Krugmann on Executive Compensation

That rewarding non stakeholders of an enterprise on the basis of short term results is not a sound idea should be self evident. A true stakeholder would in fact reduce his share of profits in order to increase his equity worth through the expansion of value leveraged out of options.

Anything else is down right stupid. A sensible package should always be a good salary and a share in a funded options package

The rise of mega corporations in which acquiring a meaningful stake is impossible has created this present morass of compensation strategies.

In any event, the compensation of bankers is a particular problem unlike any other. The Bank has a special license that allows them to borrow short term and lend long term at a decent multiple. This means that they actually print liquidity in the system. That means that they and almost no one else must be prudent in their lending practices. That means that compensation must reflect the fact that the business should only make a modest profit. If a bank decides it needs to fund something adventurous, it must be made to make the project a stand alone corporation with no formal ties to the bank that could create liability for the bank.

And it is a pretty poor project if unable to attract independent banking support.

So long as bankers compensation is tied to short term results and they can print money to cover over their misdeeds, their behavior will not change. In fact, it cannot change. After all, how difficult is it to have Luigi borrow ten million to acquire Antonio’s failing enterprise packing seven million in debt, somehow securitized by doubtful assets and then resold off shore to cash out the banking profits.

We also need to have the banks separate out true performance compensation from that derived from ordinary brokering. That is were the huge compensations came from in the first place. The president of a bank finds it hard to pay ten times his own salary to some employee he does not even like. Yet properly these are direct costs of real sales and should be actually accounted for as such and disclosed separately.

Many businessmen have destroyed their newly acquired business for failing to realize this. That is why it is unwise to ever wrap the compensation of the rainmakers with the compensation of the operations personnel and the executive.

Op-Ed Columnist

Reform or Bust

http://www.nytimes.com/2009/09/21/opinion/21krugman.html?em

By PAUL KRUGMAN

Published: September 20, 2009

In the grim period that followed Lehman’s failure, it seemed inconceivable that bankers would, just a few months later, be going right back to the practices that brought the world’s financial system to the edge of collapse. At the very least, one might have

But now that we’ve stepped back a few paces from the brink — thanks, let’s not forget, to immense, taxpayer-financed rescue packages — the financial sector is rapidly returning to business as usual. Even as the rest of the nation continues to suffer from rising unemployment and severe hardship, Wall Street paychecks are heading back to pre-crisis levels. And the industry is deploying its political clout to block even the most minimal reforms.

The good news is that senior officials in the Obama administration and at the Federal Reserve seem to be losing patience with the industry’s selfishness. The bad news is that it’s not clear whether President Obama himself is ready, even now, to take on the bankers.

Credit where credit is due: I was delighted when Lawrence Summers, the administration’s ranking economist, lashed out at the campaign the U.S. Chamber of Commerce, in cooperation with financial-industry lobbyists, is running against the proposed creation of an agency to protect consumers against financial abuses, such as loans whose terms they don’t understand. The chamber’s ads, declared Mr. Summers, are “the financial-regulatory equivalent of the death-panel ads that are being run with respect to health care.”

Yet protecting consumers from financial abuse should be only the beginning of reform. If we really want to stop Wall Street from creating another bubble, followed by another bust, we need to change the industry’s incentives — which means, in particular, changing the way bankers are paid.

What’s wrong with financial-industry compensation? In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren’t correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking: some of the men most responsible for the current crisis walked away immensely rich from the bonuses they earned in the good years, even though the high-risk strategies that led to those bonuses eventually decimated their companies, taking down a large part of the financial system in the process.

The Federal Reserve, now awakened from its Greenspan-era slumber, understands this problem — and proposes doing something about it. According to recent reports, the Fed’s board is considering imposing new rules on financial-firm compensation, requiring that banks “claw back” bonuses in the face of losses and link pay to long-term rather than short-term performance. The Fed argues that it has the authority to do this as part of its general mandate to oversee banks’ soundness.

