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Fixing the Economy
Investments, mortgages, and Social Security

Copyright © 2009 Dorian Scott Cole
About this series.

Abstract

In a perfect storm of financial difficulties leading toward 2018, we have financial market failures, mortgage financing in crisis, and a Social Security system that will run out of funding. Reform that includes mortgage funding could be the perfect answer to a perfect storm.

 

Personal note: I have placed several articles on this site over several years from my study and analysis of our economy. It was a public service (or disservice), and personally intriguing. I'm a complex systems person, and the economy is a very complex system, so it was a challenge. I want to see our economic problems fixed and that is the only interest I have in writing these articles. Not an armchair warrior, I do have many years of experience in managing and analyzing business, as well as a lot of personal experience from living with our economy.

Introducing an economic reform proposal

Recently I sent an economic reform proposal to US Senator Claire McCaskill. Why McCaskill? She represents the people. She's a family person, and has been a prosecutor, a State Legislator, and a State Auditor with a reputation as a true watchdog. She is tackling tough issues in Congress, and is frequently in the news. She gets the job done and makes the government accountable. The paper I sent her proposed innovative but rather conservative solutions to several economic problems, including our financial system, mortgage system, and Social Security, through just one broad reform. In the hope that others would also recommend this to her, or to other Senators, I'm placing a similar version here.

In this paper, I also explain my rationale. None of these are simple systems, and I don't have the benefit of an education in economics or the Congressional Budget Office economic models to work with. I have to study experts in the field, do a lot of work, and then try to explain this in terms everyone can understand.

Why we are in this spot - mortgages and the stock market adjustment

You have to know what went wrong to prevent it from happening again. This is the second time in history that a housing bubble and financial mismanagement have brought the world-wide stock market and financial system to its knees. Last time it created the Great Depression. This time we are looking for any confidence building sign to stop our downward plunge. The key is, we must have confidence in ourselves. We actually have every reason for confidence.

The 1990s, like the 1890s, were the Roaring Nineties of US and world finance. You simply couldn't lose in the stock market. The stock market might have had hiccups over the years, but the trend was always up. Dividends became much less important in the public eye than the rising price of stocks, which presented the bearer with a 10 to 30% annual increase in value, depending on the risk you were willing to take. Hedge Funds were born, didn't have major problems, and were accepted. Many other financial instruments were born, as well as some very creative accounting methods in business. Much of this should have been illegal and regulated as they had not been tested in economic difficulties.

Like most frenzies, this one wore out from dissipation of its own momentum in increasingly difficult markets. The wild gamble on the dot.com model finally ran into reality (no ROI) and burst in 2001 into a million pieces. I was in one of those companies that could have survived, but funding evaporated. The Twin Towers were brought down by terrorists, and suddenly the financial world lost some of its glitter. Investors looked for something more stable - real estate - but others still wanted that 10 to 30% annual increase in stock prices that made people wealthy and guaranteed a great retirement.

What happened in the real estate market was the push to regain the market frenzy that yielded large returns. Back to this in a moment.

In the 1980s through today, what has taken place is a major transfer of wealth from the middle and lower economic class to the wealthier class. It wasn't a conspiracy, or a purposeful thing. It was the result of a systemic... possibility - I don't want to define it as a "problem." It happened because given the right circumstances, it could, it was a "possibility."

Stock prices are not related to pragmatic things like the value of buildings and other real items. Stock prices reflect the confidence that people have that the company will perform, and the competition for that stock. It isn't hype or hot air - it's just our confidence in ourselves. The world has had good reason to be confident - the US and the rest of the world performed well economically. In contrast, today our confidence in our economic system is abysmal, financial companies are performing poorly, and the stock prices reflect that.

The systemic mechanisms that permit the transfer of wealth are many. I believe that one of the main indicators of what was happening is the velocity of money through our system. It's a calculation that the Fed makes, but there is enormous debate about what it means, and it is noted to be directly influenced by rising and falling interest rates, which is tied to the quantity of money (controlling the money supply is a Fed function). The formula indicates how quickly the money moves from Spender A to Spender B (who then re-spends the money, putting it back in circulation.)

