Subprime and the Fed

Do you remember what the market (Dow Industrials….DJIA) did last summer? Maybe you don’t because the media did not hype the market decline like it has jumped on this latest down-turn. Why? Probably because two weeks ago on February 27th , the DJIA lost 416.03 points in one day. To make things even more dramatic, the DJIA, on that day, was at one point down over 500 points. Last summer the DJIA corrected 8.46%. To date the DJIA has corrected 6.02%. Two weeks ago all we heard was the “melt-down” in China and the Yen Carry Trade. This week all we hear is “subprime”. It is quite possible “subprime” is a relatively new term to you. Here is what it is all about: (source: Wikipedia)

Subprime lending (also: B-Paper, B-tier, non-prime, near-prime, special finance, second chance lending) describes a specific lending market sector. Typically, subprime customers are those who do not qualify for prime market rates because of blemished or limited credit. Consequently, subprime customers are charged a higher interest rate to compensate for the increased risk. The general lending philosophy can be described as "priced to risk" where the interest rate the borrower pays increases as their risk level to the lender increases (but this is limited by the maximum annual interest rate as defined by law in each respective country). In the United States, subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranges from 300 to 850.
The term "subprime" is not derived from the prime interest rate; in fact the borrower of a subprime loan incurs interests rates much higher than the prime rate.

Origins and Motivations
Subprime lending evolved the same way as other businesses, with a realization of the demand in the marketplace and then providing a supply to meet it. With divorce being common in society, bankruptcies and consumer proposals being widely accessible, a constantly fluctuating economic environment, and consumer debt load on the rise, traditional lenders are more cautious and have been turning away a record amount of potential customers Statistically, approximately 25% of the population falls into this category (credit score <>

Motivation for the Lender
To access this increasing market, lenders must take on the risks associated with lending to people with poor credit ratings. Subprime lenders are usually stand-alone companies and are not affiliated with prime lenders (who take little risk with their funds). For a prime lender, the safest entry into the subprime market is to acquire an existing subprime company with established brand recognition and business stability. Subprime loans are especially risky for the lender since there is a high probability that an applicant who has a credit history that shows a long history of write-offs and slow payments will default or fail to pay on time. However, lenders may be willing to take the risk of offering subprime loans to an applicant who has a poor credit score due to short-term difficultly in maintaining their credit rating.
To offset the risk that the lender faces, subprime lenders often look for added security in the form of collateral. Examples of this are mortgages, vehicle loans, furniture loans, credit cards secured by an initial deposit that matches their credit limit, etc. Once the company registers a lien against the assets, the company can repossess the assets and reclaim a portion or all of their loss should the customer default on the loan.
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Motivation for the Borrower
People with non-ideal credit have particular difficulty in obtaining loans, and subprime lending offers them the chance to get money that they may need. The trade-off for them involves the need for collateral, very high interest rates, and often high monthly payments. In essence, if other lenders turn away a potential borrower due to their credit rating, they will go to any other lender to get the money that they need, even if it involves added expense and risk for them.
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Subprime Lending and Re-establishing Personal Credit
Some subprime finance companies offer customers with poor credit a chance to re-establish their credit and eventually become a prime customer. Consumers with poor credit can borrow at higher-interest rates from subprime lenders. Once the borrower has shown responsibility in paying off debts and re-established a positive payment history, credit rating can increase. While an overwhelming majority of mortgage loans, subprime or otherwise, are reported to credit bureaus, not all are. Customers wishing to re-establishing their credit should check that their payment history is reported.

In the past, I have written on several occasions about the “wave of liquidity” that has, over the past several years, swept over the world’s asset markets. Subprime lending has always been with us but not to the extent we have seen in the past two or three years. It’s increase and the apparent abuses associated with it, have created the current “crisis”. This can be directly traced to the “wave of liquidity”.
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The next logical question might be….Why the “wave of liquidity”?

It all started in 2001. The new administration and the Federal Reserve, led by Chairman Alan Greenspan, were very concerned about the potential economic effects of the dot.com debacle and the ensuing economic slow-down. As a defensive measure, the Fed went on an interest rate reduction spree. Rates plummeted down to a Fed Funds rate of 1%. The Fed kept rates low for about two years. Additionally, they orchestrated an “easy money” policy that enabled subprime lending. There could be other ramifications from the Fed’s easy money policy as we move forward. Some argue that the Federal Reserve needs to be reined in.

Texas Congressman Ron Paul, who has recently announced that he is a Republican presidential candidate, is one that has been very critical of the Fed’s actions. Here is what he said about it before the House of Representatives.

TRANSPARENCY IN MONETARY POLICY
by Hon. Ron Paul of Texas
Before the U.S. House of Representatives
Statement for Hearing before the House Financial Services Committee, “Monetary Policy and the State of the Economy”

Transparency in monetary policy is a goal we should all support. I’ve often wondered why Congress so willingly has given up its prerogative over monetary policy. Astonishingly, Congress in essence has ceded total control over the value of our money to a secretive central bank.
Congress created the Federal Reserve, yet it had no constitutional authority to do so. We forget that those powers not explicitly granted to Congress by the Constitution are inherently denied to Congress - and thus the authority to establish a central bank never was given. Of course Jefferson and Hamilton had that debate early on, a debate seemingly settled in 1913.