But the industry — supported by nearly all Republicans and some Democrats — will fight bitterly against these changes. And while the administration will support some kind of compensation reform, it’s not clear whether it will fully support the Fed’s efforts.

I was startled last week when Mr. Obama, in an interview with Bloomberg News, questioned the case for limiting financial-sector pay: “Why is it,” he asked, “that we’re going to cap executive compensation for Wall Street bankers but not Silicon Valley entrepreneurs or N.F.L. football players?”

That’s an astonishing remark — and not just because the National Football League does, in fact, have pay caps. Tech firms don’t crash the whole world’s operating system when they go bankrupt; quarterbacks who make too many risky passes don’t have to be rescued with hundred-billion-dollar bailouts. Banking is a special case — and the president is surely smart enough to know that.

All I can think is that this was another example of something we’ve seen before: Mr. Obama’s visceral reluctance to engage in anything that resembles populist rhetoric. And that’s something he needs to get over.

It’s not just that taking a populist stance on bankers’ pay is good politics — although it is: the administration has suffered more than it seems to realize from the perception that it’s giving taxpayers’ hard-earned money away to Wall Street, and it should welcome the chance to portray the G.O.P. as the party of obscene bonuses.

Equally important, in this case populism is good economics. Indeed, you can make the case that reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road.

It’s time for the president to realize that sometimes populism, especially populism that makes bankers angry, is exactly what the economy needs.

Debt Deflation in America

While this is all happening, the reality of prime mortgages going under water and defaulting as a business decision is been slowly rammed home. I posted six months ago that this must not happen.

The sub prime disaster has over loaded the housing market and destroyed bank capital curtailing their ability to lend.

The only solution is to make that inventory disappear and abruptly shrink the market. Because it is now devaluing housing backed by prime mortgages and giving the owners a business decision.

You own a house once worth $500,000 with a mortgage of $400,000 and monthly payments of $5000. The house drops to $300,000, if you can find a buyer. You are facing a $100,000 loss if you sell and you have already lost the original $100,000. So you walk. Over the next two years you accumulate $120,000 less whatever you spend on rent and you are back to been whole. If the bank chases you for the loss incurred which is likely approaching $150,000 after everything you offer them $30,000 to settle. Most likely they will take it.

Yes you take a hit on credit, but they were making you pay all those cards off anyway. Since you have a good job, it is no trick at all to be in a new home in a couple of years at a much better price structure. Your friendly mortgage broker will show you how. The point is that you have shed a $100,000 unrealized loss and picked up a $100,000 cash gain and certainly strengthened your real financial position.

Again as I have posted it is possible to turn this titanic around by my previously posted suggestions that no one is ever going to try. Instead we will expand the unsold inventory and let the banks own it all until no defaulters are left.



Debt Deflation in America

What the Jump in the U.S. Savings Rate Really Means

By Michael Hudson

URL of this article: www.globalresearch.ca/index.php?context=va&aid=14153

Global Research, June 29, 2009

Happy-face media reporting of economic news is providing the usual upbeat spin on Friday's debt-deflation statistics. The Commerce Department's National Income and Product Accounts (NIPA) for May show that U.S. “savings” are now absorbing 6.9 percent of income.

I put the word “savings” in quotation marks because this 6.9% is not what most people think of as savings. It is not money in the bank to draw out on the “rainy day” when one is laid off as unemployment rates rise. The statistic means that 6.9% of national income is being earmarked to pay down debt – the highest saving rate in 15 years, up from actually negative rates (living on borrowed credit) just a few years ago. The only way in which these savings are “money in the bank” is that they are being paid by consumers to their banks and credit card companies.

Income paid to reduce debt is not available for spending on goods and services. It therefore shrinks the economy, aggravating the depression. So why is the jump in “saving” good news?

It certainly is a good idea for consumers to get out of debt. But the media are treating this diversion of income as if it were a sign of confidence that the recession may be ending and Mr. Obama's “stimulus” plan working. The Wall Street Journal reported that Social Security recipients of one-time government payments “seem unwilling to spend right away," 1 while The New York Times wrote that “many people were putting that money away instead of spending it.”2 It is as if people can afford to save more.

