FDL Contributor Bill Black scorched everyone with his testimony on the failure of Lehman Brothers when he testified before the House Financial Services Committee today. His prepared remarks can be found here (PDF).

CHAIRMAN KANJORSKI: And now we’ll hear from Mr. William K. Black, Associate Professor of Economics and Law, the University of Missouri, Kansas City School of Law. Mr. Black.

BILL BLACK: Members of the Committee, thank you.

You asked earlier for a stern regulator, you have one now in front of you. And we need to be blunt. You haven’t heard much bluntness in hours of testimony.

We stopped a nonprime crisis before it became a crisis in 1991 by supervisory actions.

We did it so effectively that people forgot that it even existed, even though it caused several hundred million dollars of losses — but none to the taxpayer. We did it by preemptive litigation, and by supervision. We broke a raging epidemic of accounting control fraud without new legislation in the period of 1984 through 1986.

Legislation would’ve been helpful, we sought legislation, but we didn’t get it. And we were able to stop that because we didn’t simply consider business as usual.

Lehman’s failure is a story in large part of fraud. And it is fraud that begins at the absolute latest in 2001, and that is with their subprime and liars’ loan operations.

Lehman was the leading purveyor of liars’ loans in the world. For most of this decade, studies of liars’ loans show incidence of fraud of 90%. Lehmans sold this to the world, with reps and warranties that there were no such frauds. If you want to know why we have a global crisis, in large part it is before you. But it hasn’t been discussed today, amazingly.

Financial institution leaders are not engaged in risk when they engage in liars’ loans — liars’ loans will cause a failure. They lose money. The only way to make money is to deceive others by selling bad paper, and that will eventually lead to liability and failure as well.

When people cheat you cannot as a regulator continue business as usual. They go into a different category and you must act completely differently as a regulator. What we’ve gotten instead are sad excuses.

The SEC: we’re told they’re only 24 people in their comprehensive program. Who decided how many people there would be in their comprehensive program? Who decided the staffing? The SEC did. To say that we only had 24 people is not to create an excuse — it’s to give an admission of criminal negligence. Except it’s not criminal, because you’re a federal employee.

In the context of the FDIC, Secretary Geithner testified today that this pushed the financial system to the brink of collapse But Chariman Bernanke testified we sent two people to be on site at Lehman. We sent fifty credit people to the largest savings and loan in America. It had 30 billion in assets. We had a whole lot less staff than the Fed does.

We forced out the CEO. We replaced the CEO. We did that not through regulation but because of our leverage as creditors. Now I ask you, who had more leverage as creditors in 2008? The Fed, as compared to the Federal Home Loan Bank of San Francisco, 19 years earlier? Incomprehensible greater leverage in the Fed, and it simply was not used.

Let’s start with the repos. We have known since the Enron in 2001 that this is a common scam, in which every major bank that was approached by Enron agreed to help them deceive creditors and investors by doing these kind of transactions.

And so what happened? There was a proposal in 2004 to stop it. And the regulatory heads — there was an interagency effort — killed it. They came out with something pathetic in 2006, and stalled its implication until 2007, but it ’s meaningless.

We have known for decades that these are frauds. We have known for a decade how to stop them. All of the major regulatory agencies were complicit in that statement, in destroying it. We have a self-fulfilling policy of regulatory failure
because of the leadership in this era.

We have the Fed, the Federal Reserve Bank of New York, finding that this is three card monty. Well what would you do, as a regulator, if you knew that one of the largest enterprises in the world, when the nation is on the brink of economic collapse, is engaged in fraud, three card monty? Would you continue business as usual?

That’s what was done. Oh they met a lot — they say “we only had a nuclear stick.” Sounds like a pretty good stick to use, if you’re on the brink of collapse of the system. But that’s not what the Fed has to do. The Fed is a central bank. Central banks for centuries have gotten rid of the heads of financial institutions. The Bank of England does it with a luncheon. The board of directors are invited. They don’t say “no.” They are sat down.

The head of the Bank of England says “we have lost confidence in the head of your enterprise. We believe Mr. Jones would be an effective replacement. And by 4 o’clock that day, Mr. Jones is running the place. And he has a mandate to clean up all the problems.

Instead, every day that Lehman remained under its leadership, the exposure of the American people to loss grew by hundreds of millions of dollars on average. Auroroa was pumping out up to 300 billion dollars a month in liars’ loans. Losses on those are running roughly 50% to 85 cents on the dollar. It is critical not to do business as usual, to change.