But transparency and oversight are something else, and they’re worth considering. Congress, although not by law, essentially has given up all its oversight responsibility over the Federal Reserve. There are no true audits, and Congress knows nothing of the conversations, plans, and actions taken in concert with other central banks. We get less and less information regarding the money supply each year, especially now that M3 is no longer reported.

The role the Fed plays in the President’s secretive Working Group on Financial Markets goes unnoticed by members of Congress. The Federal Reserve shows no willingness to inform Congress voluntarily about how often the Working Group meets, what actions it takes that affect the financial markets, or why it takes those actions.

But these actions, directed by the Federal Reserve, alter the purchasing power of our money. And that purchasing power is always reduced. The dollar today is worth only four cents compared to the dollar in 1913, when the Federal Reserve started. This has profound consequences for our economy and our political stability. All paper currencies are vulnerable to collapse, and history is replete with examples of great suffering caused by such collapses, especially to a nation’s poor and middle class. This leads to political turmoil.

Even before a currency collapse occurs, the damage done by a fiat system is significant. Our monetary system insidiously transfers wealth from the poor and middle class to the privileged rich. Wages never keep up with the profits of Wall Street and the banks, thus sowing the seeds of class discontent. When economic trouble hits, free markets and free trade often are blamed, while the harmful effects of a fiat monetary system are ignored. We deceive ourselves that all is well with the economy, and ignore the fundamental flaws that are a source of growing discontent among those who have not shared in the abundance of recent years.

Few understand that our consumption and apparent wealth is dependent on a current account deficit of $800 billion per year. This deficit shows that much of our prosperity is based on borrowing rather than a true increase in production. Statistics show year after year that our productive manufacturing jobs continue to go overseas. This phenomenon is not seen as a consequence of the international fiat monetary system, where the United States government benefits as the issuer of the world’s reserve currency.

Government officials consistently claim that inflation is in check at barely 2%, but middle class Americans know that their purchasing power--especially when it comes to housing, energy, medical care, and school tuition - is shrinking much faster than 2% each year.

Even if prices were held in check, in spite of our monetary inflation, concentrating on CPI distracts from the real issue. We must address the important consequences of Fed manipulation of interest rates. When interests rates are artificially low, below market rates, insidious mal-investment and excessive indebtedness inevitably bring about the economic downturn that everyone dreads.

We look at GDP numbers to reassure ourselves that all is well, yet a growing number of Americans still do not enjoy the higher standard of living that monetary inflation brings to the privileged few. Those few have access to the newly created money first, before its value is diluted.

For example: Before the breakdown of the Bretton Woods system, CEO income was about 30 times the average worker’s pay. Today, it’s closer to 500 times. It’s hard to explain this simply by market forces and increases in productivity. One Wall Street firm last year gave out bonuses totaling $16.5 billion. There’s little evidence that this represents free market capitalism.

In 2006 dollars, the minimum wage was $9.50 before the 1971 breakdown of Bretton Woods. Today that dollar is worth $5.15. Congress congratulates itself for raising the minimum wage by mandate, but in reality it has lowered the minimum wage by allowing the Fed to devalue the dollar. We must consider how the growing inequalities created by our monetary system will lead to social discord.

GDP purportedly is now growing at 3.5%, and everyone seems pleased. What we fail to understand is how much government entitlement spending contributes to the increase in the GDP. Rebuilding infrastructure destroyed by hurricanes, which simply gets us back to even, is considered part of GDP growth. Wall Street profits and salaries, pumped up by the Fed’s increase in money, also contribute to GDP statistical growth. Just buying military weapons that contribute nothing to the well being of our citizens, sending money down a rat hole, contributes to GDP growth! Simple price increases caused by Fed monetary inflation contribute to nominal GDP growth. None of these factors represent any kind of real increases in economic output. So we should not carelessly cite misleading GDP figures which don’t truly reflect what is happening in the economy. Bogus GDP figures explain in part why so many people are feeling squeezed despite our supposedly booming economy.

But since our fiat dollar system is not going away anytime soon, it would benefit Congress and the American people to bring more transparency to how and why Fed monetary policy functions.

For starters, the Federal Reserve should:

Begin publishing the M3 statistics again. Let us see the numbers that most accurately reveal how much new money the Fed is pumping into the world economy.

Tell us exactly what the President’s Working Group on Financial Markets does and why. Explain how interest rates are set. Conservatives profess to support free markets, without wage and price controls. Yet the most important price of all, the price of money as determined by interest rates, is set arbitrarily in secret by the Fed rather than by markets! Why is this policy written in stone? Why is there no congressional input at least?
Change legal tender laws to allow constitutional legal tender (commodity money) to compete domestically with the dollar.

How can a policy of steadily debasing our currency be defended morally, knowing what harm it causes to those who still believe in saving money and assuming responsibility for themselves in their retirement years? Is it any wonder we are a nation of debtors rather than savers?

We need more transparency in how the Federal Reserve carries out monetary policy, and we need it soon.

Regards, Hon. Ron Paul.

Not bad for a Republican, eh? Paul has been one of the saner members of the Republican Congress with less emphasis on partisanship and more emphasis on solutions to our nation's problems and supporting a strict adherence to the constitution.

Paul addresses the folly of interventionism in Iraq here: http://www.house.gov/paul/congrec/congrec2007/cr030707.htm

Other Republicans should take note: This is what a real conservative looks like. And when Bush is gone and vilified in the same sense as Nixon, those who are supporting Bush now will be rushing to do damage control for their support of his criminal activities. It's time for change and it has to come from ALL sides from responsible parties.