The reality is that most consumers have little real choice but to pay. Unable to borrow more as banks cut back credit lines, their “choice” is either to pay their mortgage and credit card bill each month, or lose their homes and see their credit ratings slashed, pushing up penalty interest rates near 20%! To avoid this fate, families are shifting to cheaper (and less nutritious) foods, eating out less (or at fast food restaurants), and cutting back vacation spending. It therefore seems contradictory to applaud these “saving” (that is, debt-repayment) statistics as an indication that the economy may emerge from depression in the next few months. While unemployment approaches the 10% rate and new layoffs are being announced every week, isn't the Obama administration taking a big risk in telling voters that its stimulus plan is working? What will people think this winter when markets continue to shrink? How thick is Mr. Obama's Teflon?

We are living in the wreckage of the Greenspan bubble

As recently as two years ago consumers were buying so many goods on credit that the domestic savings rate was zero. (Financing the U.S. Government's budget deficit with foreign central bank recycling of the dollar's balance-of-payments deficit actually produced a negative 2% savings rate.) During these Bubble Years savings by the wealthiest 10% of the population found their counterpart in the debt that the bottom 90% were running up. In effect, the wealthy were lending their surplus revenue to an increasingly indebted economy at large.

Today, homeowners no longer can re-finance their mortgages and compensate for their wage squeeze by borrowing against rising prices for their homes. Payback time has arrived – paying back bank loans, whose volume has been augmented to include accrued interest charges and penalties. New bank lending has hit a wall as banks are limiting their activity to raking in amortization and interest on existing mortgages, credit cards and personal loans.

Many families are able to remain financially afloat by running down their savings and cutting back their spending to try and avoid bankruptcy. This diversion of income to pay creditors explains why retail sales figures, auto sales and other commercial statistics are plunging vertically downward in almost a straight line, while unemployment rates soar toward the 10% level. The ability of most people to spend at past rates has hit a wall. The same income cannot be used for two purposes. It cannot be used to pay down debt and also for spending on goods and services. Something must give. So more stores and shopping malls are becoming vacant each month. And unlike homeowners, absentee property investors have little compunction about walking away from negative equity situations – owing creditors more than the property is worth.

Over two-thirds of the U.S. population are homeowners, and real estate economists estimate that about a quarter of U.S. homes are now in a state of negative equity as market prices plunges below the mortgages attached to them. This is the condition in which Citigroup and AIG found themselves last year, along with many other Wall Street institutions. But whereas the government absorbed their losses “to get the economy moving again” (or at least to help Congress's major campaign contributors to recover), personal debtors are in no such favored position. Their designated role is to help make the banks whole by paying off the debts they have been running up in an attempt to maintain living standards that their take-home pay no longer is supporting.

Banks for their part are slashing credit-card debt limits and jacking up interest and penalty charges. (I see little chance that Congress will approve the Consumer Financial Products Agency that Mr. Obama promoted as a flashy balloon for his recent bank giveaway program. The agency is to be dreamed about, not enacted.) The problem is that default rates are rising rapidly. This has prompted many banks to strike deals with their most overstretched customers to settle outstanding balances for as little as half the face amount (much of which is accrued interest and penalties, to be sure). Banks are now competing not to gain customers but to shed them. The plan is to offer steep enough payment discounts to prompt bad risks to settle by sticking rival banks with ultimate default when they finally give up their struggle to maintain solvency. (The idea is that strapped debtors will max out on one bank's card to pay off another bank at half-price.)

