The AMT and the Lessons of Taxation and Class Warfare

In 1969, in order to make sure that about 100 fat cats paid their fair share Congress created the Alternative Minimum Tax...

In August 1969 as he was preparing the next year's budget Barr warned that the country faced a taxpayers' revolt. He explained, according to the Washington Post, that in 1967 there were a total of 155 individuals with incomes over $200,000 who did not pay any federal income taxes; twenty of them were millionaires. These individuals successfully used all tax loopholes available to legally evade paying taxes. The revelation attracted wide media attention and led to public shock. As he presented the next annual budget, published in the final weeks of his administration, President Johnson indicated that the problem needed to be addressed...

Unfortunately what started as a tax against fat cats has now begun to affect a large majority of Americans.

For more than three decades, the individual income tax has consisted of two parallel tax systems: the regular tax and an alternative tax that was originally intended to impose taxes on high-income individuals who have no liability under the regular income tax. The stated purpose of the alternative minimum tax (AMT) is to keep taxpayers with high incomes from paying little or no income tax by taking advantage of various preferences in the tax code. The AMT does so by
requiring people to recalculate their taxes under alternative rules that include certain forms of income exempt from regular tax and that do not allow specific exemptions, deductions, and other preferences. For most of its existence, the AMT has affected few taxpayers, less than 1 percent in any year before 2000, but its impact is expected to grow rapidly in coming years and affect about one-fifth of all taxpayers in 2010. In her 2003 report to the Congress, the Internal Revenue Service's National Taxpayer Advocate, Nina Olson, labeled the AMT "the most serious problem faced by taxpayers."(1)

The evolution of the AMT from going after 155 fat cats to one that will hit ten million people if it isn't dealt with is a great example how taxes often morph into something totally from its initial purpose and should be a lesson to all politicians about the dangers of using taxes as a means of fighting class warfare.

Unfortunately, many politicians continue to use taxes as a means of fighting class warfare in hopes of finding themselves on the same side of the table with the majority of Americans against the wealthy. For instance, here is how Hillary Clinton feels about the estate or death tax.

“I am more focused on preventing the repeal of the estate tax and returning to what I think are fairer, more effective tax rates for the wealthiest. There may be an argument to be made, which I would be open to but I think you need to look at the entire tax picture. There isn’t any credible argument that the taxes under the Bush administration have gone down disproportionately on high-income investors and earners.”

So what is the so called death tax and why should everyone be concerned when a politician uses it as a means of class warfare?

The estate tax is technically a tax on the transfer of property to others, generally to children of a decedent. It was envisioned to prevent families from passing on huge fortunes and developing a type of royalty in America.

Once again, we have a tax created to make sure that we punish the fat cats. This time they are actually taxed in death. Unfortunately, while the tax death does punish the fat cats it also punishes another class: the savers. Here is a chart of the bottom line levels of an estate's value before it is taxed. For instance, in 2002, any estate worth one million dollars and more would have been taxed. Keep in mind that an estate is everything you own including your home. It is also any retirement that you may have saved up. Let's suppose you saved $100 per month for 40 years and earned an average of 12% on that money. That savings would grow to just over one million dollars after forty years. Someone saving 100 dollars a month is no fat cat and yet they would likely be affected by the estate tax.


Let's look at another tax used by many politicians as a tool in class warfare: the capital gains tax.

A capital gains tax (abbreviated: CGT) is a tax charged on capital gains, the profit realized on the sale of an asset that was purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property. Not all countries implement a capital gains tax and most have different rates of taxation for individuals and corporations.

Here is what Barack Obama would like to do to the capital gains tax.

As part of his "Tax Fairness for the Middle Class" plan, Barack Obama is in favor of nearly doubling the capital-gains tax rate from 15 percent to 28 percent. Leaving the fairness issue aside for a moment—as well as the impact of higher taxes on economic growth—the Obama plan could also be called a "Ways in Which Government Can Collect More Taxes to Pay for New Spending" plan, since Democratic candidates are all scrambling to figure out ways to plausibly pay for
new healthcare, education, and infrastructure spending if elected.

Keep in mind that the capital gains tax taxes an gain in any long term investment including stocks and real estate. So, what percentage of American households currently own stocks?

Dramatically more Americans own financial assets now than in the recent past. As recently as 1980, only 4.6 million U.S. households owned mutual funds; by 2003 the number was 53.3 million.

More than half of American families currently own stocks, bonds or real estate. Nearly half of all U.S. households own stocks or stock mutual funds.

So, when Barack Obama promises to raise the capital gains tax to make the tax system more fair he is actually promising to raise taxes on more than half of American households and growing.

Another way in which politicians use taxes as class warfare is through the nebulous word: loophole. Whether its John Edwards, Barack Obama, or
Hillary Clinton, the word loophole is used as another tool in fighting class warfare.

