixed rate mortgages to people who had downpayments and might actually repay the loans.

The end result was the accumulation of almost incalculable amounts of systemic risk, risk that exploded and imposed trillions of dollars of losses on banks, homeowners, businesses, laid off workers, and taxpayers. Sure, some (although not all) of the borrowers who took out nutty loans had some idea of what they were getting into. But they knew of their individual risks--that the interest rate might rise, that there would be a balloon payment at some point in the future. What they didn't know--and what nailed many of them and all of the rest of us--was that the entire system was poised for a fall because the indescribably imbecilic lending had taken place on a large-scale, nationwide basis. Indeed, even the most knowledgeable federal banking regulators were either clueless, in denial, or both when it came to the systemic risk presented by the morons of mortgage lending. We're still paying the price for this disaster and will do so for years to come. The absence of consumer protection left us all without protection.

The new bureau shouldn't just impose ritualistic disclosure requirements. When borrowers arrive at the closing and find thousands of pages of documents to plow through, disclosure requirements amount to regulatory failure. The new bureau should substitute its judgment for the dysfunctional judgment of bankers (and borrowers, too, since some of them were complicit in taking out loans they realized were foolish but took anyway in order to gamble on the real estate market rising). There was a fundamental market failure in mortgage lending, and sound regulation can fix such failures. Imagine banking without federal deposit insurance if you question this notion.

Mortgage loans are already unavailable to many less creditworthy borrowers, and rightfully so. It does them--and we taxpayers--no good if the banking system accumulates a mountain of bad loans that strip defaulting homeowners of their savings, credit ratings, and pride, and taxpayers of funds badly needed for other priorities. With today's tight underwriting standards and the overall unwillingness of banks to lend, it's unlikely that the new consumer protection bureau can reduce the availability of credit a whole lot. What it may do--and this is probably what bankers fear the most--is that as the economy recovers the consumer protection bureau may prevent the banks from returning to the highly profitable insanity in which they reveled earlier this past decade. Amen, say the rest of us.

Consumer protection in this case isn't about a bunch of liberals on federal salaries singing, "If I Had A Hammer." It's about imposing and enforcing prudential consumer lending requirements on banks that protect us all. Not just borrowers with eighth grade educations, or workers whose native language isn't English, but also the most well-educated, well-read, and wealthy of Americans, because we all have a stake in the well-being of the financial system.

Back Door Deficit Spending

The best kind of deficit spending, if you're the spender, is the kind other people (like taxpayers) don't see. Even though deficit reduction is now the political flavor of the month, acolytes of John Maynard Keynes still work their agendas quietly.

With mortgage rates now running 4.5% and even lower, courtesy of the Fed's 24/7 money printing presses, proposals are being floated to consciously spur mortgage refinancings--not to increase homeownership levels, but to put more cash in the hands of existing homeowners to spend. This would add who knows how many billions of consumption to the economy. Of course, it would entail a relaxation of lending standards. One proposal is to allow homeowners with mortgages guaranteed by Fannie Mae or Freddie Mac who are current on their payments reduce their rates to 4% and borrow up to the appraised value of their homes, regardless of the value of their homes or their current financial circumstances. (Presumably, only those who aren't underwater could increase the principal amount of their loans, but those that are underwater but current could get a lower rate.) There is a name for this loan: the no doc loan. We had problems with it during the financial crisis, and some of those problems still burden us today.

Despite repeated denials by the Federal Reserve, the Treasury Department, the President's economic advisers, and other notable officials, scholars and experts, there still isn't such a thing as a free lunch. If mortgage refi standards are relaxed to spur consumption, investors currently holding the mortgages that would be refinanced would be losers. Early prepayments would cost them money because the refinanced mortgages available to investors would pay a lower rate. Overall interest rates have been falling as well, so investors wouldn't have attractive alternatives. They'd simply end up with less yield. Refinanced homeowners would have more to spend, but mortgage investors would have less to spend.

Other losers would be--guess, and you have only one chance, but you'll get it right because there's no possible answer other than--taxpayers. That would be you and me. We're already on the hook (line and sinker) for Fannie and Freddie because they've been nationalized. Nationalizing them has already cost us over $300 billion. That's more than the economies of most countries. Relaxing underwriting standards means a higher risk of loss--a lesson from the 2008 financial crisis that some seem to have forgotten. Early onset Alzheimer's must be prevalent in economic policy circles. Throw a lot of cheap refi money at people who aren't demonstrably able to repay it, and guess what? Some of it won't be repaid.