The trillions of dollars that the Bush and Obama administration have given away to Wall Street would have been enough to buy a great bulk of the mortgages now in default – mortgages beyond the ability of many debtors to pay in the first place. The government could have enacted a Clean Slate for these debtors – financed by re-introducing progressive taxation, restoring the full capital gains tax to the same rate as that levied on earned income (wages and profits), and closing the tax loopholes that effectively free finance, insurance and real estate (FIRE) sector from income taxation. Instead, the government has made Wall Street virtually tax exempt, and swapped Treasury bonds for trillions of dollars of junk mortgages and bad debts. The “real” economy's growth prospects are being sacrificed in an attempt to carry its financial overhead.

Banks and credit-card companies are girding for economic shrinkage. It was in anticipation of this state of affairs, after all, that they pushed so hard from 1998 onward to make what finally became the 2005 bankruptcy laws so pro-creditor, so cruel to debtors by making personal bankruptcy an economic and legal hell.

It is to avoid this hell that families are cutting their spending so as to keep current on their debts, against all odds that they can avoid default in today's shrinking economy.

Working off debt = “saving,” but not in liquid form

People are putting more money away, but not into savings accounts. They are indeed putting it into banks, but in the form of paying down debt. To accountants looking at balance sheets, savings represent the increase in net worth. In times past this was indeed the result mainly of a buildup of liquid funds. But today's money being saved is not available for spending. It merely reduces the debt burden being carried by individuals. Unlike Citibank, AIG and other Wall Street institutions, they are not having their debts conveniently wiped off the books. The government is not nice enough to buy back their investments that had lost up to half their value in the past year. Such bailouts are for creditors and money managers, not their debtors.

The story that the media should be telling is how today's post-bubble economy has turned the concept of saving on its head. The accounting concept underlying balance sheets is that a negation of a negation is positive. Paying down debt liabilities is counted as “saving” because one owes less.

This is not what people expected a half-century ago. Economists wrote about how technology would raise productivity levels, people would be living in near utopian conditions by the time the year 2000 arrived. They expected a life of leisure and prosperity. Needless to say, this is far from materializing. The textbooks need to be rewritten – and in fact, are being rewritten.3

Keynesian economics turned inside-out

Most individuals and companies emerged from World War II in 1945 nearly debt-free, and with progressive income taxes. Economists anticipated – indeed, even feared – that rising incomes would lead to higher saving rates. The most influential view was that of John Maynard Keynes. Addressing the problems of the Great Depression in 1936, his General Theory of Employment, Interest, and Money warned that people would save relatively more as their incomes rose. Spending on consumer goods would tail off, slowing the growth of markets, and hence new investment and employment.

This view of the saving function – the propensity to save out of wages and profits –viewed saving as breaking the circular flow of payments between producers and consumers. The main cloud on the horizon, Keynesians worried, was that people would be so prosperous that they would not spend their money. The indicated policy to deter under-consumption was for economies to indulge in more leisure and more equitable income distribution.

The modern dynamics of saving – and the increasingly top-heavy indebtedness in which savings are invested – are quite different from (and worse than) what Keynes explained. Most financial savings are lent out, not plowed into tangible capital formation and industry. Most new investment in tangible capital goods and buildings comes from retained business earnings, not from savings that pass through financial intermediaries. Under these conditions, higher personal saving rates are reflected in higher indebtedness. That is why the saving rate has fallen to a zero or “wash” level. A rising proportion of savings find their counterpart more in other peoples' debts rather than being used to finance new direct investment.

Each business recovery since World War II has started with a higher debt ratio. Saving is indeed interfering with consumption, but it is not the result of rising incomes and prosperity. A rising savings rate merely reflects the degree to which the economy is working off its debt overhead. It is “saving” in the form of debt repayment in a shrinking economy. The result is financial dystopia, not the technological utopia that seemed so attainable back in 1945, just sixty-five years ago. Instead of a consumer-friendly leisure economy, we have debt peonage.

To get an idea of how oppressive the debt burden really is, I should note that the 6.9% savings rate does not even reflect the 16% of the economy that the NIPA report for interest payments to carry this debt, or the penalty fees that now yield as much as interest yields to credit-card companies – or the trillions of dollars of government bailouts to try and keep this unsustainable system afloat. How an economy can hope to compete in global markets as an industrial producer with so high a financial overhead factored into the cost of living and doing business must remain for a future article to address.