Every day, millions of working Americans go to their jobs, play by therules and hope to make a decent living for themselves and their families. These workers strengthen our middle class and keep oureconomy going. In turn, the vast majority of American employers holdup their end of the bargain by treating their employees fairly.

But sadly, many working men and women are not being treated fairly because some businesses are using a little-known tax loophole to avoidpaying their fair share. It's workers and American taxpayers who paythe price.

...

New York Sen. Hillary Clinton, the front-running Democratic presidential candidate, on Friday urged closing a tax loophole that she said unfairly benefits a few top Wall Street financiers.

Clinton called the loophole a "glaring inequity" and joined other lawmakers in a push to raise the tax rate on "carried interest" gains made by senior partners in the booming private equity and hedge fund businesses.

...

Sen. John Edwards, D-N.C., told crowds Thursday in Des Moines, Iowa, that he would pay for new programs to benefit the middle class by closing loopholes and tax breaks now benefiting the wealthiest Americans.

Remember, the Alternative Minimum Tax itself was created to supposedly close a tax loophole that was also supposed to affect only the wealthiest Americans.

A tax increase speaks for itself. The problem is that many a politician have used tax increases as some sort of tool to appeal to emotions. We have a country of nearly half a billion people and at any given time there are millions who are less successful than they would like to be. Those millions can almost always be quantified by someone and put into percentages. The unsuccessful almost always have a resentment toward those at the top. Politicians see opportunities in appealing to such emotions. By increasing taxes that they see as primarily applying to the successful, they seek to score points with the masses who are largely less successful. Unfortunately, the reality of tax policy is almost never in line with the perception that is created by politicians.

Whether it is the AMT, the capital gains tax, the estate tax, or the nebulous tax loopholes, these, like most taxes, almost always end working the same: by affecting the majority of people.

The Prophetic Words of Dick Morris

I remember right after the November election that Dick Morris pointed out how difficult it was going to be for the Democratic Congress to govern. The problem, as he saw it, was the many competing factions that make up the Democratic party: The Blue Dogs, The Congressional Black Caucus, The Congressional Hispanic Caucus, and the group allied with Soros and the Nutroots. While all of these groups fall under the Democratic umbrella, they all have competing and varying agendas. As Morris predicted, the Democrats' problem all along has been getting all of them on the same page. This is the underlying story in their continued fumbling of the Iraq issue. The agenda of the Blue Dogs (called Bush Dogs by the Nutroots) is divergent from that of the Soros wing. Without everyone on the same page, the Democratic majority no longer functions like any sort of a majority.

Some if it has come to a head this week as Democrats are pointing fingers at each other for their lack of any coherent agenda.

House Ways and Means Committee Chairman Charles B. Rangel (D-N.Y.) accuses Senate Democratic leaders of developing "Stockholm syndrome," showing sympathy to their Republican captors by caving in on legislation to provide middle-class tax cuts paid for with tax increases on the super-rich, tying war funding to troop withdrawal timelines, and mandating renewable energy quotas. If Republicans want to filibuster a bill, Rangel said, Reid should keep the bill on the Senate floor and force the Republicans to talk it to death.

Reid, in turn, has taken to the Senate floor to criticize what he called the speaker's "iron hand" style of governance.

Democrats in each chamber are now blaming their colleagues in the other for the mess in which they find themselves. The predicament caused the majority party yesterday surrender to President Bush on domestic spending levels, drop a cherished renewable-energy mandate and move toward leaving a raft of high-profile
legislation, from addressing the mortgage crisis to providing middle-class tax relief, undone or incomplete.

The real problem from the beginning is that much of the Democratic victory came in Republican districts and with many of the Democrats in those districts moving to the right of their counter parts. Their leadership, on the other hand, is almost exclusively made up of traditional Northeast or West Coast liberals. From Nancy Pelosi, Charlie Rangel, to Ted Kennedy, those are the leaders of the party. Their liberal traditional agenda is not something that will get the likes of the Blue Dog Democrats re elected.

On Iraq, this problem is most pronounced. There is a group of almost seventy Congressional Democrats that make up the Out of Iraq Caucus. They are almost exclusively Soros types. Therir goal is the immediate withdrawal of troops out of Iraq as soon as possible. This group willing to cut off funds if necessary, and they are so extreme in their views vis a vis Iraq that many times they are unwilling to support bills with a timeline if it isn't quick enough in their estimation.

On the opposite end of the ideological spectrum for the Democrats lie the Blue Dogs. This is a group of forty plus moderates who's position tends to match that of the Republicans. Here is how their position is described.

With Democrats in charge again, the Blue Dogs have played a key role in halting an emerging plan to place strict conditions on war funding. Their revolt helped beat back that proposal, by Pelosi ally John Murtha, D-Pa. Leaders are now considering a watered-down version.

Without unity from all these groups the Democrat's majority becomes a minority.