Because Fannie and Freddie remain "private" corporations in a technical sense (you can still trade their stock if you're in a mood to speculate), their balance sheets are not incorporated into the federal government's financial statements. Indeed, Fannie was privatized back in the 1960s because Lyndon Johnson wanted to indulge in massive (for the times) deficit spending in order to advance his Great Society program while fighting a major war in Southeast Asia. Keeping Fan on the federal balance sheet would have been a political roadside bomb. So Johnson did the expedient thing (imagine that, an expedient politician) and turned Fannie over to private investors. Everyone pretended not to notice the market assumption that the government implicitly backed Fannie, and we were launched on the trajectory that led to the 2007 mortgage and credit crisis.

So using Fan and Fred as refi vehicles to stimulate consumption is likely to add to their liabilities, and in turn to the federal government's liabilities. Not all deficit spending is necessarily bad, even now. But it should be done out in the open, where all can see it and discuss its advantages and disadvantages. As long as Fan and Fred's liabilities aren't incorporated into the federal balance sheet, it's hard to notice a refi giveaway driven increase in deficit spending. For those of the Keynesian persuasion, it's an elegant solution (as academics would put it). Look for mortgage bankers, who have the most to gain from this proposal, to quietly lobby for it. And keep your hand on your wallet. There's always somebody ready to take your money and those somebodies are on the prowl.

Why You Should Avoid Debt

Many voters are clamoring for the federal government to reduce its debt levels. There are a few simple, bottom-line reasons for all of us to avoid borrowing, and to pay off the debts that we have.

You can't go bankrupt if you don't have debts. You can be poor. You can have a modest lifestyle. But you won't have to plead with debt collectors, seek out credit counselors, get painful scowls at the Bank of Mom and Dad, or file for bankruptcy.

You can't lose your home if it's not mortgaged. Pay off your mortgage, and no bank will have a reason to foreclose. Whether you're gaining equity or losing it, you won't go underwater. Of course, you have to keep paying property taxes and similar assessments. But if you have the money management skills to pay off your mortgage, those other obligations will be easy.

You won't have to sweat your credit rating if you don't borrow. For obscure and arcane reasons, your credit rating can fluctuate from month to month. It won't matter if you're not trying to borrow.

You'll live better in the long run if you spend less on interest payments. Why enrich banks? Pay less interest and you'll have more money to buy stuff.

You'll have a more secure retirement with no debt. Once you're on a fixed income, debt can be a real monster. Retire your debts and your retirement will be better.

It's hard to avoid borrowing for some things. Many can afford college, cars and homes only by taking out loans. But keep the borrowing to a minimum, and pay off the loans that you have as fast as possible. You'll enjoy the peace of mind.

Warning from Weird Financial Markets

The financial markets are getting weird (as if they weren't already). Interest rates for mortgages are at or near all-time lows, but home buying interest is dropping. Stocks are trading in tandem with each other more than ever, seemingly in disregard of the fortunes of individual companies. The dollar and U.S. Treasury securities have improbably rallied, in spite of already low interest rates. When markets behave strangely, it's prudent to check if any canaries have stopped chirping.

The decline in home buying interest stems from two factors: (a) the end of the $8,000 first time buyers credit (and $6,500 repeat buyer's credit), and (b) the large quantities of foreclosed homes and homes with defaulting mortgages sitting in bank inventories. Buyers know that home prices are likely to stagnate or drop, because banks will have to offload their moribund inventory eventually. There's no point rushing to buy now. Lower interest rates may reduce monthly payments, but buyers have learned that monthly payments aren't the only problem. They realize that a loss of equity can be devastating. Something like a quarter to a third of all homes with mortgages are now underwater. Whether the owners of those homes can still afford the monthly payments is becoming a less important question than whether a strategic default makes sense.

Today's stock markets are dominated by powerful hedge funds and other institutional traders. Many use high speed trading strategies. These big boys frequently trade the stock market as if it were a commodity. The notion of stocks as ownership of a piece of a continuing business enterprise is becoming outdated as computerized trading techniques treat the stock market like a bulk commodity to buy or sell alongside oil, copper and pork bellies. Individual investors see their modest portfolios gyrating for no reasons relating to the companies they hold. It's tough to ride a bicycle among tractor trailers, and lots of Moms and Pops are stepping back from the chaos.

The dollar and the U.S. Treasuries rallies were flights to safety at a time when the European Union seemed about to fall apart. It's still shaky, and may get shakier if there's a lot of grade curving on the bank stress test results to be announced this week or next. That the dollar would be seen as a safe haven in a time when the U.S. economy's running on flat tires doesn't bode well.

The markets are mispricing assets. Real estate prices are too high to compensate buyers for the risks of the inventory dump that's coming. But a host of government subsidies, policies and programs buffers home prices from market forces. So buyers hold back, reluctant to pay a non-market price.

Stock prices are too high to compensate individual investors for the stomach churning volatility created by the big boys. But the stock markets today are of, by and for big traders. Volatility is profitable for the short term, high speed strategies many of they employ. These big dogs don't care which way the market moves as long as it moves somewhere because they can't make a profit if prices don't change. Small investors are removing liquidity from the market and finding tranquility in bank CDs.