Notes

1 Kelly Evans, “Americans Save More, Amid Rising Confidence,” Wall Street Journal, June 27, 2009.
2 Jack Healy, “As Incomes Rebound, Saving Hits Highest Rate in 15 Years,” The New York Times, June 27, 2009.
3 Four years ago at a post-Keynesian “heterodox economics” conference at the University of Missouri at Kansas City (on whose faculty I have been for some years now), I outlined the shift from over-saving to debt deflation. Michael Hudson, “Saving, Asset-Price Inflation, and Debt-Induced Deflation,” in L. Randall Wray and Matthew Forstater, eds., Money, Financial Instability and Stabilization Policy (Edward Elgar, 2006):104-24.

Terry Corcoran on Greenspan Policy Failure

The bottom line is that the unprecedented credit collapse that we have experienced is completely a failure of governmental policy. The governors put into the system by Franklin Roosevelt with the assistance of some pretty knowledgeable folks were simply taken off toward the end of the Clinton administration and once again it was all allowed to run its course in the face of plenty of wiser heads.

When I saw them been removed, I wondered what they were thinking. Now we learn that the motive was to put a group of financially weak voters into houses, almost regardless of the cost. Now the bill has come due, and all these folks are out on their ass. How could this have had any other outcome?

When the history of these days is written, this failure will carry all the blame. An economy maintaining a four percent growth for the preceding twenty years as a result of Reagan’s tax reform was diverted into the business of destroying capital.

The tragedy is that once the horse was out of the barn, it was clearly impossible to get it back under control until the credit system itself collapsed under the weight of bad assets. I really do not think that congress or the president or the fed had the tools to actually stop the train wreck. In fact the fed facilitated the wreck by providing cheap money, although that only served to speed up the train by a couple of years.

The nation’s major banks have all lost their capital and now the nation’s reserves and possibly the capital of the globe’s banks. They could not stop it either.

Quantum of Failures

Forget the markets: massive government failure is behind world financial chaos

Terence Corcoran, Financial Post Published: Saturday, October 25, 2008

In Quantum of Solace, the new James Bond movie due next month, our hero takes on the latest threat to mankind and the survival of the free world: a businessman. Of course!

So it has been in film for decades. Now, apparently, it is true in life. Businessman as scourge is the dominant ideology of our time. We all know that most people see market-driven bankers, brokers and corporate bosses as the root of evil, corrupted and greedy--even though we all ravenously consume the products produced by market-driven business.

The concept of corporate evil is embedded in the bones of our culture; it is now taken for granted that markets and capitalism are flawed in practice and must be regulated and controlled, if not destroyed. Even in 1960, in the deep freeze of the Cold War with communism and the Soviet Union, Ian Fleming's Dr No has James Bond taken captive on a Caribbean island. No statist Fidelistas on this island. As Bond enters the underground lair of Doctor No, he stops dead in his tracks: "It was the sort of reception room the largest American corporations have on the President's floor in their New York skyscrapers."

Economics is like the movies. It's filled with papers, text books and arcane treatises referencing market failure, the general idea being that unfettered capitalism inevitably generates unwanted outcomes and, in some cases, total disaster. It's a core Marxist theme, a staple of Keynesian economics, that permeates the work and thought of just about every economic school of the ideological spectrum.

From major league economists to top rank demagogues, the message from the current economic crisis is clear. "It is the end of capitalism," said Iran's President Mahmoud Ahmadinejad, as good an authority as any these days. To steal a famous phrase, it seems like "We're all Muslim extremists now."

This week, Alan Greenspan, of all people, joined the market-failure parade. He has his reasons, of course. Better the market should take the hit for creating the mortgage and financial crisis than anything he did to monetary policy as chairman of the U. S. Federal Reserve during the great U. S. housing boom. More about Mr. Greenspan later.