The Democrats face the same sort of problems on budget and tax issues. Whether it was Charlie Rangel's so called mother of all tax hikes, or any number of budget proposals from David Obey, the leadership has had difficulty getting the Blue Dogs on board with much of their liberal agenda. Where they have been able to get the Blue Dogs on board, they have then faced the threat of a veto from the President.

The Democrats have given nothing more than a token effort to any social issue besides federal funding of stem cell research. That's because on social issues the leadership's position is no more tennable.

Their ideas about marriage, abortion, and, to an extent, the death penalty, and
Gun Control are sometimes more compatible with the Republican way of thinking. This viewpoint is supported by the Pew Research Center and their study "Beyond Red Vs. Blue"

The Republicans, on the other hand, have become nearly unanimously united. They have almost entirely coalesced behind the surge strategy and have never wavered in their demand for so called clean spending bills.

On the budget, they haven't been quite as united however the President suddenly realized what a tool the veto is. As such, the Democrats haven't been able to get much of any budgetary agenda through. In the most recent battle over the budget, the Democrats have become so frustrated that they are now resorting to threats.

Instead, Obey said, he would rip up the compromise bill and devise a new one using the strict spending ceiling set by Mr. Bush - but would reach it by whacking GOP priorities and stripping the measure of billions of dollars in pet projects for lawmakers in both parties.

Obey's remarks to The Associated Press came two days after White House budget director Jim Nussle promised Mr. Bush would veto Democrats' omnibus spending bill for exceeding Mr. Bush's budget by $18 billion.

Nussle had accused Democrats of "trying to leverage troop-funding for more pork-barrel spending," but Obey said the opposite is true - that the White House was willing to relent just slightly on domestic spending in order to obtain up to $70 billion for the wars in Iraq and Afghanistan.

While the Democrats threaten, I am reminded of the last time a President took on Congress on the budget.

These showdowns were epitomized by the budget conflict with then-Speaker of the House Newt Gingrich in 1995. Gingrich refused to pass Clinton's budget proposal, and the latter threatened to shut down the government as Reagan had done in the 1980s. Clinton did not back down, however, and eventually had his budget passed...

I suspect another President will also win this particular budget showdown. All in all, those words uttered by Dick Morris are quite prophetic.

Alan Greenspan Tries to Rewrite History

One of my least favorite things about the mortgage business is how everytime something goes wrong each party blames another party. Almost never does someone take responsibility and fix the error. Instead, they try to blame someone else and act as though fixing the error is someone else's responsibility.

I bring this up because Alan Greenspan wrote a column in today's Wall Street Journal. Greenspan laid out a very interesting and detailed version of the events that lead up to the crisis...

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.

A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.

The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.

Now, this might be the height of my own hubris, however I find his entire narrative to be nothing more than intelligent sounding nonsense. The reason is that he is trying desperately to avoid his own responsibility in the mess. I pointed out his responsibility in this piece. While Greenspan would like us to take the roots back twenty years, I think we can find something more important much closer to the present.

This is a chart of the Federal Funds Rate which as Head of the Federal Reserve Greenspan controlled until recently. As you can see between the middle of 2001 and the middle of 2003, the rate was absurdly low. It reached below one percent for a period of time. Greenspan can try and re write history however by lowering the rate that much he created loose and easy money. While he may not have predicted the mortgage mess per se, he should have anticipated the law of unintended consequences. He should have known that it was irresponsible to leave rates that low for that long. He should have known that if banks could borrow from the Fed (which is the purpose of the Federal Funds) for so little, that they were bound to act irresponsibly with the money.

He can pin this on some sort of a complicated alter universe in which a sophisticated network of globalization combined with asleep at the wheel credit agencies, arbitrage players, and poor savings. He can do this, but it still isn't going to tell the whole story. To add insult to injury, Greenspan actually tries to justify his irresponsibility while paying nothing more than passing lip service to what it actually caused.

and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

The entire piece is full of technical language and it is told in a manner only fit for an expert. I don't know if Greenspan hoped to impress anyone or if he merely actually believes the load of bull that he is selling. I do know that China, credit ratings, and poor savings rates played a much smaller role in the crisis than the irresponsible and precipitous drop that the Fed took on the Fed Funds Rate.

The root of the crisis as I see it was loans that were created for irresponsible borrowers. These loans were created because banks suddenly had an infusion of loose money that they were able to borrow from the Fed. Because the rate was so outrageously low, banks felt more room to take risks. They did and that started the ball rolling. While Greenspan painstakingly tried to explain the root cause going back to right after the Cold War, he conveniently overlooked his own responsibility in the crisis. Unfortunately for Greenspan, I don't think that history will have such oversight.

...And You Remove All Reason and Logic

The New Yorker has this analysis of the rate freeze that Secretary Paulson has brokered. It focuses on only one of the five points of why I thought this rate freeze is bad and dangerous policy. It does concur on that point, which is that this rate freeze will only marginally help those it intends to anyway.