Since 1990 the velocity has been slowing. Concurrent with that, individual savings rates have been falling... all the way down to an exceedingly low level. Individual credit card debt has been consistently rising, and credit card interest rates have been quite high. Investment in the stock market by retirement accounts has also been huge. This has created a large pool of liquid assets (cash) for banks, credit card companies, and other financial institutions to invest in stock.

What have the recipients done with all of that money? There has been the largest merger mania in history occurring during the 2000s. In the critical housing sector, investors went wild over real estate, purchasing and trading bundles of asset backed mortgages like they were trading cards.

The transfer of wealth began this way: Credit card interest of 15%, and 14% mortgage interest in the 1980s began sapping money from wage earners, lowering their spending power. Buying on credit wasn't the problem - that actually stimulates the economy. Interest is the problem. Interest lowers spending power. These and other lucrative investment opportunities fueled growth in the stock market, which presented ever higher returns. Everyone got what they wanted - everyone was happy. Credit has its price, but in the superheated economy of the '90s, no one paid much attention that the economic gap between poor and wealthy was growing, and was also eating away at the middle economic class.

These trends continued well into the 2000s, despite setbacks such as the dot.com bubble and terrorist strikes and illegal reporting in business. We would not be beaten. But the real economy was continuing to erode. Mergers eliminated jobs. And instead of companies expanding the jobs with their new gotten riches, as Supply Side economic theory predicts, they just invested in more companies and paid higher bonuses and dividends.

Families had less money to spend, we maxed out our credit, and all the while the stock market seemed to rise to the clouds. Companies got bigger and bigger, financial institutions became as big as the world, and the money went round and round in interest related circles, and stock related circles, and merger related circles. (Velocity fell and wages did not keep pace with inflation.) Money chased round and round in these circles, but it didn't get out to the people for wages.

The parallel thing that eroded middle and lower economic class wealth is this: The wealthy retained their spending power, and earned substantial interest on their investments. But those with no savings lost spending power, and lost money on interest from borrowing the money needed to keep going. The divide grew. The entire financial system moved away from one end toward the wealthy. But there was a tipping point. Individuals got so short on money and good jobs that people couldn't pay their inflated ARM financed mortgages, nor could those who lost their jobs pay their mortgages. The system tipped and slid quickly into recession, and even deflation in some markets. Unemployment rose, causing a tailspin effect with fewer people to buy goods and pay mortgages. Millions are losing their homes. There was a tragic flaw in the system - eventually a massive correction had to happen.

Then the worst of the financial practices came to light. Financial companies were leveraged 30:1. For every real dollar or secured asset they had, they loaned or invested 30. The standard in banking that was considered safe was 3:1, but financial companies outside of banking were not subject to this, and banks apparently were ignoring this rule. Financial companies developed a system to guarantee that stocks wouldn't fail: Stock guarantees.

Companies like AIG (an insurance company) created these "credit default swap" guarantees. Companies could then invest in il-liquid assets. Il-liquid assets are those that cannot be converted to cash because they may not have the value shown on the face of them. These were largely sub-prime mortgage loans from all over the world. They were often bundled by the originating bank, and then another bank who had purchased them, and then another - until the assets were far removed from their point of origin and values were well hidden. Credit default swaps were valued in the trillions of dollars. When people began to run into financial difficulties and couldn't pay their mortgages, the people holding the credit tried to cash in on the guarantee. Oops, that wasn't supposed to happen, especially not on a large scale. The value of everything always goes up, right?

How could all of this happen? The real estate market was hot. The demand for homes by speculators who wanted to flip houses, or just invest and resell, helped drive prices up. Regulation and oversight by the government, and finance company internal auditing safeguards had gone out the window. Financial institutions could make a mortgage loan and sell it for a profit the next day to another institution. So it was flimsy - big deal. They bent over backwards to help everyone get a piece of the American Dream, and to get it people overextended themselves just like they always have. Wages always went up, right?

Everyone was in on it. Appraisers inflated the appraised values of homes - the values were moving up faster than their pencils could write anyway. Internal company underwriters went with it. People were given Adjustable Rate Mortgages that would rise in interest rates to a point that they couldn't pay them, just like they always have since they were invented. Best strategy for ARMs, live somewhere two years, sell and gain collateral through inflation, and then buy another house with a good loan. It's always worked.