We’ve also heard from Secretary Geithner and Chairman Bernanke — we couldn’t deal with these lenders because we had no authority over them. The Fed had unique authority since 1994 under HOEPA to regulate all mortgage lenders. It finally used it in 2008.

They could’ve stopped Aurora. They could’ve stopped the subprime unit of Lehman that was really a liar’s loan place as well as time went by.

The survey found that only 46% of workers have tried to calculate what they need for a comfortable standard of living in their golden years. NewRetirement.com, is here to help!!!  You can use our nifty retirement planning calculator to see what you will need to save for retirement, or use our Reverse Mortgage Calculator to see how much money you can receive from a Reverse Mortgage.

Also, there is a new Reverse Mortgage guide on the website that can shed some very interesting light on this product.

In other news, a new Charles Schwab report states that nearly half (44%) of retirees claim to be supporting at least another individual financially.  While this exhibits the generosity of retirees it is also evidence that retirees are not practicing proper retirement planning.  Everyone, of course wants to help their family in whatever way they can, but it is paramount to worry about your own finances instead of your family’s.  Helping them in the short term is fine, but imagine once you are gone then how are they going to figure out their finances in the future.  Setting the right example through debt consolidation and reducing expenses, is the most prudent decision to ensure your family’s financial future. 

And finally, to add to the launching of the socialsecurity.gov site to which I mentioned in the post “Apply For Social Security Benefits Online.” It appears that Patty Duke has brought back her role as Cathy Lane from the 1960’s sitcom The Patty Duke Show to get baby boomers online to apply for Social Security benefits. While the characters she plays in the Public Service Announcements are signing up for social security, Patty, aged 62, says she will be waiting a few more years to start receiving benefits.  This is especially a good call if you are healthy and believe you will live a long life.  In fact there is s great article from the Center for retirement Research at Boston college entitled, “How Much Do Households Really Lose By Claiming Social Security at Age 62?”  Don’t fret if you have started collecting Social Security at 62 and have since changer your mind because you have the ability to restart your Social Security benefits. Here is a nifty little Social Security calculator that will help you decide when the best time to start receiving benefits.  Oh and if you would like to see the ads please visit socialsecurity.gov/pattyduke

Motivated by political pressures and the need to show a sharp increase in securities markets, the government will be inserting trillions of dollars of borrowed money into the economy. Never mind that this will increase the national debt by 20% or so in less than one year or that commitments will be made for increased entitlements which are already far beyond our ability to pay. The combination of national debt and unfunded obligations for Social Security and Medicare now total to almost $200,000 for every man, woman and child in the country. As if that’s not bad enough, that doesn’t count any personal, mortgage, or commercial debt–all of which we must also pay.

The fact is that, as a nation, we have been living far above our incomes and the need to stash some money away for retirement. Even our children and grandchildren will be unable to pay just the ongoing costs of these obligations unless everyone is subject to staggering tax rates. The tax problem will be exacerbated by the demographics leading to the inevitable increase in the aged relative to the working population.

The problem started to be evident in 1985 when the national savings rate started its precipitous drive from the historical 9% to virtually zero in 2005 and has stayed that way ever since. In order to recover those lost savings and get back to what 9% would have provided over the past twenty years, people would have to save over 20% of their income over the next twenty years. The only time our country has saved that much was in World War II when there wasn’t much to buy, even food was rationed, and Rosie the riveter worked in a defense plant. Everyone invested in Savings Bonds, even school children.

The fact is that people should be saving more than 9% today. The reason is that a lower percentage of people are getting pensions. Further, over 40% of pensions are for government employees. The majority of the people don’t work for the government, don’t have a pension, and have fewer health benefits than government employees. Now we’re promising the equivalent of Congress’ health insurance to over 40 million uninsured people even though they now get free medical care, and those of us who pay for our health insurance don’t have benefits as good as Congress.

After the decline in savings became apparent, the financial firms discounted the importance of the national savings rate. One argument was that savings rate wasn’t important because the next generation was going to inherit so much. When people found they wouldn’t get any of Bill Gates or Warren Buffet’s money, financial firms said the value of stocks had increased so much that people didn’t have to save anymore. After the stock boom ended financial firms said that the best investment people had was their house which would provide much of their retirement needs. Right now, the government and industry say what’s important is to preserve jobs and keep spending up so that businesses can thrive. Forget savings.