Although the plan will provide real relief for at least some homeowners, it’s more like a Band-Aid than like the major surgery that some of the hype makes out. That’s because at this point interest-rate resets are just a small part of the mortgage-market problem. Postponing rate resets doesn’t change the fact that too many people spent far too much borrowed money on houses with prices that were far too high, and that they are now stuck in homes that they can’t really afford and can’t sell. Even with the interest-rate freeze, foreclosures will keep rising

I believe the article is largely right, and from experience I believe that most sub prime borrowers just simply overbought. They took on property they couldn't afford. I believe that the rate increase would only perpetuate not create the problem. (Please note there is a great deal of debate on this point within the industry so my view is not a given. Some people do believe that it was in fact the rate increase that started the problem).

That said, there was something else in the article that is even more concerning.

Not for everyone, though. The plan sets up a system of triage, separating borrowers into three categories: those who will be able to keep paying after the rates reset, or else refinance their loans; those who can pay now but won’t be able to when the rates go higher; and those for whom even the current rates are too high. Only the second group will get help. Also, the plan doesn’t go into effect until next year—if your loan resets on December 31st, you’re out of luck.

In other words, what this plan will do is punish responsible borrowers and reward irresponsible borrowers. Think about what this article is saying for a minute. If you happen to be holding onto a subprime loan and you can afford the new higher payment, the rate freeze doesn't apply to you and you are forced to take that higher payment. If, on the other hand, you could afford the lower payment but not the new payment, you will have your lower payment frozen for you. Does this make any sense? How could the government possibly institute a policy that rewards irresponsible borrowers and punish responsible borrowers and think this will have anything but a disastrous effect?

Furthermore, how exactly is one to determine who can and can't afford the payments? They are going to freeze rates that are going to reset in the future. We are talking about millions of loans. What are the parameters? Who will decide? How can this turn into anything but a bureaucratic nightmare? This is a process that will be ripe for fraud, manipulation, and chaos. Again, this is a textbook example of a moral hazard. Government continues to believe that they can create a moral hazard with a positive outcome, however they do it by removing all logic and reason.

This process is going to fraught with litigation. Imagine if you are one of the borrowers that is determined to be able to pay the new loan, what is the likelihood that you will look to sue to drop your rate? What if you were a borrower that was wise enough to take a higher fixed rate? What is the likelihood you will look to have your rate lowered artificially? How can anyone possibly justify rewarding the irresponsible while punishing the responsible? There is no way this would pass legal mustard. The worst part is the absurdity is spelled out in the plan itself.

Update on the Rate Freeze

Several business journals have recently come up with editorials that echo what I have been saying about the rate freeze. Here is a snippet from IBD...

The flaws of the plan are many and fatal.

First, the deal will reward irrational behavior and encourage such behavior by homebuyers in the future. It was not logical for people to take out mortgage obligations they couldn't afford, but it will become logical for them to do so in the future if they can reasonably expect that the government and their lender will later bail them out when the going gets tough.

Second, the deal will thwart the market by keeping home prices artificially high. In recent years, laughably easy credit has let many people "buy" homes who otherwise could not have done so, pushing up prices.

We've had "liar" loans, in which people could just state their annual income without fear that their mortgage lender would call their employer to check. We've had "Nina" loans, for "No Income, No Assets." And we've had "Ninja" loans, for "No Income, No Job or Assets." Consumers, armed with the easy money provided by these silly terms, have pushed home prices to record levels when they're measured against personal income, making falling home prices not only inevitable but healthy.

Here is the view from Forbes...

Decried as a bailout of irresponsible borrowers by some and a financial industry wrist slap by others, the plan is not mandatory for the financial industry, though more than three-quarters of lenders and servicers say they embrace the idea. The biggest, Countrywide Financial, Wells Fargo, Citigroup and JPMorgan Chase, who collectively service $4.3 trillion in mortgage loans, all support the plan.

Still, independent mortgage-servicing firms, some of which are not overseen by federal banking regulators, could opt out, leaving their borrowers still vulnerable to foreclosure.

And investors may not like it. The financial industry lobby worked aggressively to make sure the plan included indemnification for them so investors of bonds backed by these mortgages won't sue them after lenders change the terms of the loans. The more lenders who volunteer to join the program, the less vulnerable they'll all be to lawyers, saying it had become industry practice.

Another issue: The plan only applies to those who are current in their mortgage payments but who are determined to be unable to afford higher reset rates. It won't apply to those who are already faltering, and it won't apply to those who face resets but are deemed able to afford it.

That raises the inevitable moral hazard question. "I'm very skeptical of this," says Bert Ely, a banking regulation consultant in Arlington, Va., who was among the first to say in the 1980s that there would be a taxpayer bailout of the federal deposit insurance fund in the midst of the real estate lending crisis of that decade. "It's government-sponsored collusion."