If financial institutions had used sound lending practices, the housing bubble would have probably been small, and then investors would have moved on. But one good thing is that it showed us some weaknesses in our system that need safeguards. Another good thing is that the bogus wealth created by the "irrational exuberance" in the stock market has adjusted and will likely settle at more sustainable levels. This doesn't completely undo the transfer of wealth that has been going on since the 1980s, but it does push the reset button and let many people start over in a sounder economy. People need to save money, not purchase on credit.

When people save money, it stimulates the economy in a safer way. Companies that need to expand can borrow it. People who need to build houses can borrow it to purchase land and products. People who save get a growing positive column on their balance sheets instead of a growing negative column. Money keeps moving. Wealth create wealth. People have more money to spend since it isn't evaporating in interest. Large financial companies don't have large pools of liquid assets to play with and put at risk (other people's money). Velocity increases. We all, repeat all, get wealthier.

Some lessons we learned from this crisis are:

  • Companies get so big that if they fail they take down the economy - we need limits on growth and mergers
  • Sound financial regulation is imperative to stop large financial institutions from risky behavior
  • Credit default swaps and similar financial instruments need to be banned. Investors have always spread their risk by spreading their investments over multiple sectors, not by getting guarantees on high risk sub-prime paper.
  • Futures should be as illegal as baseball players gambling on their own team. It can lead to market manipulation
  • Investor pressure pushes company executives to focus on stock prices, not production value, and they engage in risky and illegal behavior
  • We need a stable way to make the American Dream available to those who want it
  • Risky market practices put our future in peril, such as retirement, college savings, and affordable housing
  • We need to stop the sale of mortgages to other financial institutions, unless it is a Fannie May or Freddie Mac type institution. People who purchase mortgages should be able to count on the firm they select, such as a bank or mortgage bank, to service their mortgage locally. Preventing the sale of mortgages would stop the packaging of mortgages and the current financial mess.

Most importantly, we have to rebalance the system. No one can make any money if no one has money to spend.

The Social Security problem

Social Security has funding problems that must be fixed to remain viable after 2018. President Bush offered a plan tied to the stock market. Thankfully that didnít happen, considering the investment mess. But the system could be wiser in how it is financed.

The Social Security system is not an investment system. Payouts rely on what is currently being paid in (pay as you go). This model is OK if there will be an ever-increasing number of people paying in, and steady growth. Neither is close to reality. There are three pay-out bubbles approaching: the baby-boomers reaching retirement age now, followed a generation later by their children, and then the increase in life expectancy.

While payouts increase, the number of people paying in will reach a peak. Population growth likely will increase our population around 30%, while steadily declining to the point of zero growth plus immigration, in around 20 years. Our population growth may remain at 0, like European growth rates, or may slowly rise again. These population patterns leave Social Security funding in a bad place with growing payouts and insufficient and non-growing pay-ins. A non-stock market, sound investment strategy could become part of social security retirement planning, with great benefit to the plan financing and to individuals.

Resolution to these problems: mortgage funding

With the need for stability in our housing market, investment market, and our Social Security system, and the need for secure IRA type investments, there is opportunity for a solution to all of these needs, and this solution is government backed mortgage funding that redirect how some social security contributions are invested.

Social Security is a pay-as-you-go system. The money coming in goes back out in payments to others. It does not guarantee a pay back to contributors - the money doesn't "belong" to them. The current state of the Social Security system is actually healthy. Only around 30% of the contributions coming in are payed out as benefits. What happens to the rest of the contributions? They are used to finance the US government budget deficits. Fair enough - we all benefit from that.

In coming years this situation reverses. In around 2018 the system will begin to pay out more than it takes in. If the system is left unchanged, current retirees can be paid for another twenty years, and then we run into real trouble.

What we need for social security is a secure investment system that helps fund the system reliably into the future. The stock market is not an option, and even the banking system has many difficulties.

