Tuesday, April 20, 2010

Three Forgotten Direct Causes of The US Financial Meltdown

We are hearing a lot about how things fell apart, causes and potential fixes. But I am not hearing anyone talk about the two most significant changes to the law that, I think, led directly to our current ongoing crisis. The third is occasionally mentioned but never acted on. Regardless of how these came to be, they are all easily correctable right now - if Congress were willing to act.

(1) Loss of State Anti-Usury Regulation Authority and Failure of Congress to Restore These Protections

"Usury" is the charging of excessive interest on loans. "Anti-Usury Laws" are those that prohibit predatory lending by setting maximum interest rates, protecting borrowers from the servitude of debt that occurs when loans are compounded by such high rates of interest they can never hope to repay them. Until recently, most states had such laws, maintaining an
equitable balance between borrower and lender that let lenders profit fairly while also assuring citizens the means by which to raise their standard of living over time as they gradually paid off their debts.

In 1978, in Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp (439 U.S. 299),
the Supreme Court decided that interest rates and late fees charged by banks and credit card companies were determined by the laws of the state in which the bank was chartered, and that the state in which the bank offered loans and credit had no power to limit the interest charged.

They said the National Banking Act, passed in 1863 as a wartime measure to move control of money from the states to Lincoln's Federal government, and raise money to fund the Civil War, by creating "national banks" that centralized a national currency, intended that only the state in which a national bank was located could limit the fees it levyed.

Thus, by deciding to incorporate in a state with unlimited interest, lenders were free to impose any rate of interest they could get away with, and any amount of late charges they wanted.

The Court specifically said in their decision that it was up to Congress, rather than the Court, to decide whether to change the old law to reflect modern times and restore equal right of banking regulation to all states. Congress failed to take up the Court's implicit suggestion, even though the states had been freely regulating interest rates without objection for a hundred years, right up until the Court's pronouncement.

In other words, after 1978 the wolf was given full charge of the sheep fold. Credit card marketing, issuance, lending and collection practices became ever more predatory. Congress continually bowed to pressure from Banks and Wall Street and looked the other way while our formerly thrifty society descended into the bondage of debt.

There is a very simple fix. All it takes is a repeal of the portion of the National Banking Act that allowed this catastrophic and unfair situation to occur. No need for thousand page bills and new regulatory bodies, no reason to allow the lobbyists to rig the law. It's easy and understandable, it would restore balance, as each state's people could determine for themselves what is fair to all concerned.

Instead, Congress made a big deal about controlling the credit card companies this past year, proudly passing the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act, with the immediate result that credit card companies spent the next 9 months before the law went into effect raising rates and dreaming up new fees to impose. There's nothing in the bill to prevent the credit card company from charging 30 per cent interest, or from doing any number of despicable things that give them an average revenue of $100 per card per month... on 1.4 billion cards every month.

But Congress, still unwilling to lead us back toward sanity and thrift, refuses to acknowledge, much less fix the root problem.

(2) Short-Sighted Full Tax Exemptions For Short-Term Residential Profits: The Tax Relief Act of 1997

The right of the ordinary person to own a home of our own is a fundamental part of the American Dream that was not possible in the feudal societies of the Old World. Immigrants fled the kings of Europe, the tsars of Russia, the emperors of Asia; they fled the Collectives of communist states, the haciendas of Mexico, the castes of India: to claim their place in a society
where the ordinary man could expect the rule of law to stand with him in protecting his home and his capacity to own it outright.

Thus, throughout our history, our politicians remembered and our laws have rigorously protected access to private property ownership and the residential homestead as a necessary component of liberty.

Before 1997, our tax laws encouraged long-term home ownership and upward mobility of all income groups, by allowing people to sell one home and use the profit to buy another without paying taxes, and after age 55 to sell their home and move to a less expensive one without tax on any profit to free this money toward quality of life in retirement.

In 1997 that all changed, when Congress passed what now known as "The Taxpayer Relief Act of 1997" More information, details and language on Public Law 105-34 here.

Whatever the original good intentions may be been, the main effect was to explode the entrance of investors into single family homes, using loopholes to gobble up residential properties, artificially inflate their value, and sell to unsuspecting families led astray by concurrent changes in lending practices.