The dollar and U.S. Treasury securities are issued by a politically unified nation (okay, so bipartisanship ended about 2.04 seconds after Barack Obama was sworn in as President, but compared to Europe the U.S. is as solid as a rock). The Euro is backed by a loose confederation of separate nations that are devoted to passing the buck to someone else. The financial markets undervalued the dollar, not adequately factoring in the value of political cohesiveness. But a rising dollar impairs America's ability to increase exports, foreclosing one path to economic recovery.

Then, there is the biggest market dysfunction of all. For over one and a half years, the Federal Reserve has held short term interest rates to near zero. Bank profits have rebounded sharply but the stimulative effect of this policy has been disappointing. Banks aren't lending. They invest excess reserves in U.S. Treasury securities, mortgage backed debt guaranteed by the U.S. Treasury, and accounts at Federal Reserve banks (in effect, investing in the federal government). The credit markets for banks now operate smoothly. But the credit markets for everyone else are discombobulated. This massive dysfunction remains an enormous barrier to recovery.

While the reasons for these problems vary from market to market, they each impede America's long term economic prospects. Their simultaneity only exacerbates things. When so many important markets are mispricing assets and discouraging participants, canaries may fall quiet.

Now for the Biggest Financial Regulatory Reform: Residential Mortgages

If we likened the efforts to prevent another financial crisis to the government's program to combat the flu, here's what it would look like. The financial reform legislation now working its way through Congress changes structure and process. Regulators will operate in a new structure, with an overarching systemic risk council and a new consumer protection bureau. Processes for trading in derivatives would change, as would proprietary trading by banks. Heightened capital requirements would be imposed on banks, and troubled financial institutions would be subject to seizure and wind down by the government. Comparable changes in government programs to combat the flu might consist of structural change at the CDC and FDA, together with heightened reporting requirements for hospitals and medical professionals concerning all actual or potential cases of the flu.

But what about the vaccine? The government's primary weapon against the flu isn't structure or process. It's fostering the manufacture of vaccine. Vaccines do the most to prevent illness. New flu vaccines are produced every year. Where's the vaccine for the financial crisis?

The biggest single reason for the financial crisis of 2007-08 was the way residential real estate transactions are financed. The large majority of purchases were (and still are) made with long term mortgages--those that contemplate a 30-year or comparably long repayment period. Although many of those mortgages had adjustable rates, the amortization schedules for those mortgages (i.e., the anticipated repayment of the principal of the loan) involved only gradual reductions of principal or none whatsoever (in the case of interest only loans). Whether or not the loans had fixed or adjustable rates, they were all structured with long repayment periods and very gradual amortization of principal, in order to make home purchases more affordable.

Long term obligations are subject to a high degree of interest rate risk. Stated otherwise, when interest rates change, the obligation imposes large burdens on one party or another. If the debt has a fixed rate, the creditor takes the loss. If the debt has an adjustable rate, the borrower takes the loss. It the loss has been transferred by means of a derivatives contract, the counterparty bears the loss. The important thing to understand is that losses are sustained and someone must bear those losses. The losses cannot be made to go away. This is a crucial reason why long term mortgages are so risky.

The long repayment schedules of these mortgages were meant to serve a governmental purpose: making it easier to buy a home. The private mortgage market didn't develop a 30-year mortgage on its own. Government policy, beginning in the 1930s and 1940s, created it. To accommodate financial institutions that didn't want to hold these puppies (and there were many), the government created first Fannie Mae, and then Freddie Mac. Fan and Fred bought the hot tamales, in effect passing the long term risks onto taxpayers. However, the federal government's numerous subsidies for housing and the nation's recovery from the Depression caused home prices to rise steadily on a national level. The risk to taxpayers seemed theoretical. So more and more 30-year mortgages were written, prices rose more, and demand for housing grew apace. The secondary market for mortgage-backed securities blossomed, supported by a seemingly golden asset that never fell in value. Institutional investors far and wide piled into the mortgage markets, believing they'd found the pot of gold at the end of the rainbow. But as the mortgage markets ballooned, so did the systemic risks presented by the ever increasing number of outstanding mortgage loans. The sheer quantity of loans (encouraged by the government to increase home ownership) puffed prices up into a bubble, and that meant systemic risk was skyrocketing.

Certainly, bad lending practices made things worse. The plethora of subprime, Alt A, no money down, no doc, no verified income, more stupid than stupid loans that came into fashion added a shipload of credit risk to the the interest rate risk inherent in long term obligations. But much of the reason these loans were so toxic is they too were structured along the same lines as the traditional 30-year mortgage: a long repayment period, with amortization of principal almost imperceptible in the early years of the loan. They presented the same risks as traditional 30-year fixed rate loans, along with a big helping of credit risk. And all this was possible because of the government policy of sponsoring and subsidizing long term real estate lending.

