George Rebane

The Community Reinvestment Act will turn out to be one of the IEDs (improvised economy destroyers) that Congress buried long ago in the financial fabric of our country.  Now what it spawned has gone off.

Throughout the history (since 1977) of this great piece of social engineering, people of goodwill from both sides of the aisle have warned about the ways which implementing the CRA has mangled the finance of housing markets.  Now the monster has come to life and threatens to interrupt all credit channels in the country, and perhaps in most of the world.

Having run three companies, I am shocked – see Captain Renault (Claude Rains) scene in the Bogart/Berman film ‘Casablanca’ – at the fraction of American businesses that use debt capital to finance operations instead of or in addition to financing expansion.  Financing operations with debt means that you borrow money for everything from paying salaries to the light bill.  And if you can no longer borrow, your business quickly comes to a grinding halt.  Depending on your size, this is an event that will ripple through your suppliers and your customers, in addition to throwing your employees out of work.

The feds (both parties) have allowed a cancerous growth of laws, regulations, and policies to feed on the CRA and related legislation to create leveraged investments in real estate (mortgage backed securities, collateralized debt obligations, etc.) so complex that no one knew their true value.  All that organizations such as Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, … and countless overseas financial institutions knew is that they had to play the game of buying and selling these IEDs, or be left behind.  At this point, take a step back and recall that capitalistic enterprises will always game the markets, either free ones or those that government mangles.  We would want them to do nothing less since that is what gives us the quality of life we all enjoy.

However, things got so bad in the push to increase home ownership in the country that the congressional IEDs recently began to include sub-prime or ninja loans.  (Ninja?, no income, no job or assets.)  And the CEOs of investment banks (including, of course, Freddie and Fannie) had the gall to demand the law makers grant them favorable tax treatment on what they represented as taking risk in lending to potential flakes.  For making such loans and trading theses MBSs and CDOs, they wanted their bonuses to be taxed at, say, capital gains rates.

This argument was the unadulterated bovine scat that opened the door to rewards which were totally unsymmetrical.  Capital gains or any below-standard-income-rate is supposed to be a reward for successfully managing risk.  Only these bozos didn’t have any personal risk, they got preferential tax treatment on their above-salary compensation and golden parachutes when the company made huge profits during the bubble.  And zero, zip downside in their base salaries if their bets would blow up.  What’s not to like?

But the bottom line is that for years (decades?) no one in Congress or the regulatory agencies listened to the steadily growing alarms that were issued by people who saw the train wreck coming (see the Cato refs above).  The biggest clue to impending catastrophe was when the housing price curve took off and no longer followed the general inflation curve.

Widely known and well respected finance maven Bill Mauldin includes an ‘Out of the Box’ series of commentaries with his publications.  This week’s contribution – ‘Haste Makes Waste’ – is by Michael Lewitt of Hegemony Capital Management.  I bring it to your attention, it is worth a read.