Finally, here is the word from the Wall Street Journal

The next time we suggest that the government give advice to the private sector, tie us down until the fever passes. A couple months ago, we endorsed the idea of mortgage service companies voluntarily negotiating with subprime borrowers and investors to avoid a wave of defaults next year.

Now come the politicians to wrap their arms around the idea, and maybe give the U.S. a reputation for forcibly rewriting financial contracts. Don't cry for us, Argentina?
Both Treasury Secretary Hank Paulson and the White House are touting a plan to freeze interest payments on up to two million troubled mortgages.

This one from the New York Post falls into the category of why don't you tell me how you really feel...

Yet this plan, bad as it is, has little chance of helping most of the people who face the possibility of foreclosure - after all, 1.5 million Americans will see their mortgage rates "reset" to higher rates next year.

So Treasury Secretary Hank Paulson will propose to Congress to let cities and states issue tax-exempt debt to bail out even more borrowers.

Cities and states would borrow billions and lend the money to "homeowners" (in fact, these borrowers don't actually "own" their homes; they only own the mortgage). The "homeowners," in turn, would use the money to pay off the mortgages they can't afford - and take out new, more affordable mortgages with their city or state government. (Not all tax-exempt debt is guaranteed by the city or state that issues it, but this debt would have to be - no private investor will touch this risk right now for an interest rate that would be "affordable" to these borrowers.)

The whole idea is disastrous - and not simply because it is massive government interference in the private markets. The problems are almost too painful to describe:

Finally, in response to to my previous work on this, I received this ANONYMOUS comment...

As a threshold matter, I treat any comment that begins by citing a politician with a healthy dose of skepticism. I'm not knocking politicians for doing their jobs. I'm just stating the obvious--their views are extremely skewed.As for freezing Rates, while I respect the poster's opinion, it is built on a false premise. One artificially jaded by his admitted "insider" position. In plain English, the arguments seems to be as follows: Capitalism depends on freedom to contract. When this freedom is interrupted, the system breaks down and everyone suffers the consequences for a few bad decisions. In the poster's view, the present mortgage crisis was largely created by a few economically and intellectually inferior individuals taking on financial burdens they should have known they could not carry. Now, according to this view, the government is interfering with an important moral and intellectual lesson that the gullible, but benevolent lenders are poised to teach. Moreover, because of this, the banks will be forced to retaliate by raising everyone's rates.As previously stated,
this position is replete with foundational flaws. First, lenders may be gullible, but they are far from innocent. Brokers, Banks, and title companies have, for several years (at least), colluded to mislead so-called sub-prime consumers who approach them from a bargaining disadvantage due to their, again, so-called spotty credit profiles.

Tellingly, the prime/sub-prime distinction is a banking industy invention intended to allow banks to charge usurious interest rates. And, hidden finance charges, fees and penalties have increased the number of technical defaults (via hidden universal default provisions) and (along with other predatory practices) have resulted in an increasingly small prime consumer population. But, as of late, the mortgage industy has taken deception to a new low. Which brings me to my next point. Other than credit histories (many of which--despite the Fair Credit Reporting Act and consumers' diligent efforts to update the information--contain vague and/or incomplete negative references many years old), the vast majority of sub-prime homeowners are just as financially able as prime consumers. They are doctors, lawyers, accountants, CEOs, etc. The average sub-prime homeowner pays his mortgage, his HOA, and his taxes on time, despite paying, in many cases, twice as much as his counter-part for the same home.

Contrary to the most prevalent explanation, it is not their ability to pay for the house they purchased that is at issue. Instead, it is their ability to pay the concealed premium on that house that neither they nor their counter-part can afford.

Take for instance, the Jumbo two-year interest only ARM. If you believe the poster, these people were fully informed about the affect of the LIBOR index (or, at least, knew what it was) on their loans after the 2-year interest only period. They knew that the interest capped out at, say, 12.7% from a teaser of 7.0% and that the rate would reset multiple times (every six months). They were also informed that very few if any finance companies would refinance such a loan. I think not.

This characterization strains credability and common sense. No one would knowingly agree to such terms. The Brokers and the lenders with their secret kick-back deals assured these consumers that, though the loan would reset (giving no mention of multiple resets or the actual dollar value of the payment increase), the consumer would refinance before then. They also routinely fail to explain the variabl interest rate provision of the contract, in part, because they can't understand the LIBOR themselves. If they do understand, they know that the deal would be dead on the table if they told the customer that his payments would go from $3700.00 per month to $5000.00. So, instead, they point to the page and vaguely reference a reset at the end of the 2-year period, skipping any details. If, by chance, they are selling to an attorney, they simply let the person read it. But, unless you work within a lending institution and regularly deal with such provisions, even an attorney will be completely lost (One does not usually have the final documents until he is sitting at the table at the title company). So, most will rely on the broker's interpretation, thinking, "at worst, I will have to refinance at the end of the term." So, the customer is a little gullible too.