Once the real estate bubble burst, prices fell and numerous homeowners went underwater on their loans. Many defaulted due to unemployment. Increasing numbers are defaulting for strategic reasons. The real estate market remains in the septic tank for now. When it will recover is anyone's guess, because the sheer quantity of defaulting mortgages from the 2000s weigh heavily on the financial system and the economy.

It is unrealistic to believe that changing the structure of financial regulation and the processes of the financial system are sufficient to prevent another crisis. We need to reduce the levels of systemic risk. The 30-year mortgage and its first, second and other cousins create systemic risk of the first order. Because this risk was the biggest factor leading up to the credit crisis, federal regulators should treat it as their highest priority. Structure and process won't suffice. No package of new rules, more thorough examinations, heightened capital requirements and other measures can shield the financial system from the uncontrolled growth of risk from mortgage markets gone wild. The creation of risk must be moderated, and that means limiting access to long term mortgage finance.

Credit standards are already tightening. But perhaps not enough. There is still no meaningful secondary market for home mortgages without a federal guarantee, which means that the private market adjudges them to be overpriced compared to the risks they present. When long term mortgages can be sold to private investors without a federal guarantee, then we can be comfortable that their downpayment requirements, interest rates and other terms are reasonably priced in relation to the risks they present. That they cannot now be sold signals that taxpayers are still subsidizing real estate purchases to a significant degree.

There is little indication that the mortgage markets will be privatized. Talk now is of nationalizing Fannie Mae and Freddie Mac, which would formalize the federalization of housing finance. And why not? They're functionally nationalized already, and any privately owned-publicly backed hybrid would only perpetuate the outrage of the 2000s: private profit at public risk. But nationalizing them could contribute to the problem--the opacity of governmental accounting (which would apply to the nationalized Fannie and Freddie) would make the extent of taxpayer subsidies, already in the hundreds of billions, even less clear and therefore subject to abuse. As it is, Americans suffer grievously from taxpayer abuse syndrome in subsidizing residential real estate. One can only rationally assume the abuse would continue unabated and rarely seen if Fannie and Freddie are nationalized.

Nationalizing Fannie and Freddie may, in the end, be how the government controls the systemic risk presented by the gargantuan hordes of long term mortgages rampaging around the financial system. That would be a poor outcome, since it would continue costly policies of taxpayer subsidies, with most of the benefit probably going to the higher income brackets. And if the housing market makes another gigantic u-turn, as it did in recent years, the risks of taxpayer support of the real estate market would be realized. While most likely the federal government would simply increase the federal deficit to finance these costs in the near term, they remain real costs that eventually would be visited on taxpayers.

It's important to have a way to measure these potential costs. One way would be for federal authorities to require Fannie and Freddie to offer mortgages for sale in the private market without a federal guarantee, simply to see what price they would command. The discounts that private investors would demand could be used as a proxy to calculate the extent of taxpayer exposure. The numbers would probably be Brobdingnagian. But ignorance won't be bliss. Such a calculation would be a useful way to measure how much systemic risk is quietly building up in housing finance. Large figures would trigger alarms--and that's the idea.

How the Chinese Yuan Re-valuation Will Affect the U.S. Real Estate Market

The re-valuation of the yuan recently announced by the Chinese government has implications for the balance of trade, capital flows into China, and political relations between the U.S. and the People's Republic. What seems to have gone unnoticed is the consequence of this re-valuation for the U.S. real estate market.

As the dollar falls in relation to the yuan, it will make less and less sense for the Chinese to lend to America. They would need interest rates that covered not only lending costs and risks, but also currency risk in an environment where the yuan will almost surely rise. Current low U.S. mortgage rates, a boon to buyers who are financially qualified, are like cold pizza to lenders. And the Federal Reserve appears dead set on keeping interest rates low, lower and even lower. During much of the past decade or so, the Chinese were big buyers of American mortgage-backed investments. The mortgage crisis cooled their jets big time. Even though the secondary market for mortgages today consists almost entirely of U.S. government guaranteed investments, currency risks will make the flow of funds from China less unpredictable. It's true that Europe and the Euro don't, at the moment, provide China with attractive alternatives to the dollar. But China is working on boosting domestic demand and building an internally focused economy. Over time, it will demand fewer dollars and Euros, and provide less real estate financing in the States.

The excess inventory from foreclosures, short sales and the like will be a drag on the real estate market for years. The shrinkage of foreign credit due to the falling dollar will add to the stagnation. We'd better hope the falling dollar gives U.S. exports one helluva jump start, because it will probably tighten up an already parsimonious mortgage market.