Come on! At some point we have to take our medicine for such imprudent spending. As individuals we should be living within our income. So should our government. Hasn’t anyone heard about cutting expenses? I’ve gone through a number of Boeing financial crises. You learn that there are many things you really don’t need. Congress recently, and correctly, criticized the auto and union representatives for coming to their hearings in private jets. Yet Congress itself is bloated with all kinds of perks and overmanned with aides. There comes a time when Congress and the Administration must lead by example, then slash the spending of every government department severely. Just like Social Security and Medicare are entitlements, the lavish cost-of-living-adjusted government pensions are entitlements and will last as long as government employees live.

If we want change, let the change come from more prudent spending individually and by the government. Are we ever going to get away from politics where those running for office say they are going to give more benefits if elected? I’d like to see politicians give an honest and verifiable cash statement that would not only end deficits but reduce the horrible obligations that we’ve already left to our children and grandchildren. How about a twenty year plan to pay off the national debt and a fully funded trust for Social Security and Medicare?

The “Jolt” is more of the same shortsighted view that we’ve had for a long time. It may get us to spend more for a short while, but the reckoning will come. My thought is that the reckoning will be led by the baby boomers who have to learn relatively soon that they can’t retire without savings. As that reckoning comes, industry and the government will have to be smaller, but we’ll still be stung with a huge income tax burden because there will be fewer workers, even more people begging for handouts and the need to fund overly generous entitlement programs.

Bud Hebeler

11/25/08

Read more on www.analyzenow.com

So what will really happen?

First, the government will have to stabilize the credit markets. This could easily take several years because foreclosures will be spread out in time. Even though home prices may be less than mortgage values, people do not decide to abandon a home on quick notice. They have to carefully consider their alternatives including whether the housing market will recover and the desirability to move to a different location. This is extra tough when people can’t qualify for new mortgage because their credit rating was destroyed by abandoning a mortgage.

It can’t be long before credit card defaults hit the banks really hard thereby aggravating the situation. The top six credit card companies hold $639 billion credit card debt. Then there are $365 billion securities backed by that debt. These are bundled into groups of credit-card receivables and sold to investors, insurers and hedge funds which likely find their way into other derivatives. It’s the mortgage problem all over again because about 30% of credit card debts are from low-credit-score people. Business Week (10/20/08) predicts that this is the next big blowup ahead.

In the meantime, people should develop a better appreciation for the fact that they should be saving. The decline of savings started two decades ago from 9% national savings rate to minus numbers today. Failure to increase savings rates is surprising because of the large number of baby boomers who are starting to reach retirement age and the long-term trend of industry to go from pension plans to savings plans.

As a consequence of saving too little, incurring large debts and losing conventional pensions, people will have to save more—lots more and start quickly.

When the savings rate finally increases to the extent necessary, much of the resulting investment would help the stock market. It would also bring back some of the national debt from overseas, thereby strengthening the dollar and reducing the cost of imports. But this will take years, not days or months and will be softened by slower business growth.

By necessity, many are going to have to retire much later. This is good news if they still have updated skills and the physical capability, but they will face a difficult labor market. On the one hand, demographics show there will be proportionately fewer young people entering the work force. That would bode well for seniors trying to retain jobs. On the other hand businesses will be facing many difficulties. This is likely to be overwhelming for a number of years.

Businesses will have lower volume when consumerism declines—as it must with increased savings! At the same time, employers will also face higher taxes, at least at the state and local level if not at the federal level. Heavy industries will face costly capital improvements for environmental and energy reasons. All of these things put pressure on labor as well as encourage businesses to look abroad for less expensive sources of materials and components–if not total assembly. Lower market volumes mean less need for commercial real estate, so there will be trimming there as well.

Another new impediment is put on businesses that offer pensions when the stock market falls and shows definite signs of slower growth. As an example, suppose that a pension trust’s securities fall 10%. Then the company has to either come up with 10% more funds (think of a huge number) to add to the trust. If the forecasted growth rate for their securities in the trust drops only 1% point, they will need about 15% additional assets in the trust. Firms like General Motors and Ford are already reeling from pension promises that are beyond their capability to fund. This is also likely true for government pension promises—only more so because most government pensions have cost-of-living-adjustments which require higher reserves than fixed pensions of private enterprise.

Another consideration is that the cost of government itself will go up. More regulation and health insurance administration will add significant government employment. Many government employees enjoy automatic cost-of-living adjustments to their paychecks. And government employees on the average make more than the average employee in the private sector. If the business share of higher government costs goes up, the product costs go up thereby aggravating inflation.