Finally, as to the legal implications--and I'm an insider on this issue--this country has not seen the magnitude of litigation against major banking institutions that is currently in in the pipeline since Worldcom.

Now, this is naive and misleading on several levels. First, clearly this poster hasn't read all of my work, but just this piece. Had they read this piece, they would have known that I blamed five entities working in cohesion: the banks, Wall Street, the mortgage broker, the borrower, and the Legislature. Had they read this piece, they would have known that I even laid much blame for starting this crisis on Alan Greenspan.

Now, since the poster naively claims that my claim is flawed because I only blame the borrower, which I don't, I can stop now in the analysis, however I won't. They falsely claim that sub prime and prime don't have any difference in terms of income. While it is true that income is, in and of itself not the factor that determines prime or subprime (debt to income is), it is just a plain lie to claim that sub prime is not much more skewed towards the poor. Through logic and experience I have learned that while sometimes wealthy people have as poor a credit profile as poor people, I have learned that on the whole wealthy people have a much easier time paying their bills and thus have better credit.

They claim that it is the hidden part of the contract that sub prime borrowers can't pay. Again, in my six years, I know that overwhelmingly people buy homes at a higher price than they intended. That is my back up for my supposition, the poster gives no evidence for their hypothesis. They also claim that the paperwork is too difficult and thus the borrower is then not held responsible for the signature they gave to it. First, I pointed out that Congress has created an atmosphere in which it is easier to rip someone off. Second, that is pure hogwash. If you can't understand what you are signing, don't sign it. I had a twenty three year old that spent nearly six hours at the closing because he literally read and understood every word in every document before he signed. Good for him because he wasn't "gullible". To claim that the language was to complex and thus people agreed to things they wouldn't have is not only fellacious but irrelevant. They agreed to them and their signature is proof.

Then, he claims that sub prime is nothing more than a means for banks to charge outrageously high rates. While the rates are much higher, this poster would be surprised to learn that banks use a sophisticated manner in which to reach those rates. For the most part, borrowers get what they deserve. While sub prime is higher, it also excuses such things as bankruptcy, foreclosure, multiple mortgage lates, low credit scores, and sparse credit history. No one is forced to take on any rate, however if someone gets a sub prime loan it is almost always because that is exactly what they deserve.

Finally, they claim that my concern of the litigation nightmare in unwarranted because it won't rival Worldcom. That absurd statement speaks for itself and needs no counter.

Why Freezing Rates is Bad and Danerous Policy

According to Fox News, the President has reached an agreement to freeze rates on Adjustable Rate Mortgages for five years.

Congressional aides say the Bush administration has hammered out an
agreement with industry to freeze interest rates for certain subprime mortgages
for five years in an effort to combat a soaring tide of foreclosures.

These aides, who spoke on condition of anonymity because the details have not yet been released, said the five-year moratorium represented a compromise between desires by banking regulators for a longer time frame of as much as seven years and industry arguments that the freeze should only last one to two years.

Another person familiar with the matter said the rate-freeze plan would apply to borrowers with loans made at the start of 2005 through July 30 of this year with rates that are scheduled to rise between Jan. 1, 2008, and July 31, 2010.

This is a dangerous and bad policy on several levels.

1)Whenever the government steps in on a private contract and renegotiates it, it leads to all sorts of unintended consequences. In this case, banks use extremely sophisticated modeling techniques to determine the interest rate that borrowers receive. Those models take into account whether or not a rate will eventually begin to move or not. By freezing rates for five years, he has thrown those models totally out of whack. In other words, the risk profile of these loans no longer matches the rate as determined by the models. This not only throws banks out of whack but Wall Street as well that turned those mortgages into bonds.

Whatever liquidity problems are currently in the market, those are nothing like the liquidity problems that will be created when loan terms are changed wholesale. If banks don't receive the rate, and the underlying payment, that they expected, then we will really see some liquidity issues. Remember, one, banks expect to take homes when payments aren't made, and two, they expected certain interest rates and payments from mortgages. Now, they will get neither, and their money is tied up expecting both.

This nightmare is further perpetuated because the definition of sub prime is not clearly defined. For instance, one of the big problem mortgages are option arms. Many of these mortgages are what we refer to as monthly ARM's. That means their rate changes every single month. If Bush includes these into sub prime, he will simply create a nightmare for the banks. Since they are monthly ARM's you can bet that much of the underlying rate was based on a model that had that rate moving every month. If that rate is now frozen for five years, you can bet that banks will take a giant financial hit.

Keep in mind that if you don't care if banks take a hit, you should. If they take a hit, they will pass that hit onto the consumer in terms of higher rates on all future mortgages.

2) Bush has now also created a moral hazard. The folks that he is saving took on a mortgage profile, a rate that adjusts, that they shouldn't have. This was entirely by choice. Now, he is stepping in and stopping an event that is supposed to happen to an Adjustable Rate Mortgage. Instead of learning a difficult and valuable lesson, these folks will now get the message that risky financial moves can be met with government interference to save them before those risky moves turn into consequence.