What I recommend is a new financial instrument, 5% interest mortgage funding, with a guaranteed pay-out for all of these needs: Social Security investment and a retirement plan (similar to IRAs), that use government backed funding invested in mortgages. Under the plan, a portion of social security payroll contributions would be loaned out in mortgage funding to Fannie May and Freddie Mac, with the promise of a greater financial return for the Social Security contributor. Additional IRA or other savings could also be contributed from paychecks. Of required contributions, 90% would go directly into the government for immediate funding of the SS system (invested in deficits). The other 10% would finance mortgages through Fannie May and Freddie Mac through the purchase of mortgage funding.

Banks and mortgage companies could continue to take the applications, get a loan application fee, and earn 1% interest as a service fee until the loan is paid. The government would get 4% interest for the Social Security System, of which half would be counted as a contribution by the social security payroll name, the other 2% would help to fund payouts, and the payments on principal would fund new loans. If a bank wanted to sell the mortgage, it could only sell the loan to Fannie May or Freddie Mac Ė not to another bank or other investor. Other retirement funds could invest in the system, making their investments more secure. This would likely appeal to those nearing retirement age, or others who canít afford to lose money on standard stocks. Preference would be given to those within the system, but investment would also be available to others.

Through this mortgage funding strategy, the government (Social Security) and mortgage investors would be able to realize the benefits of interest, and the investors would be isolated from market downturns. Within the system, those who wanted to designate a portion of their additional voluntary contribution, to highly rated and safe stock investments (such as utilities, municipal bonds, etc.) could do so.

People could still go to other banks and mortgage lenders for mortgages, and for IRA investments, and investors could purchase mortgage funding, so the financial system for mortgages would remain part of the free enterprise system. Fannie May and Freddie Mac, funded by the Treasury, currently account for 44% of the $12 Trillion US mortgage market. A major part of their current operation is providing capital to mortgage banks. Interest rates for mortgages in this system would be permanently frozen at 5%.

For years, excess Social Security payments have been invested in special US Treasury Bonds, which are used to finance government deficits. This mortgage funding plan would leave that Social Security investment largely untouched, and stabilize it through interest even after 2018 when payouts would have exceeded pay-ins.

In this new plan, 10% of current contributions ($100 billion) would be invested in mortgage funding to capitalize primary residence mortgage loans. Each year, 2% interest would be returned to Social Security, raising Social Security revenue by $2.4 billion the second year, and returning 2% to investors the second year, which would be reinvested in the plan until retirement. The government's share of the interest would also be reinvested until 2018 when it is needed. For the result, see the "Social Security funding through investing 10% of contributions in Mortgage funding" table below.

Factors: Social Security annual revenue in the near future, at current rates, will be around $1,000 billion. Around 7 billion annual additional revenue needs to be available in the Social Security system after 2018. Social Security contributions increase at a ~6% annual rate, but this rate will taper off as the population stabilizes sometime around 2030.

Social Security funding through investing 10% of contributions in Mortgage funding

$ Billion

Invested SS Contributions

Mortgage funding Loans

ROI at 4%

Social Security Portion

Contributor Portion

Year

100

100

4

2

2

2012

120

224

8.96

4.48

4.48

2013

127.2

360.16

14.41

7.21

7.21

2014

134.83

509.40

20.38

10.19

10.19

2015

142.92

672.70

26.91

13.45

13.45

2016

151.5

850.91

34.04

17.02

17.02

2017

160.59

1035.62

41.42

20.71

20.71

2018

170.22

1,247.26

49.89

24.95

24.95

2019

180.44

1,477.59

59.10

29.55

29.55

2020

191.26

1,727.95

69.12

34.56

34.56

2021

In 2018, there would be approximately 3 times the additional amount required for payout. (7 billion is needed in 2018.) The system would be solvent, no increase in Social Security taxes would be required, and all contributors could count on dividing 21 billion or more in interest into their future checks. Cost of living increases would no longer be necessary. The mortgage market would be consistently funded and much more stable than being played in the volatile stock market. Housing prices and mortgage interest would be more stable, but still react to market valuations. This all would be accomplished simply through mortgage funding sold to Fannie May and Freddie Mac from 10% of Social Security contributions (and any additional contributions). We invest in ourselves.

Please express your opinion to US Senator Claire McCaskill or your congressman, at Contacting the Congress.

- Scott

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