Some people think that higher corporate taxes reduce will reduce personal taxes. Not so, higher corporate taxes are simply passed on as higher product costs so that everyone pays—just as with a national sales tax.

The net result of reduced consumerism, increased savings and higher taxes will take some time to evolve before business earnings stabilize at a lower level. When that happens, stock price-to-earnings ratios likely will seek lower values than the historical norms for decades. That’s because of at least two factors: (1) People have got to make up a large part of the savings shortages of the last two decades or face poverty in retirement, and that will take many years of cumulative effort. (2) The outlook for growth will be tempered by the consequences of an aging population that has a much different budget distribution than that of the youth. Consumerism is a disease of youth. Lower price-to-earnings ratios combined with lower earnings do not bode well for the stock market for a very long time.

An aging population brings lower national income, more government outlays for entitlements, and a disproportionate increase in the need for services, particularly medical related services. The service industry does not have as great a multiplication factor for support jobs as does manufacturing. Further, it means a significant increase in the number of retired people to the number of workers. In a couple of decades the number of retirees will be one retiree for every two workers compared to one retiree for every three workers today. By itself, that means a 50% increase in individual workers’ burdens and even more with more people on government welfare.

The part of the economy that will continue growing is the government, but it is the least productive part of the service industry. It has virtually no productivity gain. Politicians are reluctant to propose cuts in government payrolls, in part because they are part of it, but also because government workers probably constitute at least 20% of the voting public. Benefits for government workers grow disproportionately as well. Government pensions most often have cost-of-living adjustments, i.e., COLAs, and savings plans too. 80% of private sector employees do not have pensions at all, and virtually none have COLA pensions. The number of government employees with pensions is fast approaching the number of people in the private sector that have pensions. That’s because of the double whammy of the private sector reducing the number of pensions while the government’s size is increasing.

The changes from these effects do not occur in days or months. They take years to evolve. To recoup the lost savings of the past twenty years in the next twenty years would require more than a 20% reduction in consumption. This implies savings rates comparable to that only achieved in World War II when most things you could buy were rationed and little else was available. Further, virtually everyone worked and provided income for the family during the war. Saving was politically correct and even school children saved stamps to accumulate savings bonds.

No, don’t look for any rapid improvement in the stock market. There may be spurts as occasional good news is highlighted to improve the economy, but the long-term effects described above will dominate the economy for several decades. There is no quick fix for our past savings deficiencies, record borrowings, unstoppable government growth, automatic entitlement growth and inevitable demographic creep to an aging population with greater demand for services, not hard products.

At the same time, even though stock prices will seek a lower level and grow more slowly in real terms, stocks may still be one of the better hedges against inflation. Inflation will increase the apparent earnings and business assets. Since we are living in a world of ever increasing prices, everything is relative. Inflation is very hard on fixed-income investments because the real value of the principal goes down. Owning a house with a mortgage may be one of the best investments since the value of equity increases disproportionately as the price escalates with inflation and the relative value of the debt goes down. Of course this assumes that we are willing to sell our houses later on, go into smaller homes and invest the savings in something that’s liquid so we can spend it.

As bleak as the picture is as painted above, it can get worse. One of the ways to solve part of the debt problem is for the government to let inflation increase above what we consider to be acceptable levels today. That has happened to numerous other countries and our own as well. Inflation is particularly hard on retirees who are trying to live on fixed incomes. It’s not so bad for government retirees that get a kick upward every year.

It was very poor public policy to pressure lenders to make loans to people who could not afford them. The resulting boom in housing prices made it seem that a home was a great investment and worth some speculation—even by those who could not afford the payments, much less all of the other costs of home ownership. People started to consider their home as their primary retirement resource even though a house is about as illiquid as an investment can be and has negative interest. Further this policy exacerbated the lack of mobility of our work force and made people look furtively for new jobs only close to their homes.

But some good came from the resulting crash. My view is that this mortgage crisis has kick-started us on a better path in the long run. It’s better in that less consumption eventually will help provide more for the aging population and less of a burden on our children than continuing this economic madness for many more years. We’re all going to be poorer, but less poor than we would be otherwise. We may still live more comfortably than most other nations. Hopefully the troubles we suffer in the meantime will bring more economically savvy politicians into office. Perhaps they will reduce government growth and entitlements that otherwise will be an unbearable tax burden on future generations.