Bashing markets is fun, convenient and politically popular. But it also takes a certain willful disregard of events and policy to reach the conclusion that capitalist failure brought the world economy to its knees. Only conscious effort and stubborn, even malicious, obtuseness could lead anyone to conclude that, on the basis of recent events, the sources of the financial meltdown are corporate, that big business made us do it.

The role of bankers and other market players in causing the current crisis is undeniable, but it is limited compared with the massive role played by governments. From U. S. housing policies to financial regulators to central bank actions all over the world, the evidence is overwhelming that the causes of today's turmoil can be traced to massive government failure.

This failure of policy, moreover, is now being compounded. From the G7 to the G20 and beyond, governments are scrambling to push through measures and policies that cannot possibly have been thought through or properly evaluated. Bad interventions are inevitably being poured on to extinguish the fires created by previous bad interventions.

How did we get to this perilous juncture? One starting point is as good as another. But if the proximate trigger for the financial meltdown was the U. S. subprime housing fiasco, the roots of that crisis offer pure examples of government failure and regulatory policy run amok.

The front page of The New York Times last Sunday told the story of Henry Cisneros, the top housing official in the Bill Clinton administration during the 1990s. As The Times described it, Mr. Cisneros "loosened mortgage restrictions so first-time home buyers could qualify for loans they could never get before." He then went on to join the boards of a major U. S. home builder and of Countrywide Financial, the mortgage lender at the epicentre of the U. S. subprime mortage collapse. (For a list of some of the references used in the writing of this article, see www.financialpost.com/fpcomment.)

The Clinton administration set out to boost home ownership in the United States, then languishing at 64%. It began earnest work on the project under Mr. Cisneros, the first Hispanic to head the Department of Housing and Urban Development (HUD). As a direct result of HUD policy, families no longer had to prove five years of income. All they needed was three. Lenders no longer had to interview borrowers face to face.

Reacting to these and other more significant policy changes, lenders such as Countrywide Financial in California set up units to service these so-called subprime borrowers. "We were trying to be creative," Mr. Cicernos told the Times.

Mr. Cicernos sat on Countrywide's board for years. He left last year, shortly before the mortgage giant, on the brink of bankruptcy, was taken over by Bank of America. It had $170-billion in mortgage assets, most of them subprime. Countrywide CEO Angelo R. Mozilo is now the target of regulators, politicians and the media.

During Mr. Cicernos' time on the board he sat on Contrywide's regulatory committee, overseeing compliance with law and regulation, but he says he does not now recall seeing reports that one in eight of Countrywide's loans was "severely unsatisfactory" due to shoddy underwriting.

But Mr. Cicernos, the Clinton administration, Countrywide, and eventually the Bush administration, were merely vehicles for radical mortgage lending ideas promoted by housing activist groups and political operators. The full horror story of the regulation-induced breakdown in U. S. mortgage markets is to be told in a forthcoming new book, Housing America: Building Out of a Crisis, from the Independent Institute in Oakland, California.

The idea that the U. S. subprime mortgage collapse is the product of unscrupulous agents and lenders roaming the country in a deregulated market searching for ignorant buyers is overwhelmed by contrary facts. In "Anatomy of a Train Wreck: Causes of the Mortgage Meltdown" (a chapter in Housing America), University of Texas economics professor Stan J. Liebowitz documents the deliberate government policies that were brought in to destroy U. S. mortgage lending standards, pillage banks and socialize risk.

It begins with the idea, long held among activists, that U. S. mortgage lending practices prevented home ownership among low income and certain racial groups. Banks and other lenders, following normal and prudent lending standards, were accused of discrimination. The solution: Relax lending standards. One step along that road was the 1970 U. S. Community Reinvestment Act, forcing banks to lend equally to all geographic areas, regardless of risk.

A later pivotal event in the decline in lending standards, according to Prof. Liebowitz, came after 1992 when the Federal Reserve Bank of Boston conducted a study that purported to show that racial and income discrimination in mortgage lending continued to exist. It accused lenders of applying "arbitrary or unreasonable measures of creditworthiness."