3)Bush has now created a litigation nightmare. There are all sorts of folks that are currently in fixed rates, five year Arms, and other loans in which their rate either doesn't adjust or hasn't yet adjusted. Those folks are holding onto mortgages with higher rates than the folks who's rates he has artificially frozen. They will all scream bloody murder and demand that their rates be adjusted downward. They will be right. Imagine if you took on a fixed rate which was a higher rate than the equivalent adjustable rate. You did this with a certain financial loss, at least initially, because that rate was higher and with it the payment. Now, you hear that folks that didn't take the same precautions as you are now having their rates frozen for them artificially and will now enjoy lower rates, artificially again, for at least five more years. You would, rightfully so, feel entitled to the exact same rate. You would likely get a lawyer and I firmly believe that Bush has now opened banks up to all sorts of lawsuits.

4)Finally, and this is coming from an insider. This rate freeze isn't going to do anything of substance. The people that Bush thinks he is helping are in over their heads. I know because 99 times out of a 100 my borrowers always bought a property that was more expensive than one they claimed they wanted to buy. The sort of sub prime borrowers that Bush thinks he is helping are irresponsible. They bought 250,000 dollar homes when they could only afford 200,000 homes.

That dynamic is not going to be changed by freezing rates. These folks maybe able to afford to make these payments for a while longer but not forever. They are still in over their heads. Also, what about all of those folks that are in Prime loans that are adjustable rates. Won't they also demand that their rates be frozen? Won't everyone who is on time demand that their rate either be frozen or lowered? By helping the most desperate and the most irresponsible, Bush has now opened up a can of worms that he frankly can neither predict or control.

EPILOGUE:

Now, a mortgage colleague of mine tells me that a radio report says that the only loans that will be affected will be those that are according to him, "on time". On time is rather nebulous. For instance, on time could mean current. It could also mean always on time. If he is only helping those that are always on time, then he is frankly taking all sorts of profit potential away from banks, because those folks most likely would have continued to be on time with or without the freeze. If he is talking about those that are on time now, but have been late, then he is delaying the inevitable. Either way, if it isn't defined clearly, I can assure all that it will be another litigation nightmare.

Big Oil and My New Favorite Latin Phrase

A friend of mine is fond of telling this story about his grandfather. His grandfather nearly became rich in a generational manner. An associate of his approached him with an investment opportunity in a company that made something revolutionary for its time: radios for automobiles. My buddy's grandfather declined and it was too bad because that company is called Motorola.

General Electric was started by famed inventor Thomas Edison to help him sell his new invention the light bulb.

The reason that I bring up each of these companies is that both are still around and thriving today and neither relies in any way on their original products. Motorola sells products that were figments in the imaginations of science fiction writers at the time. GE has turned into a conglomerate that sells just about everything. (They even have delved into mortgages, my business, through their subsidiary, WMC Mortgage)

I bring all of this up because several other companies were also around when these were selling their original products: companies like Amoco, Exxon, and Phillips. Most of the oil companies today were around were created when Standard Oil was broken up. Standard Oil (started by famed entrepeneur John D. Rockefeller pictured below) was broken up under the Sherman Anti Trust Act.

Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal".[2] The Act also provides: "Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations...

In other words, the Sherman Anti Trust Act was created to make sure no one company acted as a monopoly and used their sheer size to stymie competition. (Its last most public use was in the break of AT&T) What about when a group of companies acts no different than one and use their own size to stymie competition? This is a question that I asked when I first started blogging at the famed conservative blogging site, Redstate. If you click the link you will see I was also met with a great deal of resistence by my conservative colleagues.

The question continues to linger in my mind many months later. I have never believed that gasoline acts anything like any market that I know of. For instance, the bedrock of any legitimate market is its insistence that every company in it evolve. The reason that companies like Motorola and GE have not only survived for a century and more is their ability to adapt to their changing market. That is what markets do. Take any company that has been around longer than a few years and you will find one that looks nothing like it did originally. From Microsoft, to Ford, to Walmart, these companies have evolved as the market around them has forced them to. After all, did Henry Ford ever imagine a hybrid, an SUV, or any of the current automobiles when he created Ford?

That never seems to happen to big oil. They continue to sell one product, the same product, in pretty much the exact same type: unleaded. There is frankly not a dime's worth of difference between big oil today and big oil in the aftermath of the Standard Oil break up. I believe this has to do with the make up of the "market": an oligopoly (or as some of you know it a Cartel).