The act allowed for "residential" real estate profit to be tax-free if the owner had owned the house for 5 years and lived in it for two. Combined with a rule called the "1031 exchange", investors posing as "homeowners" have been able to constantly buy, rent and sell property without ever paying a dime of tax.

This activity of well-funded investors in a candy store of tax-free profit, buying up every empty house on every block, sight unseen across state lines, demanding ever-expanding prices when selling (unopposed if not actually abetted by Real Estate brokers), artificially inflated demand and drove real estate prices all over the country far beyond their actual value.

Ultimately, the profiteering has made it harder and more expensive than ever before in our history for the ordinary person to afford to buy a home of their own.

Without the foolish, short-sighted provisions of the Tax Relief Act in 1997, the artificial inflation of real estate values would still be a limited, regional phenomenon, and as such would have been recognized as temporary.

Sub-prime loans would have been limited to the same small percentage of loans they historically occupied - less than 5% - and that portion of this crisis would never have occurred.

(3) The third item is another that is easy to fix, if Congress wanted to fix it: reinstate the portions of the Glass-Steagall Act that were repealed in 1999.

In the late 1990's a number of "banking reform" measures removed limits on the way banks and their investors operated. Many of the restrictions tossed aside had been in place since the 1930s, and had heretofore prevented the abuses and failures that led to the Depression. Most importantly, these old regulations assured stability by controlling speculation, limiting risk,
and reducing potential for conflict of interest.

Less than 10 years after repeal, ungoverned banks had once again raced our economy off a cliff.

Without these restrictions, banks immediately moved agressively into the speculative investment activity previously denied them, consolidating into massive conglomerates that could capture every phase of any financial transaction, including insurance and securities.

This relaxing of standards and legislative abandonment of regulation allowed banks to effectively write their own laws, free to pursue novel structures in lending that maximize profit in a full circle - these new types of financial instruments were not well understood by those issuing them, much less by the customers they sold them to.

Innovations in mortage lending destroyed the previous mutually beneficial relationship between homeowner and lender that held the lender's interests in line with the borrower's over the long range life of the note.

Thus, the traditional mortgage process offered substantial protections to the buyer, including:

(1) protecting the buyer from overpaying for a property by insisting on accurate, 3rd party appraisals. If the appraisal came back below the sales price, the bank could refuse the loan, the buyer could escape the contract, and the usual effect in practice was that the seller would agree to lower their price to the actual fair market value in order to make the sale;

(2) protecting the buyer from purchasing a substandard property that was not safe or sanitary to live in. Banks rightfully required property inspections to be sure the house had glass in the windows, a roof that didn't leak, plumbing and electricity that worked;

(3) protecting the buyer from being unable to pay their property taxes, and from losing everything if the home was destroyed by fire or flood, by using a system of escrow that collected a small amount from each monthly payment towards those charges, which the bank was then responsible for paying each year;

(4) protecting the buyer from risking losing their home by taking on too much debt. Banks, desirous of attracting savings accounts as well as loans, encouraged thrift, and were careful that a family would still have a reasonable percentage of their income left over after paying their monthly mortgage. This prevented buyers from paying so much for their house that they could not afford to maintain it, or to pay for other essential living expenses.

With the passage of the Gramm Leach Bliley Act, this was erased and replaced with a hive-like system designed to pre-empt repayment, exponentially multiply fee-taking, and to profit more from default than from compliance.

So. Lenders sold ugly mortgages, and re-financing schemes, and quick-change credit cards and insurance and checking accounts and car loans, then packaged all those loans and debts up into ugly investments and sold them. Then when it all fell apart, they repackaged it all again and sold it to Congress, who gave them a whole new stack of money and several new laws so they'd keep on selling ugly mortgages, and credit cards and car loans.... and insurance.

Despite a seemingly wide acknowledgment that we need to reinstate Glass Steagall, Congress has yet to do anything about it.


In the end, the repeal of Glass Steagall was only able to destroy our economy and our wealth because the Mortgage Cancellation Tax Relief Act had thrown open the doors of our homes to the wolves, and because of Congress's failure to restore the equitable right of each state's people to prevent usury and regulate how lenders and banks operate within their own state.

Had it not been for those two invitations to rapine by our Congress, the home we live in would still be understood as a long term investment for our old age, more of our population would be homeowners with equity than renters, and our individual states would be able to do what Congress has been unwilling to do: housebreak the wolves, no matter how big they are.

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