Prof. Liebowitz says the study was based on "horribly mangled data" and was riddled with errors. But it was politically correct, and it rose to become the basis for new national mort-gage lending standards that ignored essential principles of mortgage lending. Lack of credit history should not be a negative factor. Traditional income-to-loan ratios of 28-to-36% should not apply to low-income individuals. Maybe 5% would do. Lenders should not discriminate against certain sources of income, such as short-term unemployment insurance benefits.

The new risk paradigm "comports completely with common sense," said Boston Fed President Richard Syron, a former head of Freddie Mac, the U.S. government mortgage backer.

The impact of these new "equal opportunity" lending guidelines - described as "flexible underwriting standards" --was dramatic, says Prof. Liebowitz. "As you might guess, when government regulators bark, banks jump. Banks began to loosen lending standards. And loosen and loosen and loosen, to the cheers of politicians, regulators and GSEs."

GSEs are Government Sponsored Entities, U. S federal agencies charged with lending and insuring mortgages. Fannie Mae and Freddie Mac-- long charged with facilitating home ownership -- became out-of-control participants in the sub-standard lending explosion that followed. With the Boston Fed and other risk studies apparently showing that low-income mortgages issued under new lax standards were just as sound over time as prime mortgages, by 2001 and 2002 the U. S. housing market had become a subprime rampage.

Politicians in Congress fueled the explosion. The incestuous relationships between Congress and the GSEs is now well known, but still conveniently underplayed. For years, Fannie Mae and Freddie Mac-- right up to their multi-trillion-dollar bankruptcy and seizure by the U. S. government earlier this year -- roared out of control. They funded politicians' interests, kept mortgage interest rates low and became government-backed agencies for trillions of dollars in risky mortgage lending.

Between 1995 and 2007, the combined balance sheet of Fannie Mae and Freddie Mac, including Mortgage Backed Securities (MBS), rose from $1.4-trillion to $4.9-trillion, an annual increase of almost 15%. At $4.9-trillion, the value of these risks in the two GSEs is slightly less than the total public debt of the U. S. government. About $1-trillion dollars of Fannie/Freddie activity involved exposure to subprime and lower-grade mortgages. For an overview of the rise and fall of Fannie Mae and Freddie Mac, including their corrupt links to Congress, see The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac, by Peter Wallison and Charles Calomiris, for the American Enterprise Institute.

In 2004, then Fed Chairman Alan Greenspan warned of the looming risk in the government-backed mortgage lenders. Fannie and Freddie, he said, were taking on trillions in mortgage assets without properly accounting for, or charging for, the risk embedded in the new lax lending standards. In 2005, Mr. Greenspan explicitly warned of "systemic risk" if the two operations failed to change their ways.

Some tightening of Fannie and Freddie activity did occur, in part as a reaction to accounting scandals within the agencies, but growth exploded again in 2007. At the end of 2007, the two agencies accounted for 75% of new residential mortgage lending. James Lockhart, head of the Office of Federal Housing Enterprise Oversight, which regulates the two organizations, estimated they would soon be financing or guaranteeing 90% of new mortgages, a near monopoly.

On the surface, the mortgage push succeeded. Home ownership expanded from 65% to 69%, although most observers now believe the whole exercise was undesirable, an impossible extension of the American Dream. There inevitably must be essential financial and economic limits to home ownership. The apparent success was based on fundamentally unsound regulatory policy and massive amounts of government-backed funding.

The rapid and dramatic rise in ownership, fueled by mortgage credit, produced big increases in home prices. As prices rose, the risk flaws were overshadowed. This gave rise to even greater use of credit, as speculators and buyers piled onto a credit and ownership machine that seemed to offer no risk and guaranteed gains. No-down-payment mortgages or even 110% mortgages were easily obtained. Rising prices, fuelled by easy credit, spilled the housing bubble into the prime U. S. housing market.