I believe the proof lies in the Latin phrase: Res Ipsa Loquitur (the facts speak for themselves). If big oil is competing in a market, why has their product line stayed stagnant for so long? Why has their market not had to adapt? Let me tell you how I would see oil adapting in a real market. Right now, when you drove to your local ENERGY STATION, you would get a menu of FUELS. This menu could be customized to fit the specific needs of your car. A sports car would get the proper FUEL for that car, and the minivan would get the proper FUEL for that car. In the corner of the FUEL station, there would be an electric stand. There, an electric car could get juiced up.

Does anyone wonder why alternative fuels haven't taken off in automobiles? Think about this. There are right now automobiles that can be powered by alternative fuels. They aren't popular because there is nowhere to fuel them. For instance, if you were to buy an automobile that runs on hydrogen, you would need to go to a government sponsored hydrogen fuel station. There are about one hundredth as many of those as there are regular gas stations.

Why isn't there a hydrogen fuel tank in some of these gasoline stations? After all, given that each of the big oil companies clears at least ten billion dollars in PROFITS every year, they can certainly afford the research and development to put them into at least a few of their stations. They don't. The only sort of alternative fuel tank that they are willing to put in is E85 fuel tanks. That runs on ethanol and ethanol has recently been frowned on as a serious alternative energy source. Hydrogen, on the other hand, is run on water which is quite plentiful.

So, why don't we see hydrogen fuel tanks in gasoline stations the way we sometimes see E85 fuel tanks? I think the answer lies in the same reason that companies can make billions per year peddling the exact same product they were also peddling almost one hundred years ago. They aren't competing in any market. They never have, and they will do everything they can to keep their arrangement the exact same it always has.

Like I said...Res Ipsa Loquitur...The facts speak for themselves. These companies have billions they could spend on R & D. My vision could be a reality in years if not months if they wanted it to be. The fact that it isn't speaks for itself.

Should We Be Worried About Bernanke?

Those are the ominous words of Andrew Busch in his newsletter yesterday afternoon.

I can't recall a time ever when stock prices were at all time highs, GDP was near 4.0%, and the US dollar was making all time lows....and the Federal Reserve cutting interest rates. I think I've underestimated the inexperience of the Bernanke Fed. The FOMC stands on a Jim Cramer induced precipice and risks losing the hard won Greenspan credibility.

He raises some interesting points and frankly I have to agree with him. Ever since Alan Greenspan fixated himself with the internet bubble to disastrous results, I am weary of any Fed Chairman paying too much attention to one industry. It is clear that Bernanke is focused on resolving the credit crisis in the housing market. It appears that he is ignoring the health of the overall economy. The end result of this could be disastrous.

The treasuries have responded to this latest move the same way they responded before. They traded down initially though they have come back this morning. The reason is for this is that traders see all of this rate cutting as inflationary. Here is how the USA Today analyzed his previous rate drop.

Treasury bonds were mostly lower Monday, sending yields higher, as investors focused on the prospect that last week's sharp cut in U.S. interest rates will result in spiraling inflation.

...

The stock market has focused on the positive implication that less expensive money will stimulate growth, while the Treasury market has fretted over inflation. Cheapening the cost of money tends to tempt sellers to lift prices, setting off inflation, which the Treasury market detests.

The reality is that most likely the best move for the Fed Chair to make is no move at all. The economy is humming along nicely. The only thing that rate cuts may do is overheat it. Bernanke is fairly new in his position and this maybe where his inexperience comes into play. Sometimes the most difficult move to make is no move at all.

This brings me back to my original point. Whenever a Fed Chairman focuses on one industry while ignoring the economy as a whole it leads to disastrous results. First, the problems in the housing market are too broad and deep to be solved simply by easing credit. Right now, we have people in homes that they simply cannot afford. Furthermore, the amount they own on their homes is probably more, a lot more, than what it is worth. This phenomenon is not something that can be solved simply by extending more credit. These people are in over their heads and they can't get out. This is not something that extending credit will resolve.

So what does Bernanke do? He lowers rates, and thus eases access to money, at a time when our economy is not only heating but on the verge of over heating. As Busch pointed out, he lowered the Funds rate on the same day that the GDP numbers came out. The latest GDP figures have the economy growing at 3.9%.

The magic number for GDP growth is 3%. Anything more and we worry about inflation and anything less and we worry about recessions. With GDP growing at 3.9%, the last thing the Fed Chairman should be doing is lowering rates. Lowering rates pumps more money into the economy and expands it even further. This puts extra inflationary pressure on an economy that already has several pre cursors to high inflation: strong GDP, strong job growth, strong stock market, and weak dollar. The genius of Greenspan throughout the nineties was managing the entire economy so that it never got too hot or too cold.

This latest move by Bernanke says that he is clearly ignoring the numbers on the overall economy and is fixated on one industry. That, frankly, is not in his job description, and is exactly the sort of hubris that I believe got Greenspan in trouble at the end of the nineties. If Bernanke continues to fixate on the housing market while continuing to ignore the economy as a whole, our economy WILL get overheated, and we WILL be dealing with out of control inflation. All of it will happen totally unnecessarily.