Not all funding came via government and regulatory overreach. Hundreds of billions were raised through MBS and other risk-distribution vehicles by private players. But here too heavy doses of regulatory input and support played a significant role. The mortgages issued under new sloppy and risky lending standards were assembled and packaged and then sold as AAA-rated securities.

Rating agencies were given their power over investment and lending decisions by government. Government required financial institutions, such as insurance and investment funds, to investment in securities rated by National Recognized Statistical Rating Organizations, approved by the SEC. Only three met with SEC approval: S&P, Moody's and Fitch. Lack of genuine market competition in the ratings business, and its dependence on regulation for authority, have long been seen as hazards no regulator would take on.

The ratings firms, assured of business, fell into the lending assessment trap laid out by the Boston Fed and others. They became part of the social program. The new mortgage myth claimed that subprime mortgages issued under lax standards to low income Americans were no more risky than prime mortgages, especially when they were packaged into large agglomerations. Says Prof. Liebowitz: "Given that government-approved rating agencies were protected from competition, it might be expected that these agencies would not want to create political waves by rocking the mortgage boat, endangering a potential loss of their protected profits." Ratings inflation ensued, with AAA and other high ratings accorded to all manner of high-risk mortgage products.

Investment houses became part of the regulatory imperative. A sales pitch from Bear Stearns, circa 1998, tells investors that the old mortgage lending rules have been replaced and that mortgages granted under Community Reinvestment Act provisions are as safe as prime mortgages. "Do we automatically exclude or severely discount...loans [with poor credit scores]? Absolutely not," said Bear Stearns.

This giant circle of risk, constructed around regulation and government policy, worked all too well. In worked, mostly, because of rising home prices that covered over the risk.

Crucial to the story is the role of another U. S. government agency, the Federal Reserve under Alan Greenspan. Mr. Greenspan's low-interest rate policy -which brought the Fed funds rate to 1% through much of 2003-- helped push home values up even higher. As values rose, the lax lending standards started to look even better. Look, Ma, no loan failures!

The new paradigm seemed to be working even better than expected, making rating agencies, Fannie, Freddie, investment dealers, bankers and MBS packagers and buyers even more aggressive and more confident that the new flexible lending standards--built on the premise of ever-rising home prices--were bulletproof. Countrywide Financial, whose board former HUD director Henry Cisneros sat on, was by 2007 the largest provider of loans purchased by the government-controlled Fannie Mae, accounting for 29% of its business.

Greenspan now downplays his role in propelling the mortgage boom or the economy and the risk profile of ever higher debt. He blames a mysterious "tsunami of risk" and, in testimony before a Congressional committee Thursday, market failure. He claimed "shocked disbelief" that bankers and institutions could have failed to properly assess risks in mortgage securities.

Blaming bankers gets Mr. Greenspan (author of last year's best-selling memoir, The Age of Turbulence) off the hook for what others clearly feel he bears much responsibility. That certainly is the view of Anna Schwartz, the 92-year-old coauthor with Milton Friedman of the 1963 classic Monetary History of the United States.

In an interview with The Wall Street Journal last Saturday, Ms. Schwartz noted that the house-price boom began with the very low interest rates in the early years of this decade under Mr. Greenspan. "Now," she said, "Alan Greenspan has issued an epilogue to his memoir." In it, Ms. Schwartz says Mr. Greenpan concedes "it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated."

In other words, says Ms. Schwartz, Mr. Greenspan "absolves himself. There was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't really want to damage." Ms Schwartz adds, "I don't think that that's an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom.",

The mortgage and financial crisis now sweeping the world is the product of a colossal build-up of unintended consequences brought on by government policy and regulation. Other regulatory rules accelerated the meltdown, including post-Enron mark-to-market accounting rules and international bank capital standards that were brought in without adequate thought or preparation.

What we are witnessing today, as governments pile on massive new rounds of intervention, is a growing pyramid of government failures. It will take more than James Bond to break the pyramid.